Martin Feldstein’s column, (June 29, 2009) on inflation opines that while federal stimulus is still necessary, a combination of looming deficits, federal reserve bond purchases, and skittishness of foreign investors are pushing yields on the 10 Year Treasury up to alarming levels.

Feldstein’s major premise is detailed in the second paragraph of his column: Higher Yields have led to higher mortgage rates, reducing home buying, depressing net worth tremendously in the last six months. Further, lower home prices have caused more defaults and “weakened bank balance sheets”.

Lets correct some facts: Between 2006 and Six Months ago (December 2008), house prices dropped 27 percent. From December 2008 to March 2009 - the latest month of data,  housing prices fell comparatively 7%. Further, August 2009 Futures for Case-Shiller Composite index is currently trading at 152.0 slightly above where the index level stood in December of 2008, bookmarking the recent rise in treasury yields.

Feldstein, in his column, notes that the current spread between 10-year TIPS and 10 year Treasuries shows an inflation expectation of 2% annually. That inflation predictions have “jumped” to slightly over 2% per year is hardly alarming. 2% is often seen as an inflation target. That the jump in rates is perpetrated by fears foreign investors may no longer continue to buy US debt is simply not true.

China, most notably, while making loud noises is in a “dollar trap”, argued most notably by Paul Krugman. Fail to purchase US Treasuries, and decline the dollar’s value, making our goods cheaper and China’s goods more expensive, ending China’s competitive advantage in manufacturing.

At a high-level, if manufacturing in China continues to keep durable good costs down, and the Federal Stimulus package will improve roads and cargo lines, reducing transportation costs, price increases outside of energy spikes are hard to imagine for durable goods measured in CPI.

Perhaps Feldstein’s view of investor skittishness and his call for the Fed to assure the markets it will curb future “inflationary lending” are really directed at asset inflation: Perhaps investors believe that while policy makers are acting vigorously, nothing structurally has or is going to change to prevent another asset bubble similar to house price inflation witnessed over this past decade.

Asset inflation, be it houses or equities, is much harder to prevent than inflation in durable goods. Let us hope our fiscal stimulus and monetary policy are giving the economy surer footing to produce more, sharing those productivity gains across a wider spectrum, ensuring a diverse economy in the odds of preventing future asset bubbles.

The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.

Paul Krugman writes this week about the Irish Economy. In his column and blog, Paul notes Ireland is painfully transitioning, raising taxes to keep its fiscal position in line.

Let’s pause. If you have not read Lords of Finance yet by Liaquat Ahamed, stop reading this blog (or any other) and give the book a go. It is the cornerstone to understanding the current economic/financial crisis and comprehending possible solutions of both short and long duration.

In Lords of Finance, Ahamed writes of an eerily similar situation during the 1920s when Great Britain, starved for credit to funds its fiscal deficits, had to seek tacit approval from the House of Morgan on its proposed budget. Upon approval, Morgan helped raise a consortium of funding to help Great Britain stay afloat.

No doubt the same conversation was probably occurring in Ireland before it made its proposed increase in taxes. In the months since the world Financial Meltdown, Ireland raised debt in November 08 ($4bn),  January (Euro 6bn), and February (Euro 4bn). Then on March 30, 2009 Standard and Poors dropped Ireland’s sovereign credit rating from AAA to AA+ with a negative outlook. Since then, Ireland has not tapped the capital markets and has now tightened its fiscal belt.

This is now the choice of Ireland and other European Countries with current account deficits.  There is an immediate need to shore up the balance sheet, repay existing debts, and wait until domestic prices decline to a point where goods and services are competitive enough to be readily exported, regrowing the economy.  But waiting for prices to decline is a very painful phenomenon. Prices only decline when demand drops and a drop in demand across the board is synonymous with higher unemployment.

Ireland may be a small country (GDP wise), but its decisions are no different than California’s or many other states and municipalities here in the US. Without complete currency control, acting prudently (although potentially not economically), is the only choice to continue to tap existing capital markets, paying teachers, fire fighters and policemen. Economies in trouble and with a net debt position and complete currency control would either see a currency devaluation (in the form of a crash) or would choose to devalue their currency. Currency devaluation would hopefully occur faster than responsive domestic inflation allowing goods to be exported at a more competitive basis. Yet without currency controls, deflation is the only mechanism to getting prices to a point where exports can repay existing net debts (assuming those debts are denominated in the domestic currency).

