• Right now, required reserves at the Federal Reserve stand at ~$64 billion
• Excess reserves stand at slightly over $1 trillion, roughly equal to 7% of average GDP over the 2007-2009

In the Winter of 2008, the Federal Reserve faced a difficult decision:

• The overnight funds rate on reserves, the base rate the Fed controls, was set at 1%, but the traded rate was 0.14%. So, as predicted, the Fed slashed its rate by 0.75 points and starting paying interest on excess reserves.
• Today, the Fed pays interest on excess reserves equal to its targeted funds rate 0.25%. However, the effective rate trades between 0.10% and 0.2% according to market data from the FT, pointing to continued slack in the system.

What to do:

• GDP for 2007 was barely over $14 trillion. In 2009, it was $14.1 trillion. Assuming the US grows at 3% per year, mid-2010 GDP would have been roughly over $15.1 trillion. The difference between potential output and current GDP is the amount of money parked at the Federal Reserve, earning 0.25%.
• Stopping the payment on excess reserves could be a boost to growth of the economy. Banks will have to find a home for this money. However, faced with the uncertainty of the current economy, and an economy facing deflation, banks may simply continue to keep those reserves parked at the Fed.
• The only major use of this income in the short term, would be a new round of stimulus. Highly controversial, yet effective according to a new paper by Mark Zandi of Moody’s and Alan Blinder of Princeton. Consumers are saving more, 6.2% of their disposable income, equal to ~$700 billion. This is roughly $450 billion more than during normal times. Fair to say, this money is being parked at the Fed in the form of excess reserves.
• Suspending interest payments on excess reserves would almost certainly bring the effective rate to zero. Using the Taylor Rule, the difference between 0.1 and 0.0 would add 0.2% increase in GDP given current CPI - not much.
• Yet, cash earning zero would have to find a home. Maybe then it would be possible to fund a second stimulus. Ideas for this stimulus would be as follows:

1. Replacing all municipal buses and taxi cabs with clean burning natural gas buses and taxis made in the USA.  This would have a significant impact for both the natural gas industry as well as domestic manufacturing.
2. Expanding high speed rail for both passenger and freight transport (moving more post and parcel service onto high speed rail). Key links would be Chicago to Detroit and the East Coast as well as continued east coast service from Boston all the way thru Charlotte and Atlanta.
3. Increasing port capacity for greater exporting ability in Houston, New Orleans, Virginia Beach, Philly, New York and the entire West Coast.
4. Increasing rail capacity in the Midwest to make manufacturing easier (and cheaper) to move to the coastal parts of the country.

To be sure, the investments outlined above would be 2-5 years in duration, shifting the excess reserves to the right on the yield curve where the current 10 year treasury yield stands at 2.91%. But infrastructure investments are incredibly productive. All of these outlined above would for sure produce more than 2.91% over ten years in returns. It’s a bet worth making and funding worth investing.

Four data points (from the Market Data section of the Financial Times) start the discussion:

1. Today, the US Dollar to Euro exchange rate is ~$1.29.
2. The one year (longest published out) Dollar Spot Forward is ~$1.29 as well
3. The ~ 1 Year US Treasury Yield is 2,99
4. The 10 Year Yield on a German bond is 2.75

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0275)^10 = $1.32 to the Euro, suggesting the Euro is long term undervalued.

However, what about the following other Euro countries? Here are the following ten year yield and percentages of Euro Currency 2009 GDP:

• Austria - 3.13 (3%)
• Belgium - 3.36 (4%)
• Finland - 2.93 (2%)
• France  - 3.03 (22%)
• Germany - 2.75 (27%)
• Greece - 10.53 (3%)
• Ireland - 5.42 (2%)
• Italy - 3.99 (17%)
• Netherlands 2.94 (6%)
• Portugal 5.52 (2%)
• Spain 4.28 (12%)

By averaging the ten year yield based on the gdp of all Eurozone countries, we find the Eurozone 10 year yield is 3.57%

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0357)^10 = $1.22 to the Euro, suggesting the Euro is long term overvalued. Adjusting this calculation for % of Public Debt to GDP, the value of the Euro drops to $1.21 to the Euro

What is the explanation?

