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.

Gold Price Factors

When S&P downgraded the rating on US treasury bonds recently, investors sought two safe havens from the perceived risk resulting from the downgrade. Ironically, the first safe haven was treausuries themselves and the second was gold. Of both asset classes, gold gained the most, rallying for the 7th straight week to 1880 dollars per ounce.

Which of the factors discussed on our song Gold Price Factors is driving the price this time, you might be asking yourself.

1. Flight to safety is the greatest driver of gold prices lately.

The fear of a double dip recession combined with the S&P downgrade and european bank/sovereign debt issues has driven investors into the perceived safety of gold.

“Flights to safety increasing the net worth
Of precious metals we’re mining from the earth
Its store of value calms investors fears
From sudden panics that bring our brokers tears”

2. Easy monetary policy

To help stop the downward spiral of equity prices last week, Bernanke promised to keep the overnight interest rate at roughly 0% until the middle of 2013. This could have contributed as well to the rise in gold prices.

“Watch Ben Bernanke and soon you’ll understand
How easy money gives gold greater demand
Commodity prices trend in the inverse
Of fiat values supply becomes a curse”

When I spoke to David Rosenberg about the global economy last month, he noted that gold has been trading more and more like a currency and less like a commodity. Gold is rising on the fear the central banks are destroying the credibility of fiat currencies with excessively low interest rates and quantitative easing thus making gold a better store of value than dollars.

Blaming the Referee

Over the past couple of days a number of politicians have jumped into attack S&P for their decision to downgrade United States sovereign debt. The main theme in these attacks has been that S&P missed sub-prime and therefore lacks credibility. However, it is interesting that the people who have been doing the criticizing have had just as poor records with regards to the financial crisis of 2008.

Yesterday in an exclusive interview with CNBC, Timothy Geithner said, “S&P has shown really terrible judgment and they’ve handled themselves very poorly”. In order to further diminish the credibility of their decision he said “just look at the quality of judgements they’ve made in the past”

Paul Krugman was equally irate with the decision. He claimed that S&P lacks credibility and showed an amazing amount of chutzpah to downgrade the debt. On top of their having missed subprime, he uses the example of Japan to prove how they have been wrong in the past as well in similar circumstances.

He wrote, “And in those rare cases where rating agencies have downgraded countries that, like America now, still had the confidence of investors, they have consistently been wrong. Consider, in particular, the case of Japan, which S.& P. downgraded back in 2002. Well, nine years later Japan is still able to borrow freely and cheaply.”

Krugman, however, is ignoring the fact that a downgrade is not a prediction by a rating agency that a country will default. When S&P cut Japans rating they weren’t making a prediction that Japan was going to default and were thereby proved wrong when Japan remained solvent. S&P’s definition of a AA rating is “AA: An obligor rated ‘AA’ has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.” So S&P was RIGHT when they predicted that Japan had a strong capacity to meet their debt obligations and they did. Japan though has enormous debt – over 200% ratio to GDP – some say the highest in the world. It seems pretty reasonable that S&P wouldn’t assign them the highest possible rating, reserved for only the most fiscally responsible countries.

After Krugman rants about S&Ps decision he goes on to admit that the US does have serious problems: “And yet America does have big problems. No, what makes America look unreliable isn’t budget math, it’s politics. And please, let’s not have the usual declarations that both sides are at fault. Our problems are almost entirely one-sided — specifically, they’re caused by the rise of an extremist right that is prepared to create repeated crises rather than give an inch on its demands.”

Political uncertainty is one of S&P’s main criteria with regard to Sovereign debt, so Krugman actually makes a strong argument for the AA+ rating. While he thinks the finances are strong, he thinks there is concern with the political climate. That seems exactly sufficient to merit a AA+ rating as the AA+ rating only differs from the AAA in that it encompasses a slight uncertainty.

Geithner too talked about problems with the fiscal picture. He said, “There’s no surprise that the U.S. has a long-term and unsustainable fiscal position,” he said. “We believe that. The president believes that. That’s why he’s been fighting so hard to bring people together to try to deal with it.” Given that both men admit that there is at least some challenges and uncertainty a AA+ rating seems more than reasonable and even a bit generous.

I thought the most amazing thing though was that both men challenged the credibility of S&P based on the subprime crisis. Surprising because Krugman and Geithner have both had pretty weak credibility with regards to the crisis as well.

In fact during the formative years of the housing bubble when the Fed was still lowering interest rates, Krugman said in an interview. “During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn’t you lower interest rates?”
Excessively low interest rates is widely agreed to be one of the main causes of the crisis.

Geithner was also equally poor in his predictions of sub-prime. Before becoming Treasury Secretary, Geithner was the president of the Federal Reserve Bank of New York. He voted with Bernanke and consistently agreed with the general consensus of the Federal Reserve whose Chair (Bernanke) was still laughing off the idea that the housing market was in a bubble even in the later years of the bubble.

Krugman and Geithner came off as hypocritical and in denial. To use a sports analogy, they reminded me of the types of athletes who blame the referees after a loss. It’s the S&P’s job like a referee to make an impartial analysis and judgement and there is no real reason to believe that they are not doing anything but their best to provide objective analysis. Krugman and Geithner could have come out and said the S&P decision was fair and reflects the fact that while we are still a very solid country, the AA+ rating acknowledges that we have some political and long term fiscal sustainability problems. Nonetheless, we plan to work our hardest to regain the AAA rating. They could have accepted the loss of AAA status with a bit of integrity, instead they whined and blamed the refs.