US crisis similar to Scandi crisis?

“A senior official at one of the Scandinavian central banks told The Daily Telegraph that Fed strategists had stepped up contacts to learn how Norway, Sweden and Finland managed their traumatic crisis from 1991 to 1993, which brought the region's economy to its knees.”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/31/cnfed131.xml

The Scandinavian banking crisis may be a good case for what can happen to the banking system and the currency when you have a twin crisis. Of course, the analogy may not be perfect but it is something that the Fed is looking at closely. An asset bubble associated with loose credit occurred in these countries, but there was also a corresponding shock. In the case of the United States, the shock may just be an old fashioned oil price rise. Unfortunately, we have seen this story before.

The important lesson from the Scandi crises is that there is no easy solution that will save the economy in th short-run. There was the need to nationalize some of the banking system, and the cost to the taxpayers was significant.

The Scandinavian Crises
Norway, Finland and Sweden experienced a classic boom-bust cycle that led to twin crises. In Norway, lending increased by 40 percent in 1985 and 1986. Asset prices soared while investment and consumption also increased significantly. The collapse in oil prices helped burst the bubble and caused the most severe banking crisis and recession since the war. In Finland an expansionary budget in 1987 resulted in massive credit expansion. Housing prices rose by a total of 68 percent in 1987 and 1988. In 1989, the central bank increased interest rates and imposed reserve requirements to moderate credit expansion. In 1990 and 1991, the economic situation was exacerbated by a fall in trade with the Soviet Union. Asset prices collapsed, banks had to be supported by the government and GDP shrank by 7 percent. In Sweden, a steady credit expansion through the late 1980s led to a property boom. In the fall of 1990, credit was tightened and interest rates rose. In 1991, a number of banks had severe difficulties because of lending based on inflated asset values. The government had to intervene and a severe recession followed.

From The Anatomy of Financial Crises: Understanding Their Causes and Consequences http://knowledge.wharton.upenn.edu/article.cfm?articleid=1856&CFID=66569081&CFTOKEN=98190552&jsessionid=9a30e6e83db13d1e6c23

Banking and currency crisis – there is a link

A well-established relationship is the link between banking and currency crisis. While we have been through a period of calm in developed countries over the last ten years, an application of the twin crisis concept suggests that these negative events are linked. Glick and Hutchison, two researchers from the San Francisco Fed, have reviewed the link between banking and currency crises in 1999 and found that most banking crises precede currency crises, but the opposite is not true. Currency crises do not always lead banking crises. For the period sampled (1975-1997), the researchers found that of the 90 countries looked at 72 had banking issues and 79 had at least one currency crisis. The period saw 90 banking and 202 currency crises with the number increasing in the 90’s. Twin crises occur more often than many may anticipate. My reading of the data suggests that the prevalence of crises has fallen over the last 10 years but has not been eliminated.

While most of the crises have focused on the emerging markets, the same logic could apply to larger developed countries like the US. Because banks are not as important to the overall capital markets in the US as in developing countries, we would have to broaden our definition of banks to include other financial intermediaries or the shadow banking system. Many banking crises are caused by bubbles like what has occurred in the US mortgage market. Clearly, the values for homes have increased at an alarming rate relative to the historical and some valuation techniques. Banking crises are also tripped by non-fundamentals like a bank run which occurred with Bear Stearns. Finally, banking crises can be caused by moral hazard problems associated with financial liberalization. The whole development of new mortgage products in an unregulated manner may proxy for liberalization risk. http://www.frbsf.org/econrsrch/workingp/pbc/1999/wppb99-07.pdf

The issue is whether we can classify the current credit problem in the US as a banking crisis and whether the sell-off in the dollar is a currency crisis. I would argue that we are in the midst of a twin crisis, even if the criteria used to measure these twin crises in emerging markets are not met for the dollar.

Banking distress, like we are currently facing, will have an impact on capital flows. The dollar is fundamentally different as a reserve currency hence the change in the exchange rate or the measure of a systematic banking problem may be muted. The channel of transmission for the currency crisis in this case is not a failure of banks which creates risk aversion with investors but a monetary policy stance by the Fed which is out of synch with the rest of the world. The Fed is easing fast in a inflationary environment when other central banks have been tightening, This difference in monetary policies is consistent with “first generation” model of currency crises based on fundamentals; however, the change in risk aversion of many global investors have portfolio rebalancing effects on the dollar which is consistent with “second generation” models of currency crises.

