Comments on TIPS Article in the WSJ

This morning, Min Zeng and Carolyn Cui from the WSJ wrote a terrific piece For Treasury, a Question of Fundamentals / Department Seeks Answers for Inflation-Protected Securities.

I would add that two factors are operative in pushing real yields (TIPS) higher:

First, investors are re-balancing their portfolios from bonds to stocks on the heels of tapering comments.  A Fed less active in purchasing Treasury obligations at some future date reduces the constant bid for all Treasuries – TIPS included.

Second, the TIPS market was mispriced with negative yields.  Inflation is positive at present…and will likely remain substantially above zero for the foreseeable future.  June CPI inflation reached 1.8% on a year-over-year basis up from 1.4% the previous month,

The bottom line is Fed purchases have distorted pricing in the Treasury market.  Changes on the margin prompt swift shifts in pricing and yields.

Comments on Dudley Interview with Bloomberg’s McKee

Bloomberg’s Mike McKee conducted an interesting interview with FRBNY President Bill Dudley.

When asked about concern surrounding the potential for a spike in interest rates, President Dudley offered two points (at about the 8 1/4 minute mark).  I take issue with each.

(1) President Dudley noted that “people are talking about this [a spike in interest rates] all the time.”  Based on his experience, when events are anticipated, “things don’t happen.”

My sense is that this is an overly simplistic view.  Three illustrative examples immediately spring to mind.

NASDAQ:  Although many market participants were “talking about” a correction in tech stocks for months before the collapse beginning in April 2000, this did not “prevent” the Nasdaq from falling by 78%.

ARGENTINA:  The Argentine peso collapse in 2002 was the most telegraphed crisis in the history of recent financial crises.  Although anticipated, the peso plunged by 73% versus the USD and the economy sunk by 16% in real terms.

CARRY TRADE AND BANK OF JAPAN:  In late 2005 and early 2006, market participants were “talking about” the impact of Bank of Japan’s exit from its Zero Interest Rate Policy (ZIRP) scheduled for March 2006.  It was widely discussed and anticipated.  Nonetheless, the Nikkei peaked at the end of March 2006 and plunged by 19% into June.  Similarly, the exit from ZIRP triggered a correction in emerging market currencies – despite the fact that everyone was talking about it.

The bottom line is that expectations do not preclude events from occurring.  What could be argued is that when events are anticipated, the potential damage is reduced, since economic agents are forewarned and can protect themselves.  This assumes, however, that the agents know the “correct” response to such signals.

(2) President Dudley noted that the risk of a spike in interest rates is diminished as the Fed holds many of the “long duration assets” on its balance sheet, resulting in less risk for the private sector.

This is false for many reasons – as it both focuses on flows versus stocks and misses the linkage between public and private debt markets.

Many interest rates in the private sector are based on their spread to Treasury yields.  So any move higher in Treasury rates will immediately impact private credit markets.  Similarly, the stock of Treasury debt dwarfs flows.  So, if private market participants (either domestic or foreign) get nervous, their resultant selling paper will drive yields sharply higher still.

Going forward, the optimal path for the Fed is to more precisely hone its communication and be less dismissive of realistic risks.

Bill Poole on the Budget

Former St. Louis Fed President William Poole wrote an extremely thoughtful and provocative opinion piece in WSJ this morning – A Primer for Understanding Obama’s Budget.  The piece finds fault in the budgeting process across generations and party lines.

Sadly, there is no independent entity to report a reasonable baseline for benchmarking.  It is simply too costly.

So…perhaps…it is time for the Federal government to get the math right.

Some Thoughts on the Cyprus Situation

Watching the Cyprus situation unfold, I have to admit to being amazed / captivated / distraught / panicked (not necessarily in that order). Many times over the past few days I have started to write something only to stop because I didn’t know what to say that hasn’t already been said. But here are a few thoughts about the proposal (vetoed Tuesday in Cyprus’ parliament) that depositors share some of the burden:

(1) It was such a surprise that we’re not even sure what to call it.

This is a bit of an overstatement, I know, because there certainly was a precedent for foreign deposits being at risk of loss after the European Free Trade Association ruling in January regarding Iceland’s limited responsibility to its foreign depositors [1]. But the Cyprus proposal did generate a wide variety of phrases to describe the mandatory participation of depositors, e.g., tax, levy, seizure. The term expropriation also comes to mind – a “deposit grab” for short.

But here’s another way to think about it – an unprecedentedly-negative nominal interest rate. When I first started covering the inflation-linked bond market, I remember highlighting a key distinction between real and nominal yields – the former could be negative whereas the latter could not, in part because no one would tolerate paying a bank to hold their funds when they had a mattress as an alternative. Over time, however, our tolerance for negative nominal yields has increased, albeit mainly under the veil of transactions fees. And while the discussion over quantitative easing often centers on what happens when a central bank reaches the zero lower-bound, in practice there have been some brief examples where the bound has been breached [2]. Perhaps the deposit-grab has taken quantitative easing to a whole new level.

(2) Banks more generally face a deposit catch-22

What this situation in Cyprus has highlighted is just how important deposits are to the health of the financial system. At some level, this was already known – on one hand, deposits are a source of liquidity for a bank. It’s one of the reasons why when a bank fails, its deposits are usually quickly taken over by another institution (related to the reputation point above, this also means that deposit guarantees are rarely required to pay out). But just as quickly as they appear, deposits can also evaporate. More deposits means more liabilities, requiring a bank to hold more capital to protect itself from a potential erosion. As a result, deposits are linked to capital ratios.

