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The Federal Reserve Signals No Further Easing…Until the Next Easing

Posted on April 4, 2012, 12:12pm | James Groth

Minutes for the latest Federal Open Market Committee (FOMC) meeting were released yesterday afternoon sending the stock market down and Treasury yields up largely due to the hawkish tone of the release. Committee participants noted stronger signs in labor markets and improvements to output as lacking necessity for further easing. Outspoken hawks, President Lacker being the only one, stated that the current degree of policy accommodation beyond this year would be “inappropriate.”

Yet despite the meeting’s tone, members’ hawkish comments and the securities markets’ reactions, we will most certainly be seeing continued accommodation and likely further easing before the year’s end.

Why?

The following two charts:

The first is a 5-year chart of Treasury Bonds:

The second is a 25-year chart of commodities prices:

Selling in long-dated Treasuries has pushed yields up to uncomfortable levels. Despite Bernanke purchasing more than $40 billion per month under Operation Twist, yields on the 30-year Treasury Bond have gone from 2.7 percent when Bernanke first commenced the unprecedented buying program to just over 3.4 percent in yesterday’s trade. They are expected to go much higher. As selling pressure persists, the Fed will likely purchase more to offset the rise in yields that has been persistent since last October either through extending Operation Twist or by announcing another round of bond purchases.

The one thing that would stop the Fed from such a move is inflation pressures. This is where the second chart comes into play.

Bernanke has remained consistent pointing to a slack labor market keeping wages down and so holding off inflation. Recently he has also been pointing to declines in commodity prices (highlighted) as a sign that the initial rise in commodity prices was indeed transitory as he predicted throughout its rise.

The combination of dangerously high Treasury yields (yes, when the Federal Debt is nearing $16 trillion, even 4.5 percent on a 30-year is unmanageable), a slack labor market, and “declining” commodity prices is reason enough to continue debasing our currency.

But take a look at the charts again. Much of the weakness in commodities, or rather the slight pullback in prices, can be attributed to lower demand from the Eurozone. Similarly, some of the money pumped into Treasuries over the last nine months has come from sales of Euro area debt and other Euro securities. Recent trends point to this continuing.

Despite nearly $1.5 trillion in loans from the European Central Bank (ECB) pumped into banks and institutions since December and more than $100 billion of additional direct purchases of sovereign debt over the year, European periphery debt is still pricing in downside risk. The ECB’s efforts have attracted significant interest from domestic buyers, but institutions abroad in the US and elsewhere have not participated, and many have sold into the backstopped Euro buyers. Without further accommodation from the ECB, bond auctions in Spain, Italy, and Portugal will continue to disappoint and push up yields (as can be seen following today’s Spanish auction). Couple this with negative growth over all of 2012 and most of 2013 in the Euro periphery, as projected by the IMF (more severe projections by most economists), and one has to conclude that commodity pressures will continue to ease.

That gives Bernanke the green light.

Unless US employers start kicking up wages, inflation will be kept in check. This is regardless of the trillions printed by the Fed and the trillions more in the pipeline. Wage increases won’t broadly occur until unemployment hits closer to 6 percent, and that isn’t in the cards for……..? So, as long as the current US and Euro picture persist, Bernanke will soon once again hit the gas. Both the Fed and the Treasury can ill-afford any rise in Treasury yields.

And they are rising.

Banks and institutional investors are exiting long-dated Treasuries in droves. Yields on the 30-year and 10-year Ts are 3.4 percent and 2.3 percent respectively. That is up from 2.7 percent and 1.7 percent last fall. European buyers are parking funds that would otherwise be allocated to Ts into German Bunds which have decoupled from US Ts following the massive injection from the ECB. German 30-year and 10-year paper trades at 2.5 percent and 1.8 percent respectively. This is a significant spread from Ts, which before the ECB easing used to trade with similar yields.

Bernanke knows that without buyers from European institutions, and with domestic institutional selling, current Treasury yields cannot be supported. The Eurozone weakness and the US slack labor market is a godsend to further accommodation.