Most central banks have started to tighten monetary policy except for those countries which have been affected most by the credit crisis. The three central banks which have eased are the Fed, Bank of Canada and the Bank of England. All are facing different degrees of credit/financial crises. For Canada, the link with the US has forced easing as well as the crisis associated with commercial paper funding. For Great Britain the problem has been with mortgage lenders which have lead to the take-over of Northern Rock.

The twin crisis framework may provide a good way of looking at how the dollar may trade for the rest of the year. Any improvement in the bank crisis will carry over for dollar strengthening.

Currency intervention – Is it possible?

Whenever there are large sustained moves in currency markets, there are macroeconomic winners and losers. The losers, usually those with strong appreciation, will see declines in exports and GDP drag. The losers will start to contemplate the use of central bank intervention directly in the foreign exchange markets to arrest the change in currency levels, so it is natural to hear the current discussion about intervention to stop the dollar decline. Nevertheless, it is unlikely at this time given the underlying economics and political environment.

What academic research has shown is that first, uncoordinated intervention will not have a long-term impact on foreign exchange markets. Second, intervention without a change in underlying monetary policy is unlikely to have a strong effect. There have been periods of coordinated intervention and these have had an impact in reducing or changing the direction of exchange rates, but the number of cases over the period of flexible exchange rates is limited. The coordinated events include:
1. The Plaza Accord – 1985; push dollar lower.
2. The Louvre Accord – 1987; push the dollar higher.
3. Yen reaction – 1995; halt dollar decline.
4. Yen support – 1998; halt yen decline.
5. G7 Euro support -2000; halt Euro decline.

Intervention has been used to smooth exchange rates or reduce volatility. In general, these actions have been ineffective at changing the direction. In fact, trend-followers usually do better during these periods of volatility smoothing because the noise in the price trend is reduced.

The current dollar decline is actually quite consistent with the economics across countries. The dollar decline has matched the change in interest rate differentials with many countries. With interest rates actually higher in Europe, it should not be surprising to see a dollar decline if you believe in a carry story. For the case of Japan, even with the highest inflation in over a decade, the real rate in Japan is higher than what we are seeing in the United States. Monetary policy is looser in the United States relative to many other countries which is dollar negative. The growth prospects in the United States are also lower which is dollar negative. This is without even considering the credit risk issues concerning US investments associated with the mortgage crisis. All of this suggests that the direction of the dollar is consistent with theory.

On the political side, the general belief by most governments is currencies should be allowed to operate as a competitive market except if there is excessive volatility. The dollar, by the volatility standard, does not fit the criteria. There also does not seem to be much concern about the dollar decline in the US government. The Bush government has not made any comments that would suggest that there is a concern about the dollar. There is also a desire by the US government for a lower dollar to help exports and the current account deficit. While the ECB has commented that it is “concerned” about the dollar decline, Euroland monetary policy is hawkish and out of step with the US which has been on a course of rapid rate declines. They want to maintain the current policy which facilitates a strong euro. Without a head of the Bank of Japan, there is less likelihood of strong yen leadership for a decline.

Finally, there is still the issue of the relationship between China and the G7. The overarching issue of global imbalances has been for a Yuan appreciation and a dollar decline. We are seeing the adjustment of the global imbalances, so it would be hard to now have the G7 state that the dollar decline has gone too far when the global imbalance issue still exists. Currency coordination cannot occur without some of the large surplus countries involved in the process, and we do not seem to have an intervention consensus.

What if the equity premium is not there?

An important thought piece in the Sunday NYT was written by Peter Bernstein “When the long view isn’t so scenic”. http://www.nytimes.com/2008/03/30/business/30view.html?ref=business

The most important orthodoxy in finance for the last 25 years has been the essential need to hold stocks for the long-run. This is based on the historical equity risk premium which shows that investors have been paid handsomely for holding stocks. When in doubt, hold a good allocations in stocks (2/3rds equity and 1/3rd fixed income or other). If you have doubts about what you should do with your portfolio, don’t worry, just hold onto your equities and you will be fine. Yes, you will see ups and downs in any given year, but the best allocation policy is to put them away and not worry about the day-to-day fluctuations.

