September 12, 2011
Fed Policy - No Theory, No Evidence, No Transmission Mechanism
On Friday, the yield on 1-year Greek debt surged above 90%, while Wall Street still has barely blinked, evidently convinced by the bailout mentality of the past three years that governments will simply make the problem go away with public funds. One thing is certain - public funds will indeed be used to address this problem. But it is also nearly certain that those funds will be used to recapitalize European financial institutions (ideally, restructured ones) following a major default of Greek debt. The reason for this is simple. With Greek debt now beyond 144% of GDP and on track toward 180% by year-end, neither a further extension of credit to Greece, nor a modest writedown of its debt, would be sufficient to restore Greece's ability to service that debt over time.
It was only in June (see Greek Yields: "Certain Default, But Not Yet" ) that we published a schedule showing the probability of default implied by Greek yields, with several lines showing the probability of default depending on the expected date of default and the assumed "recovery rate" (the percentage of face value that bond investors could expect to recover in the event of default). That wistfully optimistic chart is reprinted below.
Amésos: Adv (Greek): Immediately, forthwith, straightaway.
As I noted in June, "At the point that a near-term default becomes likely, we would expect to see one-year yields spiking toward 40% and 3-month yields pushing past 100% at an annual rate (essentially pricing near-term bills toward the anticipated recovery rate). This temporarily reassuring situation, unfortunately, strongly contrasts with the longer-term outlook for Greek debt. Even assuming a 60% recovery rate (that is, assuming a default would wipe out 40% of the Greek debt burden), the implied probability of a Greek default within the next two years is effectively 100%. The only way you get a lower probability is to assume a far lower recovery rate."
With the soaring level of Greek yields last week, the default probability schedule has now become white space. Except on the assumption of disastrously low recovery rates well below 40%, the probability of default, regardless of the time horizon, plots as a bunch of horizontal lines, all at 100%. Simply put, the Greek debt market is screaming "Certain default. Amésos."
[Geek's Note: The implied probability of default is calculated as (1-exp(-(Y-Yf)*T))/(1-R), where Y is the yield in decimal form, Yf is the yield on a presumably default-free security (in this case, we're using comparable German yields), T is maturity, and R is the recovery rate, also in decimal form.]
Fed Policy - No theory, no evidence, no transmission mechanism
Undoubtedly, one of the main factors prompting a benign response to what is now virtually certain recession and virtually certain Greek default is the hope that the Fed will launch some new monetary intervention. While Wall Street appears to view the present weakness as a replay of 2010, it is strikingly clear that the evidence tells a different story, with a broad ensemble of data implying near-certainty of oncoming recession (see An Imminent Downturn ).
While we have to allow for the possibility of a knee-jerk speculative response in the event of further Fed intervention, it is also much clearer now than it was in 2010 that quantitative easing does not work, and that even its marginal effects have reached the point of diminishing returns. To a large extent, the only basis for further Fed action here is superstition in the absence of either fact or theory.
Ultimately, effective policy acts to relieve some constraint on the economy that is actually binding. Effective policy has some "transmission mechanism," where changes in the policy target can be expected to translate into decisions that improve the allocation of resources and the level of activity in the economy. Effective policy is also preferably grounded in historical evidence that supports its effectiveness, or at the very least does not contradict the action. At present, the policy menu advocated by Ben Bernanke has none of these advantages.
Consider, for example, a further round of quantitative easing through purchases of Treasury securities. With $1.6 trillion of excess reserves already sitting idle in the U.S. banking system, it is inconceivable that the U.S. faces any binding constraint that would be eased by the creation of more reserves (which is what QE does). With the 10-year Treasury yield already below 2%, it is also inconceivable that the U.S. faces any binding constraint that would be eased by further depressing that yield. Moreover, from an investment standpoint, it is difficult to envision a situation where long-term Treasuries purchased at current prices will not result in a loss for the Fed at some future date when the position is unwound - even a 0.25% increase in the 10-year Treasury yield presently would wipe out a full year of interest earnings. So the Fed would take a loss on newly purchased bonds even if it unwound them at a 3% Treasury yield four years from now. A failure to eventually unwind the position would be predictably inflationary. As for Bernanke's baseless view that higher stock market values trigger a "wealth effect" and a "virtuous circle" of spending and income, it is well-established in decades of economic data that each 1% change in stock market value is associated with a transitory increase of only 0.03-0.05% in GDP.