Signaling aside, the Fed is not finished. They won’t be until either Congress forces their hand, or for some reason American employers decide to bump wages and share the wealth. At present, a larger percentage of corporate earnings are going towards profits than to wages than at any other period since 1947. That may help shareholders, and the wealthy, but it is short-term and does not improve the economy as a whole. Expect more easing, expect more wealth divide, and expect more central bank control of the “free market.”

A Financial Products Agency is a Bad Idea

Posted on April 3, 2012, 10:21am | Anthony Randazzo

Back in February Eric Posner and Glen Weyl, both of the University of Chicago and deservedly respected economic and legal minds, wrote a paper proposing a Financial Products Agency. The idea is relatively simple—just as the FDA must approve new food and drug products for consumption, an FPA should approve all new financial products with a test measuring for social benefit. 

This is a terrible idea for at least three reasons:

First, an FPA would not have stopped the financial crisis. Let us assume for a moment that this FPA existed in 1998. Back then, when subprime debt began to pick up its pace, there was little understanding of the risk that was building up in the system. We can't just assume that having an FPA would mean regulators have somehow gained hindsight. Regulators were aware of what was going on to the degree that they had the resources to manage and the expertise to understand and didn't do anything then. Let's assume again that the FPA existed in 2004. Around that time regulators like Greenspan and Bernanke were well aware of the housing bubble but either did not think the risks were that big or did not think it was appropriate to step in. With rising housing prices (that all the regulators never thought would go down) masking the risks of subprime debt by preventing defaults, it is very hard to believe that regulators at this FPA would have done much to stop the risky financial products Posner and Weyl blame for contributing to the financial crisis.

Second, the model of the FDA is not a great idea unless you want to stunt markets. While the public has come to depend on the FDA to keep them safe there are regular outbreaks of diseases and complications with medicine. Even approved products can be misused. Beyond this, there are numerous cases where the FDA has prevented positive health outcomes, such as slowing down cancer prevention drugs for political reasons or sheer incompetence. And given the bureaucratic nightmare that is the FDA, it is impossible to know what drugs have not been pursued simply to avoid the compliance and approval costs and headaches. What we do know is that there is a growing problem of drug shortages in the U.S. and it is in part because of the FDA.

Finally, the whole argument for an FPA is based on the premise that derivatives contracts were significant contributors to the financial crisis. But derivatives—even the most risky contracts—are innocuous vessels. Blaming them is like blaming money for the crisis or computers. Though an argument can be made that there was too much money via central banks and too much computing power pushing high frequency trades, it is not the money or the computers but how they are used in connection with the other factors that caused the crisis. Derivatives contracts became a problem because the underlying assets they were being created with were misunderstood and financial institutions did not properly hedge their risk. If AIG had set aside the necessary amount of capital relative to its risk exposure, there wouldn't be as much carping about derivatives. If lending standards had not fallen so low, the subprime debt levels that did exist would not have been there to generate such a massive amount of unhedged, misunderstood, risky derivatives for subprime debt in the first place.

Unfortunately, despite these problems, the FPA finds the approval of NY Times business columnist Gretchen Morgenson, who wrote over the weekend regarding this proposed idea:

It is a refreshing rejoinder to the mantra on Wall Street — and in some circles in Washington — that financial innovation is always good and regulation is always bad. Bankers often argue that complex financial products are among America’s great inventions. But given that exotic instruments played a central role in the credit crisis, it is worth questioning the costs and benefits of such financial innovations. 

I agree that it is always worth questioning and debating and wrestling with ideas. That is the best way to avoid getting tunnel vision on something. But in this case, the idea under consideration is not a very good one.