Countries in crisis (such as Portugal, Spain, Greece and even Italy) have taken advantage of Eurozone financing for government financing. This purchasing has negated the need to tap domestic and foreign capital markets for purchases. This lack of foreign exchange has created a void for deciphering where the euro is truly in demand. This is further evidenced by an officer of BBVA’s notorious quote earlier this summer.

What this essentially means is that current account surplus countries such as Germany are forced to help out current account deficit countries such as Greece and Ireland. Yet the Eurozone has a current account deficit. If Germany and German banks are bailing out Greece and Ireland, countries such as China are only buying German bonds. This makes German sovereign bonds the “on the margin” security denominated in Euros sold and traded in foreign currency and not just in Euros.

The “marginally available” security is probably the major explanation why the Dollar Spot is valued closer to the Covered Interest Parity Calculation using the German 10 Year Bond than the composite of European Bonds.

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.

After the stimulus bill passes, President Obama and Tim Geithner will propose the next bank bailout. The concept of the bailout is the “bad bank”: Toxic assets are lifted from the bank balance sheets so lending can resume.

The key to stimulating lending is to resume interbank lending. Interbank lending can not fully resume until banks are comfortable their bank counterparts do not have any toxic assets, which under-performance could trigger a default. A default would make it difficult for the lending bank to receive its cash.

Look at the LIBOR yield curves on

feb-9th-2007-interbank-lending

feb-6-2009-interbank-lending

The steepness of today’s yield curve shows how skittish banks are in lending money for long durations, including one year.

Many worry the “bad bank” will cost the taxpayers money. Banks will not sell toxic assets for their true worth. Yet if banks agree to sell, many fear the taxpayer will pay too much. These “toxic assets” are packaged “subprime” mortgages. As job losses continue, home prices continue to decline and defaults continue to increase. Volatility makes valuing these assets almost impossible. Worse, this volatility is starting to damage mortgages further up the food chain.

Restarting the ability to make these mortgages worth anything are the following two statistics.

1) Real Median Household Income has not increased since 2000 - incomeinamerica1

2) Since 2000, The US Current Account Deficit has increased as a percentage of World GDP

Since consumers are (were) 70% of the US Economy, any increase in home values in the bast eight years has been on the backs of household borrowing. Until US Families can annually earn more, home values and mortgage portfolios will not follow suit. Homeowners need to pay back existing loans and earn more for future consumption at the same time.

The economy that increases real median household income is the next question. The recent share, both overall size and contributions to growth of the Finance Sector, contributed to our current state.  This is not assigning blame. We need capital to back people, ideas, bringing improvements to today and tomorrow’s economy. But we need to make more than financial products if we are going to lead the world, resume growth, and further pay for social security and medicare/medicaid.

Which brings us to the bailout. Must we do something? Yes. But lending can not resume to its 2006/2007 state unless we have an economy with a stronger manufacturing base to support it. Leverage on leverage only brings defaults and further trouble.

That is the challenge of this administration and the the private sector -aka - everyone. If we can create an economy that creates wealth for everyone, our future will be far brighter.

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.

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.

What will 2009 look like? This blog offers key spreads to examine routinely for signs of economic recovery. In chronological order

• The Fed Funds Effective vs. Target Spreads.
• The TED Spread
• LIBOR vs. Investment Grade Bonds

Fed Funds Spread

The Fed Funds Spread, the difference between the “Target Rate” and the “Effective Rate” for Federal Funds is essentially the measure of slack in the economy. Today, the Target Rate is set to 0.25% and the “Effective Rate” for overnight funds trades at 0.11%: banks can not find enough opportunities (or see too much risk) to lend. Instead, banks choose to keep excess funds within the Federal Reserve.