Ireland is being used as an example of when economies are too reliant on the financial sector. To be clear, robust capital markets are critical to any functioning economy. Yet it is also important to note the following function: The limits to the magnitude (1x, 2x, 3x) of a sale of any business are equivalent to its estimated Rate of Return on Assets divided by its weighted average cost of capital - In a simpler Mogdliani Miller world this is the rate of asset return divided by the sum of the funding spread above the risk free rate and the risk free rate of return. In other words, the numerator to any business sale is the Rate of Return on Assets and the denominator is the return a new buyer is willing to accept. In the last eight years, we’ve grown because of the denominator: capital became cheap and offered increasingly attractive multiples for business transactions. In the next eight years, we must focus on the upper bound, the return on assets, the productivity of the country and its ability to make goods and services, representative of its currency.

Paul Krugman, in a blog post last week, offers an explanation for how private investors would think about asset purchases under the treasury plan. With no disrespect, here is my explanation:

Assume the purchase of a “legacy asset” (or purchase of a toxic asset, or the purchase of a pool of subprime mortgage) is a the purchase of cash flows for a period of 20 years. Many mortgages go out beyond 20 years, but let’s keep this at 20 for argument’s sake.

How much would I be willing to pay?

Well, a review of march-27-world-bond-yields, with at least an A rating, that go out 20 years, make me think I should get at least 8%. So, if I buy that asset for $100.00 (for which it is valued on the banks books), I’m expecting annual cash flows of $10.25 for the next 20 years.

It is fair to say, that given the horror stories everyone has heard about subprime mortgages, one would need a return far greater than 8% in order to buy one your own.

So the Treasury and the FDIC step in, and debt financing for up to 85% of the assets, with a matching equity contribution.  Assume then that the FDIC is able to offer 85% of the price on a non-recourse basis (meaning no other assets of me, as the the investor, would be touched eg - my home, my car should I be unable to service the debt). Then assume the FDIC offers 5% financing for the full 20 years. This, however, is a big IF, based on the Legacy Loan Terms sheet offered by the Treasury. Rates and Length could be far less generous.

Yet, if I were to receive 5% and 20 years of FDIC debt, my pre-tax return as the equity investor would be ~21%.

Assuming the FDIC offers these terms, the question then is, is a 21% pre-tax return to equity enough to entice investors to buy bank assets at their listed price? Secondly, is the program, with loans and equity contributions enough to remove the glut on bank books and get lending activity going again?

If the answer to either question is no, then the program has not (by itself) done enough to re-gain control of the credit markets, restart lending, and grow the economy.

But back to the 21% return for a second. In an article earlier this month in the FT, there were some pretty grim statistics about households behind on their mortgages. Nearly 12% of all home loans were either a month behind or in foreclosure. This statistic across of all households, but imagine what it is for those carrying “subprime” mortgages. Was this statistic modeled into the asset, valued at $100, on the bank’s books? That is not clear. As the equity investor, if I stress tested not receiving 12% of my cash flows annually, just to be conservative, my equity return under this scenario drops down to 12%. Given that this is a subprime mortgage pool, it could be fair to say, this investment is now not worth it.

Suppose then that a 21% return is the magic number. How much, assuming my stress test, would I offer a bank then for a $100 asset? The answer is $90, or a 10% haircut. The final question then is: Is losing 10% enough to to entice banks to still sell and remain solvent? Again, if the answer is no, then the program has not helped get lending going again.

Reading over this plan, it is my assessment that it will take time to start this program and get it functioning. The key then will be: what might happen in the mean time to banks and the economy and will we need a new set of assumptions to value these assets at that time?

The Fed mulls an inflation target, to stabilize the economy. Robert Shiller and George Akerlof, in their new book Animal Spirits, argue for a “credit target”, a level of lending to keep the economy near full employment. In the middle is an old question - Should Central Banks consider Asset Bubbles a form of inflation?

