Operation Twist

Today the Fed announced a new measure called operation twist. The idea behind this move is that they will be selling about 400 billion dollars in short maturity bonds (3 years or less) and will use the proceeds to buy an equivalent amount of bonds of longer maturities (6 years or more). This will have no effect on the Fed’s balance sheet because they will be selling the same value of assets as they will be purchasing. However, this will extend the average maturity of bonds that the Fed holds from 6 years to just over 8 years. Part of the Fed’s logic is that short term rates cannot raise very much because the Fed Funds rate is practically 0% and the Fed has pledged to keep it there until at least mid-2013. On the other hand, they do believe that the purchases have the ability to drive long term rates lower. The 10-year yield is considered to be an important benchmark for mortgages so any reduction could potentially help support weak home prices and make mortgages more affordable.

There is a pretty widespread belief that the Fed’s move today will have almost no effect on the general economy. If the Fed’s round of QE2 in which they purchased 600 billion of long term securities had no measurable impact on the economy, then surely “operation twist” which is dealing in lower sums and doesn’t even expand the Fed’s balance sheet will likely not have any substantial effect either. 61 percent of economists polled by bloomberg predicted that the move would not have a meaningful impact on unemployment and 15 percent thought it would have a potentially harmful effect. Todays drop in the dow of 2.5% was further proof that Fed’s move is not being met with great hope from investors. The best thing that could be said about today’s move is that it drove many of us to listen to an old classic.

Thoughts On Interest Rates

Here are some thoughts on the S&P debt downgrade as well as a discussion of interest rates.

Firstly, I don’t think that interest rates are going to be that affected at least soon. If you are an investor, it is hard to imagine that you haven’t already done your own calculations about the creditworthiness of the US government and all the other factors that affect interest rates. So for instance if you are a big bond investor, it’s hard to imagine that haven’t already analyzed the governments balance sheet and assessed the political climate – so just because one rating agency moved their credit rating of US sovereign debt from AAA to AA+, it unlikely that you would all of sudden start dumping your holdings of treasuries. So for example, if the analysts at Pimco had decided to buy and hold government bonds, I can’t imagine that they would alter their decision based on S&P having a slightly different analysis than them (Moody’s and Fitch still agree with the AAA rating).

So in the short term I don’t think we are going to get a spike in interest rates. That being said, I think this event is significant in that it sheds light onto the fact that many factors driving interest rates are going up in the long term.

Here is a list of factors that i think over the long term will put upward pressure on interest rates.

1. Fed Funds Target Rate – It’s hard to imagine that the fed can keep interest rates at 0 forever. Someday interest rates will rise back to a more normal level of 4 to 5%.

2. Inflation – Milton Friedman once famously said that “inflation is always and everywhere a monetary phenomenon”. With massive money printing through several quantitative easing programs and ultra stimulative monetary policy, it is hard to imagine that sooner or later it won’t show up as inflation. It is likely that inflation has already started to show up in higher food and energy prices.

3. Credit Premium – Although, I said the S&P downgrade wouldn’t likely affect interest rates severely in the short term – it signals that there might be a higher credit premium built into treasuries at some point. It will be interesting to track the premiums on credit default swaps that insure US government bonds. I think that the issue of demographics will be a large factor that strains government finances. There will be many more Americans eligible for social security retirement benefits as well as increased health care spending over the coming years. Over the next 20 years roughly 80 million Americans will be eligible for social security. According to the US Census, the dependency ratio measured as the percentage of people over 65 to those of working age population will rise from 22% to 38% in the next 25 years.

4. Liquidity premium – This could be a factor but only once a crisis unfolds. The treasury market will remain liquid unless there is an investor panic of sorts. This would likely result in a flight to safety to Gold.

5. The End of QE – The end of Quantitative easing means less demand and that the Fed will no longer be suppressing long term yields.

6. Foreign demand – Countries like China, Russia and Brazil have been vocal about their displeasure with the United States handling of their finances. It is unlikely that China will suddenly dump US bonds but they could just let some of it mature or diversify their investments a bit more. That could also mean lower demand.

7. Supply – More debt (more supply) since the debt deal that was passed did very little to affect the upward trend of debt, this will also put upward pressure on interest rates.

