Tuesday, August 3, 2010

Seven Faces of “The Peril”?

Chris Ciovacco of Ciovacco Capital Management sent me this interesting comment:
If you have followed the Fed for any length of time, you know they give every syllable careful consideration when making any kind of public statement. You don’t need to have a Ph.D. in Fed watching to understand yesterday’s release of James Bullard’s paper concerning quantitative easing is a carefully calculated move to signal to the markets the real possibility exists the Fed will begin buying Treasury Bonds in the not too distant future.

We read Mr. Bullard’s Seven Faces of “The Peril” last night and put together a “read between the lines” interpretation of what it could mean to individual investors and the value of assets in the coming weeks and months. Regardless of whether or not you agree with or feel this type of policy will be effective in the longer-term, there is no question the Fed can significantly alter behavior and impact asset prices in the short-to-intermediate term. This means an announcement of quantitative easing in the coming weeks could significantly impact where stocks, bonds, and commodities settle on 12.31.2010.

Our detailed comments on quantitative easing and Mr. Bullard’s paper can be found in: Reading Between The Lines: Bullard’s Paper:

After reading James Bullard’s twenty-three page paper on possible monetary responses to further economic shocks, we feel it is important for investors to gain a basic understanding of how future Fed policy could impact the value of an individual’s savings and other financial assets. The basic premise of Mr. Bullard’s work is as follows:

  • Current Fed policy keeping interest rates low for an extended period may be causing the economy to fall into an undesirable steady state of low nominal interest rates and low inflation expectations.
  • This undesirable steady state is similar to what sparked Japan’s lost decade.
  • Current Fed policy reinforces a low expectation of future inflation, which in turn helps keep inflation at bay as market participants feel no compelling reason to take actions in preparation for future inflation. These actions might include investing, buying hard assets, or taking out a loan before interest rates go up.
  • Keeping rates low for an extended period also creates a perception that “things must be bad; therefore, it is not a good time to hire, expand, or take risk".
  • If there is no credible reason to believe policy or inflation rates are about to change, there is no impending event to prepare for future inflation.
  • Rising inflation expectations can become a self-fulfilling prophecy as market participants begin to prepare for a future with higher inflation and higher interest rates.
  • The best way to shock market participants out of the undesirable steady state is to begin a program of quantitative easing, where the Fed purchases U.S. Treasuries.
  • In order for quantitative easing to sufficiently increase future inflation expectations, market participants must believe the Fed will do "whatever it takes for as long as necessary" to obtain the objective of sufficiently positive inflation. This means the Fed must be willing to leave balance sheet expansion in place for as long as necessary to create expectations of higher future inflation by market participants (consumers, investors, companies, etc.). This remainds us of past "bazooka-like" policy moves, where policymakers would say, "You think we can't create positive inflation? Just watch."

What could all this mean to me and my investments?

Let’s start with quantitative easing, where the Federal Reserve buys Treasury bonds. Using a hypothetical example to illustrate the basic concepts, assume a typical American citizen has some Treasury Bond certificates in a shoebox under their bed. If the Fed offers to buy those bonds, they will be exchanging paper money, not currently in circulation, for a bond certificate. After the transaction, the American citizen has newly printed money and the Fed now has a bond certificate. It is easy to see in this example the Fed has increased the money supply by buying the bonds. The Treasury Bond represents an IOU from the U.S. Government. When the Fed buys bonds in the open market, it is like the government buying back its own IOU with newly created money. This is about as close to pure money printing as it gets.

How is this policy any different from lowering interest rates or increasing bank reserves?

Lowering interest rates and flooding the banking system with cash has one major drawback; if the banks won’t issue loans or customers do not want to take out loans, the low rates and excess bank reserves do little to expand the supply of money in the real economy. Therefore, these policies can fall into the "pushing on a rope" category. Quantitative easing, or Fed purchases of Treasury bonds, injects cash directly into the real economy, which is a significant difference.

How could all this create inflation and why should I care?

In a simple hypothetical example, assume we could keep the amount of goods and services available in the economy constant for one year. During that year, the Fed buys enough Treasuries to exactly double the dollar bills in circulation. The laws of supply and demand say if we hold supply constant (goods and services) and double demand (dollars chasing those good and services), prices will theoretically double. Obviously, if the prices of all goods and services doubled, the purchasing power of your current dollars in hand would be cut in half. This is known as purchasing power risk.

If the Fed starts buying bonds what could happen?

Since the Fed would be devaluing the paper currency in circulation, market participants would most likely wish to store their wealth in other assets, such as gold, silver, oil, copper, stocks, real estate, etc. The mere announcement of such a program would begin to accomplish the Fed’s objective of creating an expectation of higher future inflation. The expectation of future inflation can lead to asset purchases and investing, which in theory creates inflation by driving the prices of goods, services, and assets higher. In fact, the creation of this document and your reading of it assist in the process of creating increased expectations of future inflation, which is exactly what the Fed is trying to accomplish.

Chicken or Egg: Inflation Expectations or Inflation

Mr. Bullard hypothesizes the current economy may need rising inflation expectations to come first, which in turn would help create actual inflation since it would influence the buying and investing habits of both consumers and businesses. If you feel the Fed will “do whatever it takes” to create inflation, you may decide you need to protect yourself from inflation by investing in hard assets, like silver and copper. Your purchases of hard assets would help drive their prices higher. The mere perception of the possible devaluation of a paper currency can change the buying and investing patterns of both consumers and businesses.

Wild Card Makes 945 to 1,010 on S&P 500 Difficult

From a money management perspective, understanding possible Fed actions, especially before high stress and volatile periods arrive, can assist you in making more rationale and well planned decisions. Even prior to the release of Bullard’s paper, we hypothesized some possible market scenarios on July 22, 2010 in Bernanke, the Fed, Deflation, and the Dollar. The comments from July 22nd still apply, but it appears now as if the Fed would move directly to an asset purchase program.

