December 22, 2008
The Dollar Crisis Begins
On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”
Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.
And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.
In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.
As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”
I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely.
For our part, we continue to prefer Treasury inflation-protected securities, largely because TIPS prices now reflect the prospect of sustained deflation over the next decade, in the face of a government that is issuing enormous volumes of liabilities and has nearly doubled the balance sheet of the Federal Reserve over the past 3 months. There is little question that we will observe near-term deflation in the CPI, particularly given that oil prices have plunged to a quarter of the level we observed at the speculative peak several months ago (Malthus Schmalthus). Still, with TIPS priced to deliver real after-inflation yields of 3-4% (higher for shorter maturities, but with greater risk in the event that the CPI drops for more than a few months), the combination of growth in purchasing power and relatively low duration risk is very reasonable. Corporate yields remain high, but have far more risk. Historically, corporates have not tended to bottom far in advance of the general stock market, since they are largely driven by the same risk factors and investor perceptions. A significant shift in exposure toward corporates would be, to some extent, a “bottom call” on U.S. stocks. While it's certainly possible that the November lows were the final lows of the market's decline, we would not invest on that basis, and we certainly don't have the evidence to indicate that investors have adopted a robust and sustained preference toward market risk.
As for stocks, whether or not the November lows were the final lows, I would expect that the market will remain in a very wide trading range of about 25-35% while the economy sorts through the still considerable uncertainties of the current recession. I continue to view stocks as undervalued, but am also very aware of the tendency for valuations to overshoot as much to the downside as they often do to the upside. In the Strategic Growth Fund, we remain well-hedged against major and unexpected market losses, while managing our option hedges to allow for moderate participation in more “local” fluctuations.
For now, near-term conditions still appear relatively constructive. Investors are breathing a sigh of relief as we get some distance away from the financial panic of October and November. The short-term help extended to the auto industry last week was also helpful in removing some important uncertainties. Moreover, with 2008 soon coming to an end, there some chance of a fairly hard “short squeeze” here. My impression is that many investors and investment managers believed that it was prudent to “lighten up” on stocks as they were plunging in October and November, locking in significant losses. The only thing worse than locking in a loss in a declining market is to miss the subsequent recovery as well. That prospect, coupled with the generally lighter trading volume around the holidays, makes the market particularly amenable to a good squeeze. We don't invest on that basis, of course, and are maintaining a moderate investment stance. That stance will continue until we observe less attractive valuations, a deterioration of market internals, or both.
As of last week, the Market Climate for stocks was characterized by favorable valuations, moderately unfavorable market action on the basis of broad measures, but further improvement in “early” measures of market action. Essentially, stocks appear undervalued, and investors – while not evidently adopting a robust preference for taking on market risk – are at least backing away from the extreme risk aversion they had several weeks ago. The easing of risk aversion is certainly helpful, though as an economist, it still appears somewhat early to begin “looking across the valley” toward an economic recovery. Most likely, in my view, the market will continue to move within a wide trading range for several more months at least, while the ebb-and-flow of information about the economy gradually clarifies the longer-term outlook.
As I noted in April (04/14/08 – Which “Inning” of the Mortgage Crisis are We In?), I expected the second, third, and fourth quarters of 2008 to be the “heavy hitters” in terms of foreclosures, with the foreclosure rate peaking between about November 2008 and January of 2009. I continue to believe that the foreclosure rate is currently near its peak, and will ease as we move through 2009. However, I also noted that a second spike of mortgage resets will occur the third quarter of 2010, which means that the foreclosure rate (and associated loan writedowns) will most probably pick up again in the first quarter of 2011. So if the stock market does enjoy a new bull market as we move through 2009 (which is my expectation, though we'll take the evidence as it comes), my sense is that it will be one of the shorter-lived variety, much like some of the cyclical bull rallies we observe during the “secular” bear market from 1965 to 1982. That isn't to say that such an advance would be disappointing – even if the next bull market, whenever it occurs, simply peaks at the 2007 highs, stocks will have doubled from their recent lows.
As a reminder, a “secular” bear market comprises a whole series of bull-bear cycles, with the characteristic that each successive bear market tends to achieve a lower level of valuation at its trough, on the basis of P/E multiples, price/revenue multiples and so forth (even if actual prices don't break to new lows in each successive bear).
In bonds, the Market Climate last week was characterized by unusually unfavorable yield levels, and generally favorable yield pressures. As I've noted before, the return/risk profile in bonds is much more determined by by yield levels than by market action, because sustained periods of speculation in bonds are unusual. At this point, my reservations about long-term Treasury bonds here should be probably articulated as an outright warning: regardless of short-term factors, long-term Treasury bonds (nominal, not inflation-protected) face unusually steep price risk here.
For our part, the Strategic Total Return Fund continues to be invested primarily in Treasury inflation-protected securities, with about 25% of assets allocated to foreign currencies, utility stocks, and precious metals shares (where we modestly clipped our exposure further, to about 10% of Fund assets, on recent price strength).
Peace on Earth
Wishing you a Merry Christmas, and a bright, happy Hanukkah.
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