Look at the 2008 Commodities Bubble:

• January 2nd, 2008 - According to the Financial Times, One month Oil Futures on the NYMEX were $99.62
• July 2nd, One month Oil Futures were $144.26
• December 30, One month Oil Futures were $39.03

That the Fed insists on Core Inflation, excluding energy, made it miss how energy moves all consumers prices. Consumers pulled back on gasoline purchases in the short term and in the long term, terminated SUV purchases, crippling GM and Chrysler.

Yet during oil’s rise, the Fed had to reduce the Fed Funds rate as the effects of Bear Stearns was first on its mind. It’s not clear the Fed could have raised rates to prevent oil’s rise, without crippling the economy.

Preventing the Housing Bubble though could have eliminated what we currently witness: Global de-leveraging and massive reassessment of household wealth. The sheer amount of leverage also helped fuel stock market booms (of which some was real) giving consumer confidence in 401k statements. Add to this the house market boom, household behavior such as reverse mortgages, credit card spending, an overall negative savings rates would probably not have occurred.

Yet the Fed’s role in determining over-investment is tricky, politically controversial. Without world-wide coordination for world wide bubbles, false arbitrage opportunities such as the Carry Trade can wreak havoc on international trade/commerce.

What Shiller, Akerlof, and all concerned about asset bubbles really want is an economy where the Financial Sector does not a) contribute the most to GDP growth and b) rise too disproportionately in terms of total GDP. This was our economy prior to this crisis. The economy must have real growth, not growth due to paper assets. Once perception is pricked on over priced assets, no one knows an assets true worth, causing trust and lending stop.

If Central Banks can not politically prevent asset bubbles, then our government must improve its risk management program. Two logical improvements are as follows:

1. Regulation and oversight must increase. Madoff’s false profits now cause hospital wings  to go without funding. Mortgage Originators are forcing real family pain on false interest rate promises.  And we all witness a loss in market confidence.
2. Running government surpluses in healthy economic times. 90 years ago, John Maynard Keynes worried about this very issue we now face. Certainly, government surpluses up until now would reduce our worry over how much debt we must now raise.

Only a start, but planning for the future must occur to prevent a future colapse of this proportion.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.

As Congress released the second round of TARP funding this past week, anxiety grew that its original purpose is failing: banks are not lending.

To discern why, we must think about the relationship between the TARP funding requirements and Federal Reserve Monetary Policy.

With banks taking write downs during the fall of 2008, its plausible to assume TARP funding was the only new source of capital - all remaining bank liabilities and assets were matched after write downs, tied to existing economic activity. The only source of capital for new economic activity was TARP funding, now $700 billion. To give comfort to this assumption, add up the market capitalization of the largest US banks - far smaller than TARP.

By law,  TARP funding is preferred equity on a bank balance sheet, with a 5% annual dividend. Add on administrative costs, and a loan just to break even needs approximately 6%, just to service the taxpayer requirements of TARP. Yet through Open Market Operations, the US Ten Year Treasury currently yields 2.34%, according to the Financial Times and the effective Fed Funds rate is 0.18%. TARP funding requirements place this large source of new capital no where near this historically low yield curve, completely at odds with Open Market Operations.

Two years ago, overnight treasuries traded at 5%. When the economy grows at 3% per year, an inflation at 2%, a business owner merely switches on the lights to pay back a 5% interest bearing loan. Yet in today’s environment, 5% is expensive. In today’s environment -a ZIRP interest rate environment - a recessionary environment - a deflationary environment,  those willing to accept north of 5% (6%) is a classic adverse selection problem: The smart businesses horde cash as new cash is too expensive. The businesses accepting such a loan may not be able to pay it back.

Faced with the prospect of new bad loans, it is no surprise banks are not lending. They would rather preserve capital to plug foreseen bad loans in the coming year. Further, to achieve 5%, M&A is a preferred method, scooping up the right loan packages at the right price.

A Solution:

This page has long argued TARP dividends should be a rolling average of the yield on treasury bills/notes - the opportunity cost of taxpayers funding the banks. If yields are low, economic activity is weak, keeping dividend payments manageable. If yields are higher, (assuming no runaway inflation) economic activity has increased as treasuries were sold for corporates, again making dividend payments manageable. We hope the new administration makes this change.