Ms. Morgenson makes the problematic assumption at the start of her column that regulators would somehow have behaved differently if there were an FPA before the crisis. "Imagine if there were a Wall Street version of the F.D.A.," she says, "How different our economy might look today, given the damage done by complex instruments during the financial crisis." But as we were just pointing out, there was lot of authority to limit Wall Street. Financial markets are and have been one of the most heavily regulated industries in the U.S. But the only thing that I can think of that would have actually changed regulator behavior prior to the crisis would be something that eliminated regulatory capture. An FPA, just like the SEC, would have been filled with bureaucrats more than willing to use a light hand on approval procedures to ensure they had a job with some firm after their civil minded spirit got drilled into the pavement of Manhattan with one to many luxury cars. 

Then, Ms. Morgenson begins to lay out the case for the FPA, noting that the Posner/Weyl paper argues we should be able to regulate financial markets because they are different from the real economy, where a more laissez faire approach is good. The two leading problems with this argument are that:

1. Financial markets are so interwoven with the real economy that you can't truly separate the two. Financial markets are the lifeblood of new businesses, which in turn are the lifeblood of the U.S. economy. So anything regulations that unnecessary restrict credit are actually hitting the real economy; and
2. The problem is not a lack of rules but the absence of the right rules. If we learned anything from the crisis shouldn't a key lesson be that a lot of rules without regulators smart enough or inspired enough to enforce them winds up with meaningless protections and a false sense of security. It is foolish to depend on this regulatory crutch again and again. It is literally insane.

The next piece of the Posner/Weyl argument is that derivatives that are risky bear limited social utility and can cause system risk. I counter by arguing that: 

1. Just because something has limited social utility does not mean it should be restricted. Fantasy baseball may actually reduce productivity at work places across America, for instance, and may not get past a social utility censor. But I'll join up with an Upper Peninsula anti-government militia if the government tries to stop me from competing for glory; and
2. Derivatives in a market that has too-big-to-fail banks may cause systemic risk—but the problem there is the bloated banks and the lack of handling failed institutions. If every bank had 75 percent capital requirements there would probably be very little derivative risk. Of course we'd also have a nonexistent banking system. The key here is to solve for moral hazard and improper incentives in the system, not try to limit financial activity on the other side of the equation.

Ms. Morgenson further carries the Posner/Weyl case forward by noting they also want the proposed FPA to measure financial instruments for "how they affect capital allocation, and whether they might add useful information to the marketplace." Again, a couple of points:

1. How could an FPA really understand where capital should be allocated? Every regulator under the sun thought that capital flowing to the housing industry was a good idea during the bubble era. Imagine the FPA arguing in 2002 that there was too much capital flowing to the housing industry. It never would have happened, and on the off chance that our revisionist history unearths a Mike Burry to have influence in this FPA, the counter political pressure would have been too strong to let them do anything. Everything politically during the bubble was pushing capital towards housing. The Bush "Ownership Society" mantra. The previous decade's changes at Fannie and Freddie and FHA. Basel rules favoring housing. Even a massive accounting scandal at the GSEs failed to really derail their political or financial activities, so strong were the pressures to increase home ownership rates.
2. And why should a financial product be disallowed if it doesn't provide useful information to the marketplace? If I want to structure a deal with my neighbor where we place a complicated bet on the outcomes of real estate values from the properties of people two streets over, with a few voluntary counter-parties financing the bet... why should anyone else care? Posner and Weyl may respond they would care if my personal failure on coming up short in the bet posed a risk to the financial markets. But I would again push back that the problem then would not be the derivative contract but the fact that the system was so poorly incentivized that I could become a systemic risk.

The Posner/Weyl paper says in the introduction that Dodd-Frank is an empty vessel and on this point we agree. My remarkes are not a defense of Wall Street today or the regulatory system. This FPA idea is just not the right response mechanism to that problem. 

Regulators Making Moves to Force More Banks Into Mortgage Settlement

Posted on April 2, 2012, 10:49pm | Anthony Randazzo

A few weeks ago we warned that the mortgage settlement might not be limited to just the five banks that signed on, but that regulators would find a way to force others into the agreement, like PNC and US Bancorp. Well, today the NY Times reports:

Federal regulators are poised to crack down on eight financial firms that are not part of the recent government settlement over home foreclosure practices involving sloppy, inaccurate or forged documents. Last week, a senior Federal Reserve official recommended fines for these additional firms, raising questions about how deep foreclosure problems run through the banking industry.

