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Monday, January 14, 2008


more on federal reserve limitations -- and the coming BRIC bust

i previously commented on the limits of what the central bank of the united states can really do to help beyond its ability to cut short term interest rates. "money rains" are much more problematic than many equity traders seem to believe, and the fed under ben bernanke has shown so far no proclivity whatsoever to actually print money.

i've also talked at length about the inefficacy of rate cuts -- a liquidity measure -- in a systemic bank solvency crisis, which is what we are apparently faced with. ben bernanke himself will tell you:

Although the TAF [term auction facility] and other liquidity-related actions appear to have had some positive effects, such measures alone cannot fully address fundamental concerns about credit quality and valuation, nor do these actions relax the balance sheet constraints on financial institutions. Hence, they cannot eliminate the financial restraints affecting the broader economy.

the depth of the solvency issue may have been underscored last week in bank of america's move to absorb countrywide, which many have speculated came at the encouragement and with the implicit backstopping of the government as countrywide faced imminent bankruptcy. this amounts to a government-coordinated and quite possibly government-financed bailout, with promises to BoA by the government to make them whole on eventual portfolio losses. more and more obvious bank recapitalizations/bailouts will probably have to be attempted in the coming months.

but what i haven't said, indeed hadn't considered much until now is the possibility that fed rate cuts may have little or no stimulative effect on the economy precisely because of how they work to expand credit and economic activity. paul krugman:

Monetary policy mainly exerts its influence through housing: high interest rates squeeze home construction, low rates encourage it. Interest rates have much less direct effect on business investment. The reason? Housing lasts much longer.

Suppose you take out a loan to buy a machine whose economic life is only 5 years — which is highly likely, given both physical wear and tear and technological obsolescence. How much difference does it make whether the interest rate on the loan is 4 percent or 6 percent? Not much: the monthly payment on a 5-year loan at 4% is less than 5% lower than the monthly payment on a loan at 6%. So interest rates don’t have much effect on business investment.

On the other hand, suppose you buy a house with a 30-year mortgage. The monthly payment on a 4% mortgage is more than 20 percent lower than on a 6% mortgage. So interest rates make a lot of difference to housing.

So here’s what normally happens in a recession: the Fed cuts rates, housing demand picks up, and the economy recovers.

But this time the source of the economy’s problems is a bursting housing bubble.

i think few informed parties question that cuts in the overnight rate are going to nearly nothing to bring back housing. as noted in the orange county register:

“Let’s say that the Federal Reserve lowers the Federal Funds rate to 2%, does this mean that we are going to start buying homes and U.S. automobiles again? The reason why nobody is willing to buy a home today is not that interest rates are too high; the reason is that home prices are too high. Nobody will want to buy a home today when they know that if they wait they could get the home for a large discount.

“This means that it does not matter what the interest rate is on mortgages; nobody is buying. And thus, it does not matter what the Federal Reserve does with the Federal Funds rate. And I actually believe the Federal Reserve knows this. They are well aware of the ineffectiveness of the Federal Funds rate to help bring back the U.S. housing market and/or the U.S. auto sector. Thus, I still believe that many of the Federal Reserve Governors are going to be reluctant to lower the Federal Funds rate even if they ultimately go ahead with a decrease in the rate on January 30th.”

if rate cuts are stimulative primarily through housing, but housing this go-round is unresponsive to rate cuts, it seems there may be relatively little fed policy can do to prevent recession from taking hold and even deepening over the next few years as housing excesses are worked off.

one avenue of positive feedback many economic eyes have been on is exports, which a plunging dollar has aided over the last few years. (of course, rate cuts have helped the dollar down.) krugman believes export growth to have been crucial in avoiding recession earlier in 2007, and so a perceived recent stall in export growth is of some considerable concern. the economist too notes that export growth was responsible for 30% of gdp growth in 2007 through september.

but i for one don't expect much to come of exports as an economic stimulus. first, exports are a relatively minor share of the american economy. second, credit contraction should have a deflationary effect that curtails dollar weakness against export market currencies like the euro -- rate cuts may simply not kick the dollar lower as banks limit the supply of dollars. third, the hypothesis of "decoupling" -- that foreign economies will grow right through an american recession and continue to demand american exports -- seems as specious and wishful a thought as it ever has been in the age of globalization; exported american and japanese bank credit has helped to fuel asset booms in china, india, brazil, russia and elsewhere, and its my opinion that contraction will pull the rug from under these highly-leveraged and (of late) very speculative economies.

satyajit das comments further on this last point:

While emerging market economies are likely to grow at a higher rate than developed countries, equity valuations and earning growth may not be sustainable. Earnings quality is variable and growth has increasingly been driven by investment income – stock market, currency and property speculation. Investment returns in many case are below the cost of capital and projects are predicated on high, continued economic growth well into the future.

Share prices are prone to being influenced by insiders and their associates. In the case of China, most traded shares are in government enterprises that continue to be controlled by the State. Some Chinese shares aren’t even really shares as they don’t convey full ownership rights equally to all shareholders.

The Indian and Chinese markets have been driven by a number of initial public offerings generously priced to provide investors (themselves privileged insiders) with large gains. A few shares contribute disproportionately to market performance. A handful of stocks drove the rise in India’s Sensex Index in late 2007 reflecting the lack of liquidity in many stocks. In China, restrictions on foreign investments by domestic investors and the lack of investment alternatives has contributed to the sharp increase in the price of Chinese stocks. Borrowings by corporations and individual investors have been channeled into the stock market creating dangerous levels of leveraged exposure to share prices.

indeed, it's quite possible that it's already been done. the FXI, an ETF of chinese shares, put in a double-top in october as the credit crisis spread, and has since put in a series of lower highs while holding 165 in a descending wedge. i have little insight on a slowdown in china's economy, but this looks for all the world like the beginning of a collapse in china's speculative mania. kevin depew notes that government efforts to rein in speculative growth may be taking hold, and barry ritholtz highlights the collapsing baltic dry index (a measure of international shipping costs).

does that mean the end of the debt supercycle? perhaps not. but i think it will mean that even very vigorous reflation efforts -- even if ultimately successful in staving off an international credit unwind, capital flight from the united states and deflationary disaster in the end -- will not allay a powerful recession in the nearer term which will not spare the BRIC nations.

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