But what if this view is wrong? What if we are going to be in an extended period of poor performance for the equity markets and the equity premium is not there? This does not mean that you will not be paid for taking risk, bu the idea of holding stocks as the best return to risk may not be present over the next few years. Of course, this will mean that any recession will have a long life. Stagflation will be with us for some time and may get worse. Of course, the assumption for many allocators is that since we do not know the future we should hold stocks as the base position.

For many baby-boomers the next twenty years may be the most important, yet what is the alternative. Fixed income has a negative real yield. Cash is no better. The glamour of hedge funds is gone. The case for stocks may be based on the lesser of alternative evils. It certainly is not a time to reach for riskier asset. Or is it? Perhaps this is the time when you are paid for taking risk, but the issue is where you should find these opportunities an holding a stock index may not be the solution.

An interesting observation on trade and farm economics

What would David Ricardo or Adam Smith say about this logic?

"I am still a cotton farmer, and I have been in the fields in Mali, where all the work is done by families with small land holdings. Cotton production costs 73 cents per pound in the United States and only 21 cents per pound in West Africa, so American farmers do need protection in the international marketplace."

Jimmy Carter in the Washington Post, Dec 10, 2007.

Bank crises -- How long can they last?

Make no mistake about it. The credit crisis of 2007-08 is not a mortgage crisis but a banking crisis. It is not an isolated problem albeit the subprime mortgage crisis is the root cause. You can define banks in the traditional way or through the shadow banking system of financial intermediaries but the decline in credit is affecting all parts of the financial system and should be looked at in the context of as banking crisis. Bear Stearns, while not technically a bank, saw a classic bank run. The lack of liquidity or funding could not be stemmed because the asset on the balance sheet could not be converted to cash fast enough.

We should look beyond the financial history of the United States and view this bank crisis in the context of other global banking crises. We do have information on other banking crises and can use it to gauge what may be the potential length of the current US problem. These banking crises do not end overnight. The process may take years and they have not been limited to developing countries. The last banking crisis in the US was the savings and loan debacle which lead to the RTC as a bailout mechanism. A table of the banking crises in developed countries shows that they can last about a year as a median, but on average will take much longer to solve. If you measure the crisis as starting in August 2007, we have a long way to go to solve this credit crunch. The average crisis will last around 4 years.

Glick and Hutchinson (1999), two authors who have written extensively on the issue, define a banking crisis as a situation where at least one of the following conditions holds: i) the ratio of non-performing assets to total assets is greater than 2% of GDP; ii) the cost of the rescue operation is at least 2% of GDP; iii) banking sector problems result in large-scale nationalization of banks; and iv) extensive bank runs lead to emergency measures.

By their standard, we may be early in defining this as a full- fledged banking crisis, but we are showing all of the signs. The non-performing loans as a percentage of all mortgages may hit their criteria. The rescue operation is only beginning but if we follow the lead of some presidential candidates the cost to taxpayers could be substantial. While there may not be nationalization, we are heading toward more banking regulation as evidenced by the Treasury proposal for more Fed powers. The extensive bank runs and potential failures have already led to emergency powers for the Fed.

Do not expect any quick solutions; however like other banking crisis what will be notable will be the uneven impact on a economy. We are already seeing some this. The Midwest which never had the housing excesses is less affected than other parts of the country. Banks which followed traditional lending practices have good balance sheet and are thriving. All this means is that volatility will be greater and there will be greater differentiation across companies and asset sectors.

Appendix B from “Asset price crises and banking crises: some empirical evidence- Anne Vila; Bank of England Banking crises using qualitative identification method (after Glick and Hutchinson (1999))

Canada 1983-1985
Denmark 1987-1992
Finland 1991-1994
France 1994-1995
Germany 1978-1979
Italy 1990-1995
Japan 1992-1997
Norway 1987-1993
Spain 1977-1985
Sweden 1990-1993
United Kingdom 1975-1976; 1984-1984
United States 1980-1992

The dream of farmers a reality, but what will the summer hold?

