September 17, 2007
The Fed: Magical Fairies and Pixie Dust
“All you need is faith and trust
- Peter Pan
Wall Street continues to hold its breath about the upcoming decision by the Federal Reserve. There's no question that the Fed's decision will have a market impact. This is not because Federal Reserve operations matter, but because investors believe they matter. The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that – typically about $2 billion dollars – is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window” – though higher than in recent years – still amounts to only about $3 billion.
There is no well defined “monetary transmission mechanism” by which these minuscule amounts affect bank lending. Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the “year 2000” turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990's, when reserve requirements were removed on all bank deposits other than checking accounts.
To believe that the Fed operations matter, you have to believe that a $13 trillion economy is controlled by a few billion dollars of reserves and discount window borrowings, none of which vary materially from year to year.
The notion of a powerful Fed is not knowledge born of analysis, but belief born of repetition. Stop to think about how you learned that the Fed controls the economy. Not that interest rates are important (which is certainly true), but specifically, that the Fed is important. I learned it in college, from the “money multiplier” theory that links bank reserves and bank lending (obsolete since the early 1990's when reserve requirements were largely eliminated). Some investors learn it by hearing that the Fed “controls interest rates” and by quietly equating “interest rates” with “Federal Reserve.” Some investors learn it by seeing economic outcomes that follow Fed moves “with a long and variable lag” (as one would learn that the sun rises because the rooster crows).
Once we believe that the Fed is important, we look for confirmation in the same way people read their horoscopes and remember only the accurate ones. If recessions follow expansions and expansions follow recessions, then any magical spell that is routinely invoked during recessions will also be routinely followed by expansions (though perhaps with a lag). Similarly, any wave of the wand that routinely accompanies late-stage expansions near full capacity (as Fed tightenings do) will typically be followed by economic softness.
Correlation doesn't imply causation. We need to ask: what is the mechanism by which Fed actions have these effects? If we're convinced that the Fed matters, we can't stop at belief or argument – we need consider reasonable mechanisms, and then actually test them against data. If investors don't do this, they have nothing but superstition. They quietly equate the black cat, or the ladder, or the broken mirror, or Ben Bernanke with an outcome, without looking for any testable relationships that link cause and effect.
So let's look at the data. All figures are in billions of U.S. dollars.
A few notes. The Federal Funds Rate is the overnight rate at which banks lend their excess reserves to other banks. Excess reserves are typically only about $2 billion of the roughly $45 billion in total reserves. Meanwhile the Discount Rate is the interest rate on funds lent by the Fed to U.S. banks. That amount is presently about $3 billion. These are the quantities and interest rates over which Wall Street is obsessing.
The Federal Reserve controls one monetary aggregate – the U.S. monetary base, the vast majority of which represents currency in circulation. In a nutshell, the Fed buys U.S. government debt and creates “base money” in the form of either bank reserves or currency. Of the $552.4 billion in securities purchased by the Fed since 1990 to create new base money, $546.3 billion – about 99% – represents currency in circulation; the pieces of paper in your pocket that have “Federal Reserve Note” printed on top.
In general, "injections" of base money by the Federal Reserve into the banking system don't stay in the banking system at all. The vast majority of base money created by the Fed is not used for new bank lending, but to provide a reasonably steady $30-50 billion a year in new currency that predictably gets drawn out of the banking system and stays there.
Total U.S. bank reserves have grown by only $3.1 billion since 1990, to a total of $44.9 billion. Again, it is the day-to-day trading between banks of this amount (and actually, only of “excess reserves” – typically about $2 billion dollars) that determines the Federal Funds rate.
The Federal Reserve lowered the “discount rate” and opened the “discount window” a few weeks ago. Total borrowings from the Fed have increased from about $360 million in July, to $3.2 billion currently. While some analysts have breathlessly noted that “borrowings from the Fed have soared to the highest level in years,” the total amount of this “fresh liquidity” is about the same as the total assets of the Strategic Growth Fund.