One way to reduce the liability side of a bank’s balance sheet and hence improve its capital position is by shrinking its deposits. The direct threat the proposal posed to deposits, even though rejected, suggests that the objective may be fast achieved. Hence the proposal that depositors share some of the burden may have been a misguided attempt to provide much-needed liquidity while at the same time improving the capital position of the banking sector.

(3) Reputation has taken a huge hit

Whenever I talk about the recent financial crisis, one of the things I highlight is the importance of reputation when confronted with challenges. Like regulatory capital, reputation serves as a buffer providing a firm, or a sovereign, with the ability to overcome difficulties. Without it, things can quickly spiral out of control.

The proposal that emerged over the weekend on Cyprus has irreparably damaged reputation at a time when it is most needed. Gone is the credibility of political leaders – just one week before the proposal was announced, Cyprus’ president said losses on depositors were “out of the question”. This is reminiscent of assurances various banking chief executives made in the early stages of the financial crisis – our confidence has been thoroughly undermined. Gone also is the credibility of the European deposit guarantee. Now that a deposit-grab has been put on the table, it is hard to envision a clear path to reopening the banks in Cyprus while avoiding a massive deposit outflow (as I write this, the “bank holiday” has been extended through the weekend).

[1] Duxbury, Charles, and Charles Forelle, “Iceland Wins Case on Deposit Guarantees,” Wall Street Journal, January 28, 2013, available at http://online.wsj.com/article/SB10001424127887323375204578269550368102278.html.

[2] Keister, “Why Is There a “Zero Lower Bound” on Interest Rates?” Liberty Street Economics blog, Federal Reserve Bank of New York, November 16, 2011, available at http://libertystreeteconomics.newyorkfed.org/2011/11/why-is-there-a-zero-lower-bound-on-interest-rates.html.

Fed Policy Drives Equities: Just Released Money Supply Data

Today, CFS monetary and financial data should help the Federal Reserve and market participants refine relative costs and benefits from the present monetary policy mix.

Our study shows how the policy of purchasing Treasury and mortgage securities by the Federal Reserve or quantitative easing (QE) accentuates swings in equity markets.

Yet, recent gains in CFS Divisia M4 are consistent with improved economic growth of 2.5% to 3%.

For Monetary Notes and Views:
http://www.CenterforFinancialStability.org/amfm/Highlights_Feb13.pdf

For Monetary and Financial Data Release:
http://www.CenterforFinancialStability.org/amfm/Divisia_Feb13.pdf

Campaign to Fix the Debt Letter

The Campaign to Fix the Debt has worked with former presidential
advisors and more than 150 economists and thought leaders to pen a bipartisan letter urging that Congress and the President enact a plan now that strengthens our economy, phases in gradual but necessary reforms, and puts our national debt on a downward path relative to the size of our economy.

As friends of the CFS know, we have enthusiastically promoted the idea of debt and deficit reform in the United States.

The Campaign’s letter can be viewed here.

For CFS work on specifics:
The Financial State of the Union, September 20, 2012
Demand for U.S. Debt Is Not Limitless, WSJ, March 28, 2012
Budget Solutions: Then and Now, July 19, 2011
Treasury Maturities: The Other Fiscal Problem, March 10, 2011
Hidden Risks from Expanding Governments, May 11, 2010

Overstated Hit to Retail Spending

The WSJ this morning published a terrific piece on the hit to retail spending due to the 2% hike in payroll taxes (see Payroll Tax Whacks Spending).

To be sure, higher taxes are problematic.  However, the piece overstates the damage from this one measure to the overall economy.

Prior to posting the CFS monetary aggregates and components earlier this week, we combed the data for key themes such as the impact of the payroll tax hike on the economy.  It is clear that the 2% boost in payroll taxes marginally reduced liquidity in the banking system.  However, the small decline in bank deposits could also reflect the drawing down of funds to invest in strengthening stock markets.

So on balance, the payroll tax hike is an unfortunate drag on growth.  However, the financial system is heeling.  Banks and corporations are flush with liquidity.  So even if retail spending is reduced on the margin (the WSJ notes that a family with an annual income of $65,000 will lose just over $100 per month in spending power), corporations are and will continue to invest.  This too is clear from the CFS monetary and financial data.

Better Growth Ahead: Money, Markets and the Fed

Today’s Forbes column by Lawrence Goodman notes that:

The economy seems to be coming back and is stronger than indicated by the GDP statistics released this morning. The Fed may reach its 6.5% unemployment target sooner than many expect.

The financial sector appears to be on the mend – based on CFS money and banking data.

Corporate cash balances are beginning to migrate into the economy.

Financial market distortions – as evidenced by the value of bonds and stocks – are at extremes not witnessed in over 90 years.

To view the column:
http://www.forbes.com/sites/greatspeculations/2013/01/30/bernanke-still-pouring-shots-of-qe-to-markets-already-drunk-on-liquidity/

View on WSJ “QE’s Impact Defying Logic”

The Wall Street Journal’s Tom Lauricella wrote a thoughtful piece this morning called QE’s Impact Defying Logic.  The story focused on FX markets.

I enjoyed the perspective.  However, two counter examples resonate:

1) The comparison is largely against the majors.  Countries from Korea to Costa Rica to Brazil are screaming about outsized currency moves and pressure.  This is due to QE by the major central banks.  So, QE is impacting currency markets.

2) QE is also having a dramatic influence on asset prices – see http://www.centerforfinancialstability.org/amfm/Highlights_Nov12.pdf.

The article raised the point that if inflation ultimately pushes higher in the US, major currencies will suffer.  The question remains.  Which one will fall furthest?

We believe that the CFS monetary and financial data will help provide an early warning signal.