The school of agriculture's dean of admissions was interviewing a prospective student, "Why have you chosen this career?" he asked.
"I dream of making a million dollars in farming, like my father," the student replied.
"Your father made a million dollars in farming?" echoed the dean much impressed.
"No," replied the applicant. "But he always dreamed of it."

The high commodity prices have been a boom for farmers. Land prices are up and incomes are at their highest levels in decades. You have to go back to the big grain spike of the early 1970’s. There is no bust in the farm belt, but even here there is talk of problems.

Floods in the Midwest will reduce the quantity that will be produced which affects income. Competition from Latin America in the export market has been strong even with a falling dollar. Financing is becoming a problem as lending standards across all products are tightened in response to the home mortgage crisis. Volatility is at the highest level in decades so any decision of when and how to sell is filled with risk. Selling crop forward is always an issue that can be filled with regret for any farmer.

Futures price for grains have been settling higher than the cash market, so the price the farmer receives at the elevator is not the same as what a farmer is seeing at the CBOT. Commodity markets have been under significant stress from the flow of new participants. This summer will also provide an interesting backdrop for the classic fight between hedgers and speculators. We have seeing margin increases on speculative positions which will change the dynamics of liquidity.

Unfortunately, whenever there are these price spikes, there are excesses in behavior. The lessons of one market usually will not carry over to the next, so bubble behavior in commodities should start to appear.

Federal Home Loan Banks add to rescue

The Federal Home loan Banks have been allowed by the Federal Housing Finance Board to purchase more mortgage securities and increase their asset base given their current bank capital. They should now be able to purchase up to $150 billion through an increase in their limits to purchase assets up to six times their capital base from three times. This increase FHLB leverage will allow for new marginal mortgage buyers in the secondary market on a temporary basis. This does not add money to the financial system but allows for credit expansion to offset the deleveraging by traditional banks. The increase in their capital buying ability is for a two year period.

The current action adds to policy changes in Fed lending and the buying ability of Fannie Mae and Freddie Mac. This should lead to tightening of mortgage spreads and may change expectation in the mortgage market. We should see more interest is selling Treasuries and buying mortgages. If mortgage credit becomes more reliable, mortgage transaction will start to increase and there may be some clearing of the market. This will not solve the crisis but it a good alternative to cutting the Fed funds rate. This type of action will be dollar positive because it reduces the chance that the Fed will have to follow a policy of continual cuts.

The strength of emerging markets – still the main theme of 2008

One of the major themes of 2008 will be the continued growth of emerging and developing markets. It has been characterized as the decoupling investment story. This growth theme has not been believed by many investors either for the long or short-run. Past history states that the direction of the US and the policies of the developed economies will determine the fate of the emerging market but times have changed. The old rules and assumptions applied to emerging markets currently do not seem to apply. The new emerging market world is characterized by four conditions:
1. Growth decoupled from United States
2. Sustainable high growth rates
3. Current account surplus positions
4. Growth independent of foreign aid

All four of these conditions are unusual. It has been the lack of these conditions which have been the key arguments for avoiding emerging markets, yet the current environment have made all of the old assumptions are faulty.

Growth can be had without the United States being a leader. The rise of the middle class in many of these countries have allowed for internal growth. The strong demand for commodities has also pushed up the growth rate for emerging markets. The lack of capital expenditures in commodities have lead to higher prices which provide cash flow for new capital investments by these countries.

Growth can be sustained at relatively high level and not just something that is a short-term phenomenon. First, and foremost the education and infrastructure developments mean that many emerged countries have the environment to sustain growth. Second, the commodity boom is not something that will not be short-lived.

Current account surplus can occur with emerging markets. The restructure of balance sheets with better fiscal management mans that cash flows from exports have allowed many emerging market countries to have better current account situations. The variables that were used to measure the potential for currency crisis are all pointed in the right direction.