In contrast to about $2 billion in excess reserves that is the basis for the Federal Funds Rate, and about $3 billion that is currently being lent at the Discount Rate, the U.S. banking system presently carries about $3.4 trillion in real estate loans, and $6.3 trillion in total loans. Gross domestic product is currently about $13.8 trillion.
While the Fed has purchased a total of $240.7 billion in U.S. government securities since 2000, mostly to create currency, foreign investors have purchased $1,185.8 billion in Treasuries alone. Indeed, foreign purchases have absorbed all of the increase in U.S. Treasury debt over the past year (and then some). It makes a great deal of sense to pay attention to foreign capital flows and the U.S. current account. In contrast, except for the psychological effect on investors, it is a mistake to believe that Federal Reserve operations control the economy.
The Fed is, at best, a square-dance caller - the guy who by mutual consent gets to holler out when to swing your partner and when to do-si-do. The Fed provides coordination, but it is a mistake to think it has power. When the barn is on fire and people no longer find it in their best interests to follow along, you can bet they'll dance to their own tune (as we're starting to see in the Eurocurrency market, where LIBOR has significantly diverged from thee Fed Funds rate being "called out"). The Fed can provide a modest amount of liquidity to the banking system, but it can't provide solvency to the mortgage market. It's dangerous to believe that a reduction in the Fed Funds rate or the Discount Rate will materially change credit conditions here.
Still, we'll all be gathered there under Ben's helicopter on Tuesday, hoping for a sprinkling of magical pixie dust.
Off to Neverland!
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund continues to hold a fully hedged investment stance – fully invested in a diversified portfolio of individual stocks, with an offsetting short position in the S&P 500 and Russell 2000 indices to mute the impact of market fluctuations. As usual, when the Fund is fully hedged, the primary source of expected returns is the difference in performance between the stocks held by the Fund and the indices we use to hedge.
The Fund is emphatically not hedged based on a forecast or expectation of a major market decline here. It is hedged because – on average – the S&P 500 and other indices have lagged Treasury bills under similar conditions. If market internals were to improve materially (without establishing a steeply overbought condition), we would remove a portion of our hedges and accept some amount of “speculative” exposure, despite valuations that I view as rich.
Though observed P/E ratios may not appear extreme, these multiples implicitly assume that record profit margins will be sustained indefinitely, and that earnings will permanently remain at the top of the long-term growth channel that has connected earnings peaks across past economic cycles. Historically, when earnings have been similarly elevated, the price/peak-earnings ratio on the S&P 500 averaged less than 11, and the price/forward-operating-earnings ratio would have been closer to 9. A “modestly elevated” P/E on record earnings at record profit margins is an exorbitant multiple on normalized earnings. Investors will learn this over the complete cycle.
Credit spreads remain wide, and risk-sensitive spreads like 6-month commercial paper to 6-month Treasury bill yields and LIBOR to Treasury bills (the “TED” spread) are particularly concerning. While recession risks are elevated, we still don't have sufficient evidence to expect a recession as a probable outcome. A further weakening of the stock market coupled with a drop in the ISM Purchasing Managers Index would dramatically increase the risk of imminent recession.
Bonds have behaved well, but with a relatively flat yield curve, low yields at longer maturities, and a wide spread between Treasury bill yields and the Fed Funds rate, it's not at all clear that reductions in Fed controlled interest rates must or will translate into lower market interest rates. Indeed, yields on longer-term Treasuries are low enough that even modest yield increases (within a normal band of trading fluctuation) could wipe out the entire annual total return – even if yields remain in a general downtrend from a longer-term perspective. Suffice it to say that we would be much more inclined to extend our durations on bond price weakness (i.e. higher yields), even given the increasing recession risks. The Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 10% of assets in precious metals shares, where the Market Climate continues to appear favorable on our measures.
New From Bill Hester: Recessions and Bear Markets
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