It is time to take stock of where the market sees the economy moving in 2009. Let’s examine

• Overnight Index Swap (OIS) Futures - tracking the effective Federal Funds rate
• Three-Month Eurodollar Futures - tracking three month LIBOR - the base private lending rate
• Oil Futures - tracking energy
• Dow Futures tracking industrial performance

2009-economic-indicators1

Let’s start with the base of the economy, the effective Fed Funds rate. By reviewing OIS Futures, the Market believes by the fall of 2009, the Fed will have increased the target funds rate to 0.5%. Further, economic activity will be strong enough that the effective rate will mirror the target rate by both the midyear and by the end of the year. Treasuries expiring in December 2009 yield 0.41%, according to the Wall St. Journal, close to the effective funds rate Dec-09 futures.

Three Month Eurodollar futures, a mirroring instrument to 3 month LIBOR trading on the CME state marginal increases in lending cost.  Considering treasuries expiring in March 2010 yield 0.4% (compared to treasuries expiring in December 2009), there is still a very high TED Spread - the private capital trust spread -by the end of 2009.

Oil futures-according to the Wall St. Journal-  show robust increases in energy cost. Further, according to the WSJ, there is no change in Dollar futures against a world currency basket through 2009. This shows a pickup in world oil demand, potentially a pickup in global economic growth.

The Dow, however, points down. This could be explained in two ways:

• The first is inflation. According to the FT, the Five Year Treasury Bond trades at 1.51%.  According to the WSJ, Five Year TIPS trade at 2.65%. Declining prices mean declining profits, which pushes down share prices. Declining prices coupled with increasing energy further pressures profits.
• The second - compounded with deflation - is the cost of debt. Fair to say, this fall was miserable for bond offerings. This past week was positive - companies actually went to market- weekly-bond-issues-ft-january-5-9-2009 - but for those companies able to issue debt, it is expensive, especially relative to treasuries -as mentioned before - of similar duration.

In 2009, the market predicts a start to economic recovery. That the fed funds effective rate will mirror the target rate and that the target rate will increase by end of 2009 shows positive economic activity. While 3-month LIBOR is low through 2009,  the actual cost of debt to firms - both in spreads and the growth/contraction in inflation - still puts long term pressure on economic growth.

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

The Yield Curve is increasing in discussion as a predictor of the US Economy.

First, in defense of the Yield Curve, it is a good predictor of future short term interest rates. Let’s take the UK and the US current short term Yield Curves, courtesy of the Financial Times.

The UK Yield Curve:

The US Yield Curve:

• The official UK Central Bank interest rate stands at 2.00%
• The Fed Funds target rate stands at 0.25%

With similar economies -troubled financial sectors, and nerve racking current account deficits -there is almost no question the UK will mimic its “special relationship” counter part and further slash interest rates to boost its economy. Hence, the UK curve slopes down in the short term.

Recovery:

Now, let’s read the yield curve tea leaves for the US economy:

• The Cleveland Fed votes yes
• Paul Krugman votes no

Paul is right. That the “effective rate” of Fed Funds trades at 0.14%, mirroring overnight Treasury Bills means the yield curve can only slope positively (The UK curve highlights why Paul is correct). Two years ago, life was much different.

• Fed Funds “effective rate” was 5.30%.
• Overnight 3m Treasury Bills traded close to 5.00%.

That the 30 Year Treasury Bond trades today at 2.81% shows a very weak economy, regardless of the slope of the curve. Further, it shows a long time until economic recovery. Larger economies require larger yields to balance the supply and demand of money.

When investors resume believing in corporate bonds, the yield curve will start to increase in slope. Treasuries will be sold and corporates will be bought. The key to economic recovery will not be the purchase of existing corporates - most of those were sold when yields were low. Rather, the key will be when new corporates are issued and issued cheaply (low yields). This will start putting new profits (more return on equity) back to companies for investment and further economic growth. Unfortunately, it has been a very light fall and continues to be a light winter for new debt issuances.