The last assumption that developing countries can have sustainable growth without foreign aid is probably the most engrained in Western though yet it is the premise that is most problematic especially after Reading William Easterly’s The White Man’s Burden: Why the West’s Effort to Aid the Rest Have Done so Much Ill and so Little Good. The developed world may not be needed to help these countries because they have found a means of obtaining economic independence or just do better when left to their own devices for finding an economic structure that works.

William Easterly, who has also written The Elusive Quest for Growth, may be one of the most insightful researchers on economic development and growth. Certainly, he is one that is most willing to confront conventional thought. This willingness to question convention through thoughtful gathering evidence makes him essential to thinking about growth and development. His premise is there are planners, who represent the traditional thought of dealing emerging markets and searchers who are the agents of change who look for viable solutions. Easterly destroys the underlying assumption for all aid based on the big push. The big push argument has driven all World Bank, IMF, and Western aid in general. For growth to be sustained in developing countries requires large amount of aid to get countries jump started on a high growth trajectory. Without this aid, growth will only be sustained at low levels. A careful review of research as well as his experiences at the World Bank has him conclude that the countries do not need a big push. They do need the rule of law, property rights, governments that will not steal from the people, and aid that is targeted to specific goals which are measurable. High growth has been in those countries where the market structure allows individuals to creatively find solutions to specific problems. Market structure is necessary to finding good economic solutions.

The change in the market structure may be the most important factor that will allow developing economies to stand on their own and be decoupled from the developed economies and the current crisis. Of course, we are talking about the long-run and not just the current cycle.

Do we need a Home Owners' Loan Corporation (HOLC)?

An interesting research piece was done well before the current housing crisis by Price Fishback, William Horrace, and Shawn Kantor for the NBER in 2001, “The origins of modern housing finance: The impact of federal housing programs during the Great Depression”. This is a good economic history of the housing policy in the 1930’s. Two programs were the core of housing policy during the New Deal.

One program was FHA insurance which still exists today to promote home ownership. The development of GNMA was an effective program for promoting home ownership. These Federal programs revolutionized housing finance by making it national through the packaging of loans. The insurance reduced the premium associated with the risk of default.

The second policy program was the Home Owners' Loan Corporation which was used to refinance or restructure mortgages which were ready to or in default. The program was used to support restructuring of delinquent mortgages facing foreclosure. This was not a guarantee program. It was a program to forestall default and reduce the chance an excessive amount of the housing stock flooding the market and further depressing prices. The objective of the researchers was to see whether the HOLC was able to stop defaults based on refinancing the mortgages and reduce the plunge in housing prices. The evidence on the effectiveness of these programs was mixed. The default rate was by any measure high for the mortgages taken on by the HOLC so it is hard to measure whether the defaults were less then without the corporation. These were mortgages on the brink. But, the program delayed housing from coming on the market during the height of the Depression; consequently, there was less chance of the further feedback of declining home prices forcing more foreclosures. The program was short with lending only extending to 1933, but the portfolio of over 1 million loans had a long-term impact. Many of the defaults were delayed until the 1940’s. So in a sense, the program was effective. Unfortunately, the authors of the research do not have enough evidence to conclude that HOLC was a complete success.

The concept of a HOLC for the 21st century may be an effective way of delaying some of the foreclosures in the market and may be an alternative to the setting up a moratorium for foreclosures. Alan Blinder provides a nice peice on this type of program in an NY Times editorial.

http://www.nytimes.com/2008/02/24/business/24view.html The government would take terms that were at lower market rates but would save the expenses of going through foreclosure and fire sale at this most sensitive time.

More government action -lower rates and more mortgage purchasing power

The Fed lowered interest rates by 75 bps yesterday. While some market participants were expecting 100 bps, this was the right action by the Fed. The Fed still has room to further lower rates if needed, but they should not use all of their power to lower the Fed funds rates too early. The credit crisis seems to have had ebbs and flows with changes in information. There still needs to be further writedowns and we do not know what mortgage foreclosures will look like as the overall economy deteriorates.

A further concern should be the the chance of a liquidity trap which we saw in Japan during the 1990's. This is a real issue when there is a combination of a slowing economy and interest rates close to zero. The Fed's statement yesterday pays lip service to inflation, but this is also a serious concern. Real rates are strongly negative.