The firms cited include, non surprisingly, SunTrust Bank, U.S. Bancorp, PNC Financial Services, plus five more: MetLife, EverBank, OneWest, Goldman Sachs, and HSBC’s United States bank division. The Times story continues:

The recommendation is the culmination of an investigation begun nearly two years ago over accusations that bank representatives had been churning through hundreds of documents a day in foreclosure proceedings without reviewing them for accuracy, a practice known as robo-signing. Some see the Fed’s recommendation as an attempt to push these firms to agree to the terms of the broader mortgage settlement involving the state attorneys general and federal officials. 

Count me as one of those seeing a push. More of a shove really. PNC, for example, believes that it is going to be required to sign on to the new national mortgage servicing standards and modify mortgages. But where Bank of America and JP Morgan Chase have plenty of investor mortgages to write down principal on—essentially using other people's money for their own fines—PNC does not. From their perspective this is unfair punishment, since they'll actually have to pay the fine.

In one sense, they are right. It isn't fair. But there really shouldn't be any write downs. There is a $1.5 billion settlement pool set up for the roboforeclosed and anyone whose home was wrongly seized can still bring legal suit. And if PNC and others committed the same failures they should pay into the settlement pool too. But modifying the mortgages of borrowers now, borrowers unrelated to the robosigning, is bad housing policy but extortion and not justice being served. 

Sound Money: Tide Laundry Soap Becoming Gold Standard in the Drug Trade

Posted on April 2, 2012, 7:57am | Anthony Randazzo

It is fitting that this story would surface around the same time that Bernanke has been harping about the gold standard. From TheDaily:

Law enforcement officials across the country are puzzled over a crime wave targeting an unlikely item: Tide laundry detergent. Theft of Tide detergent has become so rampant that authorities from New York to Oregon are keeping tabs on the soap spree, and some cities are setting up special task forces to stop it. And retailers like CVS are taking special security precautions to lock down the liquid. [...]

Tide has become a form of currency on the streets. The retail price is steadily high — roughly $10 to $20 a bottle — and it’s a staple in households across socioeconomic classes. Tide can go for $5 to $10 a bottle on the black market, authorities say. Enterprising laundry soap peddlers even resell bottles to stores. “There’s no serial numbers and it’s impossible to track,” said Detective Larry Patterson of the Somerset, Ky., Police Department, where authorities have seen a huge spike in Tide theft. “It’s the item to steal.”

So... what is up with this? Why Tide? Joseph Salerno picks up the story on the Christian Science Monitor blog:

This is just another confirmation of [Carl] Menger’s insight that the market responds to the absence of sound money by monetizing highly salable commodities. It is clear that Tide has emerged as a subsidiary local currency for black-market, especially drug, transactions — but for legal transactions in low-income areas as well. Indeed police report that Tide is being exchanged for heroin and methamphetamine and that drug dealers possess inventories of the commodity that they are also willing to sell. But why is laundry detergent being employed as money, and why Tide in particular?

Menger identified the qualities that a commodity must possess in order to evolve into a medium of exchange. Tide possesses most of these qualities in ample measure. For a commodity to emerge as money out of barter, it must be widely used, readily recognizable, and durable. It must also have a relatively high value-to-weight ratio so that it can be easily transported. Tide is the most popular brand of laundry detergent and is widely used by all socioeconomic groups. Tide also is easily recognized because of its Day-Glo orange logo. Laundry detergent can also be stored for long periods without loss of potency or quality. It is true that Tide is somewhat bulky and inconvenient to transport by hand in large quantities. But enough can be carried by hand or shopping cart for smaller transactions while large quantities can easily be transported and transferred using automobiles.

Sound money can be hard to come by.