How serious is this?

We should stress Mr. Bullard’s work relates to contingency plans only. He states a deflationary outcome could occur in the U.S. "within the next several years". In a conference call on Thursday, Bullard said, "This is a matter of being ready in case something else hits. What if there's a terrorist attack? What if there is some kind of trouble in the Asian recovery or something like that?" He added, "The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away".

Unfortunately, sometimes when an option is given to the markets, it forces the hand of policymakers. This means markets may remain volatile for a time, maybe even long enough to bring about an announcement of quantitative easing from the Fed. We will continue to comment on this topic from time to time in our blog, Short Takes.

You can download an executive summary of The Seven Faces of "The Peril" by clicking here. I will add on Chris Ciovacco's comments, focusing on what more QE will mean for pensions.

In March 2009, I wrote a comment on how quantitative easing is pushing pensions to the brink. And how are pensions in the UK right now? Reuters just reported that FTSE 100 firms pay record pension contributions:

The country's top 100 companies made a record 17.5 billion pounds in pension contributions last year, some paying more into their schemes than to shareholders to tackle deficits, consultant Lane Clark & Peacock (LCP) said.

FTSE 100 firms increased contributions to defined benefit (DB) schemes by 50 percent to help plug shortfalls due to the market turmoil that hit pension assets, LCP said in a study published on Wednesday.

"By some distance, (this is) the highest contribution amount that we have seen in the past six years," said Bob Scott, partner at LCP and the report's main author.

Higher contributions as well as rallying markets helped cut the corporate pension deficit to 51 billion pounds ($78.88 billion) at the end of June 2010 from 96 billion last year.

Payments last year to defined contribution (DC) schemes, the cheaper option used as an alternative to DB, nearly doubled compared to the last five years to more than 21 billion pounds.

The largest reported contribution was by Royal Dutch Shell

at 3.3 billion pounds.

BAE Systems, British Airways, Invensys, Lloyds Banking Group , Morrisons, Rolls-Royce, Serco and Wolseley paid more into their schemes than they did to their shareholders in 2009.

LCP said that one-third of the sample, or 32 companies, failed to make reference to pension risk or did not report taking any steps to reduce it in their 2009 accounts.

In 2009 pension schemes continued to budget for increasing life expectancy by increasing their members' longevity estimates, which LCP said added 9 billion pounds to FTSE 100 balance sheet liabilities.

"These adjustments reflect as well pressure from the pensions regulator and auditors for assumptions to be more prudent," Scott said.

The extra cost of longer-living pensioners could be partly offset following the government's announcement that inflation increases to pensions will be switched in future to the consumer price index from the current retail price index.

If the switch had already taken place the pension deficit would have been cut by 30 billion pounds, LCP said.

And public sector pensions are faring worse. The Telegraph reports that Public sector workers need to pay more towards pensions, experts warn:

Private sector workers are allowed to pay lower National Insurance in return for not receiving the second state pension later in life.

But public sector workers are also opting out of paying full national insurance and yet still receive the second state pension, which is part of generous public sector pension schemes.

Ros Altmann, a pension’s expert, said public sector workers should not be allowed to pay the reduced amount. She also pointed that public sector workers are benefiting because their pensions are unfunded schemes paid for by the taxpayer.

She said that by making public sector workers pay the full amount, the Treasury could save £6.6 billion a year.

Her comments were made in a response sent to John Hutton as part of a Government consultation of public sector pension schemes.

She said: “This complexity has allowed an anomaly for unfunded public sector pension schemes which costs taxpayers billions of pounds every year.”

Private sector workers pay 11 per cent in National Contributions of which 9.4 per cent pays for the basic state pension and 1.6 per cent pays for the second state pension.

At the same time, public sector workers only pay the lower 9.4 per cent in National Contributions.

The second state pension is effectively a top-up to the basic state pension.

It comes amid growing concerns about the pension industry. A Daily Telegraph investigation suggested a range of little known fees and levies typically wipe more than £100,000 off the value of middle class workers private pensions.

A government spokesman said: “The lower national insurance payments mean reduced rights for pensions payments from the State in the future which means lower costs for the Exchequer.

"Additionally all contributors in contracted occupational pensions both in the private & public sectors pay reduced rate national insurance contributions.

"In any case we don’t recognise the numbers being quoted and haven't been shown any calculations."

In the US, the WSJ reports that lawmakers in at least 10 states have voted this year to require many new government employees to work longer before retiring with a full pension, or have increased penalties for early retirement. A similar proposal is pending in California. Mississippi, already among the states requiring more years of service for a pension, is weighing the additional step of increasing its retirement age.

In Canada, there is a big fight between public sector unions that want to keep the momentum on pension reform and the private sector which wants changes to the Canada Pension Plan to take a back seat.

But what does all this have to do with QE? Put simply, more QE will exacerbate pension shortfalls, at least in the near term, because liabilities will explode as long-term bond yields fall further. Even if assets rise, it won't be enough to make a dent in aggregate pension deficits.

I am not convinced the Fed will engage in more QE. Just the perceived threat that they can come in at any moment and buy more bonds should scare the daylights out of speculators who are thinking of massively shorting Treasuries.

Importantly, the Fed may be jawboning the market down to cap any potentially significant backup in yields. They will continue flooding the banking system with cash to reflate risk assets, in an attempt to introduce mild inflation in the economic system.

Finally, with CMBS delinquencies rising to the highest rate ever, the Fed must remain vigilant. Pensions hold a large chunk of outstanding CMBS, which is why a rise in delinquencies will hit their portfolios particularly hard. All this means we can expect more pension reform down the road.

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