I still don’t think that interest rates are going up severely in the short term. However, i do see many long term factors that will put pressure on interest rates to rise. Just like in the last crisis, problems only started unfolding once interest rates started to rise and homeowners with adjustable rate mortgages couldn’t afford to pay the interest payments, the US government will also have much greater problems once interest rates start to rise. That will likely be a weight on the entire economy.

The New Central Bankers Dilemma

When I penned the song Central Bankers Dilemma in the summer of 2008, I was writing about the dilemma a central banker faces during a period of stagflation. When a central banker raises interest rates he constrains growth and when he lowers interest rates it exacerbates the inflation problem. Recently Japan and Switzerland engaged in expansionary monetary policy but not to stimulate their economy but rather to stem their currencies from appreciating more. Today central bankers have a new problem of how to deal in a world where developed countries have ultra stimulative monetary policy. When the United States keeps its overnight rate at roughly 0% it is very hard to raise interest rates without having your currency appreciate. Countries like Canada and Swtizerland whose economies have fared fairly well have had to maintain lower than normal interest rates to prevent a rapid appreciation of their currency. Canada has kept its overnight interest rate at 1% despite a reasonably robust economy. Luckily, Switzerland and Canada can do this without worrying too much about inflation. Unfortunately for some developing countries that is not the case.

In Brazil, interest rates are already extremely high – the overnight rate is roughly 12%. However, even despite the high interest rates, growth and inflation are both above trend. In Brazil’s case it would seem obvious that they should raise interest rates even more to cool off inflation and growth. However, in a world where other countries have nearly 0% interest rates, further moves to tighten monetary policy will make the Real even stronger. Since December the Real has already gained 10% on the dollar and has already made it very difficult for exporters. From a personal level, it is clear to me that the Real is already overvalued when I travel to countries like Argentina and the same things cost less than half the price. This marked difference is especially difficult to understand when Argentina is actually a more developed country than Brazil (based on GDP per Capita).

So the Central bankers dilemma for developing countries like Brazil is whether to raise interest rates and risk a further appreciation in the currency or to lower interest rates and risk even greater inflation. Sounds like a great subject matter for a song!

Talk with David Rosenberg

I recently had the pleasure of talking with David Rosenberg, chief economist at Gluskin and Sheff and we talked about some of his impressions on the economics behind several of the songs on Recession Sessions .

Greenspan’s Defense
Rosenberg is no defender of the Maestro, and gave the legendary Central Banker a very poor grade. He also made clear to differentiate between the easy money policies of Greenspan and Bernanke. Rosenberg told me, “If you Gave Bernanke an economy that was growing at 5% – he certainly would not have kept rates that low for so long.” Rosenberg feeling was that at least Bernanke can pin his ultra-loose monetary policy on a weak economy, whereas, Greenspan had no such excuse.

This Time Around (Song about the Canadian Economy)
Rosenberg is still fairly bullish on the Canadian economy. Canadian banks have strong balance sheets, the fiscal situation is relatively better than other developed countries and the Canadian economy benefits from a recent strengthening in commodity prices. That being said, he doesn’t think that the Canadian fiscal situation is very solid either. He used the expression, “in the land of the blind, the one-eyed man is king” to sum up Canada’s fiscal situation. He understands the American economy to be 20 years behind the Canadian economy right now in terms of dealing with a serious fiscal situation.

Gold Price Factors
There was a story a month ago when George Soros sold most of his gold holdings that gold could be in a bubble.
Rosenberg’s opinion was that Gold is not even experiencing a mania let alone a bubble. He said that if you normalize the price of gold by the money supply that you don’t have a bubble at all. A bubble would start to emerge at around 3000 dollars an ounce.
He says, that gold is trading more like a currency now and less like a commodity.

Is it over yet?
Is it over yet was Rosenberg’s favourite song on the album.
His answer to the question was a resounding NO.
The global economy still faces major risks. The biggest of which are the European Debt crisis, the Japanese economy and the US economy which also faces major headwinds. However, he was not completely gloomy about the US. He added to his claim that, “The United States has immense wealth and they have a knack for getting their act together.”

Let’s hope they can do it again this time before the August 3rd deadline to raise the debt limit.