This is the first spread to watch. When the “effective rate” trades at the “target rate”, the economy is performing to its potential in the current interest rate environment.

The TED Spread

The TED Spread, the difference between three month LIBOR and three month US Treasuries, is essentially the measure of trust between the private and public sector. According to the Financial Times, three month LIBOR trades at 1.47%. Three-month Treasuries trade at 0.0014% (zero). That’s a big spread.

This spread can not converge until overnight LIBOR -which mirrors the Fed Funds “effective rate” - trades at the Fed Funds Target rate: Effective Rate vs. Target Rate convergence implies upward pressure on treasury yields, making overnight treasuries trade at a minimum of 0.0025%.  This is the start to redeeming trust in the private sector vs. the public sector.

LIBOR vs. Investment Grade Bonds

This spread measures competition and confidence in the private sector’s ability to earn income. Today, one year LIBOR trades at 2.09%. Reviewing Global Investment Grade Bonds from the Financial Times, most trade at ~6.00% yield.

global-investment-grade

This is the final spread that will show uptick in the economy. When this spread converges, trust in corporate earnings is restored: the public market respects corporate earnings enough to offer a suitable substitute to banks as a source of debt funding.

The LM Curve as Perspective

Reviewing the LM curve, demand for money equals the supply money at a given output and interest rate - in this case a zero interest rate environment.  Output could increase in a zero interest rate environment, with expansion of the money supply (as the Fed is currently doing) and with expansion of the government spending (as Obama is planning). Given we are in a contractionary economic environment, one could argue the US has only slid down the LM curve - money supply expansion has not worked -, awaiting a shift in the IS curve with new fiscal expansion.

However, a healthy economy has demand for money at positive rates. For this we look to the convergence of the spreads listed above.

Preparing for 2009, this week marked a terrific example of de-leveraging in practice.

• As of Friday, December 19th, according to the Financial Times One year US Libor was 2.09%
• As of Friday, December 19th, according to the Wall Street Journal, no Treasury expiring prior to 2015 yielded more than 2%.
• And, as of Friday, December 19th, according to the Financial Times, the Fed Funds effective rate was 0.11%

So, there has never been a cheaper time to borrow, right? Only if you have an FDIC (taxpayer) stamp next to your offering. Take a look who issued debt this past week, courtesy of the Financial Times.

Financial Times: Week ofDec-19th-bond-issues-us

One side note: Even John Deere Capital got into the FDIC mix! So don’t tell GM and Chrysler they can’t have taxpayer loans.

According to the WSJ, this week was the final week in 2008 for private bond offerings. The lack of Corporate Debt issued should provide guidance that the US Economy (by force or by choice) is continuing its de-leveraging.

Final side note: According to the Wall Street Journal, The Illinois Finance Authority is set to offer $500 million in bonds on December 26th. Though it is independent of the State, this should be an interesting post-Christmas verdict on Governor Blagojevich.

As predicted, the Federal Reserve Open Market Committee (FOMC) dropped its core interest rate by 75bp. A surprise to many, not to this blog. Enough bragging, these are scary times:

• The first reason is the FOMC statement: “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent”

A target range? This is the first time in recent memory the FOMC has stated it would establish a range and not a specific rate for its open market operations.  The minutes of this meeting will be very interesting:

• This blog will predict that the FOMC will admit it has lost control of the Fed Funds rate.

And that is very scary. Even though the Fed now pays interest on reserves, instead of only buying short term treasuries -, the actions to control the Fed Funds rate are not working: There is no demand to use capital in this economy: From the Financial Times:

• The Fed Fund rate sits at 0.12%, remaining unchanged from before the rate cut.
• Overnight LIBOR is 0.0115% (because the Fed pays interest on reserves)
• Overnight 3m Treasuries are 0.01%

Deflation:

Reserves sitting at the Fed have ballooned to almost $700 billion, comparable to envisioned TARP program.  Yet that money is parked there most likely because the Fed has been gobbling up Treasuries, driving the yields to zero. It is not going outward into the economy.