At best, a further round of QE would create an even larger pool of zero-interest assets that somebody would have to hold. That could prompt some of the same reaching-for-yield that we saw during QE2, misallocating resources, distorting markets, but ultimately producing no durable effect. So yes, by embarking on QE3, the Fed could try to engineer a brief burst of speculation in financial assets and commodities, and could put some additional downward pressure on the U.S. dollar on the foreign exchange markets. But to what real end other than the total loss of the Fed's remaining credibility?
A second option for Fed intervention would be a so-called Operation Twist, whereby the Fed would increase the maturity of its portfolio in an effort to further drive down long-term Treasury yields. Again - the 10-year Treasury yield is already below 2%. What binding constraint could the Fed possibly hope to ease through such an operation?
When companies invest, interest costs represent only a portion of their hurdle rate. Most of the reluctance to invest here is because there is already enormous slack capacity, and even for new products, there is generally great uncertainty as to whether there will be robust demand for the output. The Fed is kidding itself if it believes that a slight further reduction in long-term Treasury yields will matter in that calculus. Moreover, the literature on "real options" is clear that significant economic uncertainty is much like the implied volatility of an option - high uncertainty increases the benefit of waiting to "exercise" the option. Material restructuring of mortgage debt and sovereign debt, as painful as it might be in the short run, is really the only way to remove the drag of deleveraging and the weight of credit uncertainty that have anchored the economy in unemployment. Nothing in theory or in decades of economic evidence is sympathetic to the notion that a "twist" operation would have real effects.
On the subject of Operation Twist, we've been asked whether lengthening the Fed's portfolio might be a prelude to attempting to inflate away part of the U.S. debt. Actually, quite the opposite. The effectiveness of inflating away debt is greatest when the public holds long-dated government debt. Indeed, from a liability-management perspective, the Treasury really ought to be issuing long-dated Treasury debt to the public here with both hands, particularly if yields decline further on credit concerns. This would be much like the corporate practice of issuing new stock into frothy and elevated markets (which is a common sign of aging bull advances). On any substantial decline in yield, the best way to preserve the solvency of the U.S., particularly if we have inflation in our long-term future, is to lock in low interest costs for very long maturities.
A third option for Fed intervention would be a reduction in the interest rate that the Fed currently pays on reserves. This would have two effects. First, it would reduce the income of banks from this source, and would therefore likely reduce the interest paid on time deposits. At the margin, that would make non-interest bearing cash an even closer substitute to bank reserves, and so - predictably - the other effect would be a reduction in the amount of reserves held on account at the Federal Reserve, and a corresponding increase in vault cash at banks. That's about it.
If the Fed was to go whole-hog and begin charging interest on reserve balances held at the Fed, the equally predictable result would be a wholesale collapse in the amount of reserves held at the Fed, and a simultaneous explosion in the amount of vault cash and currency in circulation (in effect, the monetary base would be unchanged, but its composition would shift sharply toward currency instead of reserves). I guess we could all buy stock in paper companies and manufacturers of green ink, but those are about the only real beneficiaries we would envision.
In short, neither economic theory nor established economic evidence provides any basis for the belief that further monetary intervention and distortion would ease any binding constraint on the real economy at present. This does not, of course, rule out the possibility of speculation grounded in superstition and a misguided impulse to reach for yield, but the Fed's ability to weave yet another set of Emperor's Clothes is justifiably deteriorating.
As a final note, since the likelihood of fresh credit strains is rapidly increasing, it's important to recognize that reserves are different than capital. Reserves represent funds that the bank has taken in through deposits and which have not been used for new loans, securities or other investments. Capital is the difference between the assets of a bank (regardless of whether they take the form of loans, securities, or reserves) and the liabilities it owes to depositors and bondholders of the bank. Too little capital, and a bank has no cushion against insolvency - assets might fall short of the amount needed to satisfy liabilities. So keep in mind that if a bank loses money on loans or other investments, those losses can cut deeply into capital even though the bank is highly "liquid" on the basis of reserves. Fed actions to inject "liquidity" can help a bank satisfy demands for cash if depositors cut and run, but those actions do not add to bank capital, and do not improve the solvency of the bank.
Market ClimateAs of last week, the Market Climate for stocks remained hard-negative, with valuations and market action both negative here. Strategic Growth and Strategic International Equity remain well hedged here, though we've been very flexible by allowing brief periods of modestly positive exposure at those points where the expected return/risk profile of the market peeks above zero. Presently, we are much more concerned about a major, abrupt break in the market than we are about missing a "fast, furious, prone-to-failure" clearing rally, but again, we'll take our evidence as it arrives, and remain open to shifting our investment stance in response to the evidence we observe. Strategic Total Return continues to carry a duration of about 1.5 years, with about 20% of assets in precious metals shares, and just under 4% of assets in utility shares.
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