This chief policy issue is now getting banks to lend appropriately while still selectively lowering excess leverage. As important as the lowering of rates by Fed yesterday is the increase in lending lines by Fannie Mae and Freddie Mac. Regulators approved $200 billion in purchasing power. Refinancing when rates are falling relieves payment pressures.

Add PDCF to the central bank toolbox

The primary dealer credit facility was added by the Fed to the TAF and TSLF lending program. This allows borrowing by non-bank primary dealers from the Fed. Given the lack of liquidity in the mortgage market, this is an excellent means of providing financing for market making activity and may be the best way of providing some relief to the housing market while solving the liquidity gridlock on Wall Street. Lowering the cost of borrowing allows the Fed dropping of interest rates to be passed on the housing market. The spread on GNMA, FNMA, and Freddie mortgages have only widened since the end of the year, so cutting Fed funds has not been particularly effective. While there are added risks from the uncertainty in cash flows for mortgages, liquidity has been the key problem.

The $30 billion used to finance positions for the acquisition of Bear Stearns by JP Morgan also was a helpful action for the market. The unraveling of a large broker dealer would not help liquidity and would cause a lack confidence in the financial system, so providing lending is more important than lowering the overall rate. A bank run can be curtailed by providing funds not by changing the cost of funds. The discount rate cut while a minor action also puts this key bank lending rate closer to the Fed funds rate which makes it more attractive for banks to use as a funding facility. Forget moral hazard arguments now is the time to provide funds and Chairman Bernanke seems to have learned the lessons of the Great Depression well.

The week of 100's

This has become a week of extremes. We moved above $1000 per oz for gold. The oil market has moved firmly above $100 per barrel and ended above $110. The yen has moved below 100 with continued appreciation. The global markets are moving with a strange level of momentum.

There is an almost unprecedented desire to hold gold which has moved from $700 to $1000 in about one year. Gold may be an inflation hedge but the inflation is only at 4 percent for the CPI. There are strong flow effects caused by so much inflation worry.

Oil has moved higher even with a US slowdown expected. Where is the recession price concession? This is not following the economic relationships of the past.

The yen has further appreciated with moving flowing back to Japan. The home bias is strong when there is a large increase in risk aversion. The carry trade of borrowing short and lending to weaker currencies may be a thing of the past.

Fed Bailout of Bear Stearns

The Fed is behaving like the lender of last resort by providing funds to bailout a sinking Bear Stearns. This crisis has moved beyond issues of moral hazard from using public funds to bailout a private firm. Funds are necessary to maintain the integrity of the financial markets. The Fed is using its authority to lend to a non-bank entity through a special vote of the Board of Governors. The Fed pledged to "continue to provide liquidity as necessary to promote the orderly functioning of the financial system". The credit was extended through JP Morgan.

The stock market has seen increased volatility and has sold off hard even after economic news that was slightly better than expected. The problem is now determining what to do with Bear Stearns. Once liquidity to a dealer dries up there is little that can be done to save the firm. The only option is for some form of orderly liquidation of positions and there usually little that is orderly during a market sell-off.

Why you have to look at all economic announcements

The Fed credit lending plan caused the market to sky-rocket yesterday, but today the dollar reached new lows. Some market reporters are saying that Europeans believe the plan will not work. That may be true, but misses the other news coming out of Europe.

What actually is going on is the strong industrial production numbers announced for the Euro-zone. Without having to resort to massive injections of central bank funds, the European economies look like they have decoupled from the US and will be able to continue at a good growth. The industrial production numbers came in at 3.8% which is significantly higher than what was expected at 2.6%. While down from the highs of 2006, the industrial production numbers are staying above the 3% market for the last year when looking at a six month moving average. The low with last month's number looks more like an outlier.

It is surprising, given the better economic conditions, that European stock indices are off much more than what is seen in the United States. The Eurostoxx index is off 17% versus 10% for the S&P 500. While many are discussing a decoupling story, there seems to be a hesitancy with putting more money with this view.