If you believe in Milton Friedman, then you believe the following:  Without lending activity and expansion of the monetary base - demonstrated by these spreads - then at best, the money supply is not keeping pace with the economy. Therefore, deflation.

It might be worse. If the expansion only sits in existing treasuries, and those treasuries are not new issues for new government programs - aka - the stimulus, then all we’ve done is increased the demand for treasuries and done nothing to expand the economy. Further, remember the taxpayer has only saved money from the latest treasury issuance. Other issues had more expensive yields. In a deflationary environment, this problem is only compounded. 

Until the stimulus is enacted, we must expect a deflationary environment for at least the short term. And that will cause the FOMC to continue its inabilty to control the Fed Funds rate.

Dec 15th and 16th are when the Fed meets for the final time in 2008, when it will decide how low the Fed Funds rate should be.

No ordinary time:

1. The Fed Funds Rate sits at 1.00%. But the Effective Rate as of Friday, Dec 12th according to the Financial Times was 0.14%
2. Fed Reserves normally are $800-900 billion. Today there are $1.5 trillion in Fed Reserves, according to The St. Louis Federal Reserve.
3. Treasuries normally pay positive interest rates. According to the Financial Times, overnight rates for three month treasuries are paying 0.03%. Further, the latest auction showed people are willing to pay the US Government more for less in the future. (deflation).

So what should the Fed do?

• Conventional wisdom leading up to this meeting was that the Fed would cut interest rates by 50 basis points from the current 1.00%.
• I argued in a previous post that only a 50 basis point cut would do nothing.
• Now, the expectation has shifted (maybe thanks to my Note….just maybe). CME Fed Binary Options prices as of Friday, Dec 12th show the market is betting on a 75 basis point cut.

The three major reasons against a 50 basis point cut are as follows:

• For some time, the effective Fed Funds rate has been trading below 50 basis points, making a 50 bp cut moot.
• With demand for Treasuries now essentially inelastic, part of the Fed’s open market operations are simply ineffective.
• Since the Fed’s rate cuts in the fall, bank lending has not responded. I argued in Note 16 one way to view this. Here is another: A look at the St. Louis Fed research shows M2 has remained largely unchanged from October 20th to December 1st. We need a resounding effort to get capital out of Fed Reserves and into the private markets.

A 75 basis point cut will occur by Close of Business, Tuesday the 16th.

But a 75 basis point cut may not help all that much without a spur of domestic demand.

• St. Louis Fed research shows corporate Aaa bond yields have remained largely unchanged over the fall: While base rates have declined, spreads have widened.
• The Commercial Paper Market has dramatically shifted from private market consumption to the Fed. According to the St. Louis Fed, in October, the figure of borrowing from the Fed was $450 billion. Today, it still is over $250 billion.
• This week, according to Financial Times data,  The American Express -now- “Bank” jumped on the bandwagon of FDIC backed debt raising, floating $5.5 billion of debt at yields of 2-3%.

In short, the Fed’s and other government’s massive expansion of credit market intervention is now more powerful than Open Market Operations. While the need for a 75 basis point is important and required, other actions are now more powerful to spur economic recovery.

Turning to 2009:

The fact-pattern above gives pause to how big a stimulus package needs to be vs. how quickly it needs to be spent. I am for a massive Fiscal Stimulus of at least $600 billion. But every dollar borrowed by the US Government (especially today) is a dollar unable to be accessed by Private Companies for new projects and investments, even in ZIRP land.

As Paul Krugman said today on “This Week”, it is hard to spend $600 billion dollars, even for the Government. Domestic Demand stimulus will only be effective therefore in boosting the private economy if “size” is optimally aligned with “velocity” and “accuracy of spending”.

Still, look for a 75 basis point cut this week as the final message of 2008 in preparation of massive fiscal stimulus in early 2009.