Fed steps in to fund more collateral - Term Securities Lending

The problem with a credit crisis is limited lending, the quantity side of the equation not the price or rate. Credit is rationed without regard to price. Lowering the interest rate does not help in this type of environment; consequently, the Fed announcement that they will lend up to $200 billion and take collateral other than Treasury securities is the best possible action. This will provide stability to the mortgage market and infuse funds into markets that are in disarray. Securities lending which is secure for set periods may calm the markets and eliminate the risk of margin calls or pulling of overnight funds.

This is a smart move by Chairman Bernanke and an effective use of the Fed's role as lender of last resort.

OIl market taking on a new life

Go back a year ago and you would have seen an oil market in contango with the nearby contract at $60 and the futures one year out at $66 per barrel. We look at the same forward curve today and you see the nearby contract at $108 and July 2010 at $96, a steep backwardation.

So this is a commodity curve when the biggest oil user is going into a recession? The curve suggest that oil dynamics are changing with emerging markets having a stronger impact on price and OPEC being able to hold the line on production and cheating during the transition to recession. Unfortunately, the futures market messenger will be shot for this run-up. There is continued growing of the long positions in crude.

The complexities of money –

Is the Fed easing enough in the current environment? This is not an easy question. Of course, the cost of credit from the Fed has been lowered and there is a TAF mechanism for lending but are these policy actions working? One method of looking at the effectiveness of monetary policy is through analyzing the money supply. Don’t forget that one of the big research issues concerning the Great Depression was whether there was enough money in the economy. Milton Friedman made his career on the argument that the Fed was not easing and the contraction of the money supply was the key cause for the depth and length of the Depression. If credit is not expanding we can look at it through the lens of monetary growth.

Unfortunately, the numbers do not provide a simple answer. In fact, the monetary aggregates show a very mixed picture. Some would argue that this mixed picture is a clear testimony for why money does not matter. I would argue that the confusion itself is sending some form of signal and we are required to develop an appropriate story for what may be driving the economy.

For example, a close look at the monetary base shows that there was a significant decline near the end of the year before the introduction of the TAF. The YOY change in monetary base has been in decline below 5% for a number of years. Surprising, M1 money supply has also shown flat growth since the fourth quarter of 2005. There have been other periods of negative growth which have been associated with the slowdown in 1996 and the recession in 2000. Broad money as measured by MZM has moved above double digits but this could be due more to a shift in portfolios. More money is moving into cash alternatives. Total debt has been growing at a faster rate than money. There is a strong argument from these numbers that money growth has not been as fast as financial growth which has been driven by leverage. The velocity of MZM money is showing a decline which is consistent with a cut in the growth of leverage will cause financial debt to move more in line with money growth

Consumer credit has been stable at around 5% since 2003. Nonfinancial commercial paper is still growing around 20% but the strong declines during the last recession suggest that there is plenty of leverage reduction to go with this credit slowdown.

One of the more interesting charts provided by the Monetary Trends publication of the St Louis Fed is the Taylor rule for the Fed funds rate associated with different inflation targets. We are now at rates which would be appropriate for 2% target inflation, but the Fed funds rate was just too low relative to even a 4% inflation target. If there is a lag between rates and inflation, we should not be surprised by the current environment. Using the McCallum rule for combining the monetary base growth and inflation targets, we are in the band that is associated with 2% inflation. There clearly is a breakdown in a number of monetary relationships.

Real rates in the US are negative –

We live in a real world and if you look at real rates there is not a strong case for investing in US fixed income. With nominal yields moving lower under the expectation that the Fed will further cut rates and with inflation moving higher, real yields have been plunging. The fall of real yields to negative territory is consistent with the decline in the dollar. Other countries have seen erosion of real rates but the US is leading the pack.

The large divergence between real differential and nominal differentials makes it clear that carry trade analysis has to change. We have not seen the going dispersion of real rates over the last fifteen years so any nominal yield work was sufficient. But, we currently have two effects. One there is growing dispersion in inflation around the world. Inflation volatility increases with rising inflation. Two, there is growing dispersion in nominal rates as different countries pursue different monetary policies. The differences in nominal rate sis not a function of expected inflation. Consequently, there is growing dispersion in real rates.

Economic news was not surprising last week - more of the same only worse

ISM manufacturing index comes in below 50 which means that the idea that exports will drive the manufacturing sector is not doing enough to offset the internal slowdown.

Construction spending is down and vehicle sales are anemic. Factory orders are negative and the ISM non-manufacturing numbers are also below 50. Initial jobless claims are slightly lower and the continuing claims are slightly higher. The Challenger job cuts were down 14 percent over the last year and the ADP employment change was down over 20,000. We ended the week with non-farm payrolls down over 60,000 and manufacturing payrolls off by over 50,000.

Mortgage delinquencies are now pushing closer to 6%. The housing market is still on a downturn.

The real story is the credit crunch. Dow Jones lost 350 points on the back of hedge fund and mortgage fund failures. The systematic delevering by financial institutions who extend credit is the number one issue driving the financial markets. Or, as mentioned by the blog Calculated Risk, "Who is this guy Margin who keeps calling me?”

TAF to the rescue

We have commented that there is limited actions that can be taken by the central bank during a credit crisis; however, the one action that can be helpful is providing liquidity to banks. The Term Auction Facility, TAF, whereby the Fed lends against different collateral can be very effective if funds are not available from other sources. The TAF has been raised to $50 billion for the March 10 and 24th auctions and the Fed has stated that it will make $100 billion available through repos.

These funds could be used by banks to finance the purchase of mortgage collateral by banks to make liquidity for others. With spreads so wide for even high quality collateral, this is an effective means of stabilizing the market. Of course, we will have to look at the Fed balance sheet to determine whether this action more than offsets the reduction in credit elsewhere.

Mortgage meltdown?

The mortgage market is going through a significant upheaval with spreads widening to levels that we have not seen since the mid 1980's. Since the beginning of the year we have seen spreads move from 160 bps to the current level of 225 bps for current coupon 30-year GNMA 8% coupon and from 170 bps to 240 bps for 30-year FNMA 8% coupon. A year ago we were looking at spreads in the 100-120 bps. What is surprising about these spread changes is that GNMA has the full faith and credit of the US government and FNMA is a government sponsored entity GSE.

Ar these a good deal? Hard to say because the underlying collateral may be changing and it is not clear what the impact would be on the pool if there are increases in delinquencies and foreclosures. We are in uncharted territory, but what was previously a low risk instrument is now priced as a risky security.

This widening of spreads starts to change the calculus of investing for foreign capital. In the near term, the higher risk has pushed capital back to home countries which have currency account surpluses, but over time these spreads will look attractive and will offset some of the decline in Treasury yields. Using interest differentials for government bonds may send false signals on what may happen to global capital flows.

Market is more negative than the Fed -

The relationship between the Fed funds rate and short Treasury yields is usually very tight. The 3-month bill rate will be only slightly above or below the Fed funds rate. If it is above the Fed funds rate any significant amount, the Treasury market is saying that they exact that the Fed will raise rates. If it is below the Fed funds rate, the market expects a rate cut.

The differences between the Treasury yields and Fed funds are now at levels well beyond the norm. The market is stating that they expect that this recession is going to be much worse than the Fed is forecasting and have thus driven down rates. Just as important, there is a significant flight to quality. With more hedge funds have trouble and the mortgage market in disarray, the demand for Treasuries especially on the run issues is significantly greater than the current supply. Three-month Treasury yields are now below 1.5% so at a 150 bp discount to the Fed funds. The Fed is behind the curve.

The relationship was closed after the last Fed cuts but recent events have caused more quality flight. Watch these numbers closely.

Central bank politics -

Who will be the head of the Bank of Japan? The five year term of Governor Fukui is up in less than two weeks and there is no guess on who will lead the central bank. The Bank of Japan actually gained its independence relatively recently and this is a test of whether the monetary authority will be independent of the Japanese parliament. The likely successor is deputy governor Muto, but it is anyone's guess whether this will occur. Now some of the current problem in Japan has nothing to do with monetary policy. It is unlikely that the Bank will deviate significantly from its conservative stance, but this is an area that can become politicized.

The relationship between government and central bank is a problem that will grow as we enter more economic uncertainty around the globe. The central banks of the world have been left alone to follow strategies of inflation targeting and not worry about growth targets. If there are recessions in a number of countries, there will be more talk of having central banks that will focus on the growth side of the equation.