Tuesday, September 9, 2008

Asset Class Analysis - Interest Rates

Misperceptions Surrounding “Inflation”

Sunday’s government bailout of mortgage giants Fannie Mae and Freddie Mac have spawned a large amount of disagreement around the motivations of such a move and it’s implications on the credit markets over the longer term. To be sure, the placement of these companies (who are essentially nothing more than unhedged investment firms operating with 50:1 leverage) is another step in the direction of interventionism and a furthering of the world financial community’s mantra of privatizing profits and socializing losses.

The argument is being made all over the financial media that the intention of the Fed and the Treasury is to reinflate the credit bubble, and that these attempts are further evidence of an impending hyperinflation in the US Dollar. But as has been the case during previous interventions of the last year, the credit markets do not believe this theory and refuse to discount the possibility of future inflation pressures by maintaining low rates on treasury bonds.

This article seeks to distinguish between the various points-of-view on the issue and will attempt to derive a thesis for the future movements of treasury and corporate bonds based on the best evidence.

Inflation: What is it?

As is the case for all of my analysis, I look at markets and economics through an Austrian Economic Theory lens. The contemporary definition of inflation is “a general rise in the price level.” Austrian economists reject this and say that rising prices are a symptom of the greater problem which is “an expansion of the supply of money and credit.” I believe this definition to be correct.

Prices can rise or fall for many reasons. Supply and demand factors can cause certain goods’ prices to fluctuate due to social changes, geopolitical issues, scarcity or overabundance, fear or greed and many other factors. Due to the complexity of markets we can never really know why prices are moving and in reaction to what.

For example, take the price of oil. Try to figure out how much of it’s historic rise in price is due to a depreciation in the dollar, how much is due to supply concerns (peak oil and geopolitical), how much is increasing demand from emerging markets, how much is (or was) reckless speculation, etc. There is of course no way of knowing.

So if we are not able to draw definitive conclusions over why prices move, how do we then conclude that all investors should take last month’s inflation report and use it to decide how well purchasing power will be preserved over a 1, 10 or 30 year period?

Additionally, by compiling a different basket of goods, one can derive a vastly different price picture. One example of doing so is substitution of the Case-Shiller home price index for the OER (Owner’s Equivalent Rent) that is used currently for the “shelter” portion of the CPI price basket. Making this adjustment on calculations going back 8 years, shows that price measurements during the housing boom were massively understated (as rent prices lagged behind) and are now massively overstated as home prices fall and rent prices have moved sideways. Current inflation levels using this method would be barely positive, whereas the reported number is around 5.6%. A big difference.

So in summary, the CPI measurement of inflation is extremely flimsy. It is laggy to an unknown extent, it’s composition is subjective (and has been changed numerous times) and it offers no insight into the future of price movements. There must be better ways to explain ‘inflation.’

Do the Fannie/Freddie/Bear Stearns bailouts constitute “money printing?”

The case is made by many that in response to all of the problems facing our economies, the Federal Reserve, foreign central banks, and the US Treasury are acting in coordination to pump up the money supply. They are achieving this by simply “printing more money.” Whether people say this metaphorically for “credit creation” or not is important. There is only 1.2 Trillion dollars worth of physical US Dollar notes in circulation. This is a penance to the size of the debt markets, which is akin to saying that we use a debt based currency (or a fractional reserve banking system - basically synonymous.) Even if this physical money supply was inflated by a large number (say 50%), this would not have nearly as much effect on the overall supply of money and credit.

The US (and foreign) governments could elect to go further into debt to try and support these markets, but ultimately the size of the credit markets are too big to bail out. An increased supply of government debt in circulation will only seek to anger the biggest investors of those bonds - foreign governments. The amount of politics needed to undertake any huge increase in US debt would be prohibitive for it to make an impact. However, these are politicians we are talking about. So I wouldn't be surprised to see them try. Even so, the psychological effect wouldn't be felt until much later.

This is what the bond markets know when handicapping future credit conditions. Those that are stuck looking at last year's prices get stopped out of their short treasury trades.

What is a “credit crisis?”

The basis for our economy is fairly simple: Expand the amount of debt in the system in order to facilitate investment that will yield a positive rate of return. The positive rate of return is supposedly ensured by technological innovation and production efficiencies, but also by the rising credit levels that eventually boost asset prices. The people that purchase the debt (savers) are coerced by this cycle into switching sides (going into debt), as they have a negative real rate of return on their savings (think 1997 or 2004 - rising home and stock prices that are far higher than any bond yields). In other words, the creators of debt attempt to monetize their way out of debt by creating more of it. This is the root cause of the growing disparity between the rich and the poor.

This process was all moving along nicely until sometime in 2006, when all of a sudden home prices began to fall. “Not to worry,” said the government. “It would only be temporary,” and “won’t have any residual effect on other markets.” By August 2007 that perception changed. A year later it had spread to every corner of the globe, leaving no market untouched. The perception that asset classes will always rise faster than the cost of credit used to purchase them had suffered a material shift. The willingness for savers to switch to being indebted disappeared. The always increasing pool of greater fools had run out. “Peak Credit” had arrived.

This seemingly benign development is considered to be a “credit crisis.” The tumbling asset values create a circular chain reaction of delinquency, liquidation and further falling asset prices.

What the Fed and the Treasury do seem to understand, is that they only have power over the psychology of the investor, and at that their power is limited. They feel that by improving investor sentiment toward asset prices, they will be able to cure the disease of falling asset prices. Each major intervention has been with that as it’s goal. They know that they cannot create enough credit themselves, because the overall size of the credit markets dwarfs even their enormous balance sheets combined. This is the rational side to the Fed’s and the Treasury’s interventions.

What these two institutions can’t seem to grasp yet, is that savers are not interested in investing because they feel that asset prices are going to drop lower and they are better off waiting. Banks have the same feelings about lending. The Fed is pushing on a string. Eventually, the asset markets will stop going lower and investors will come back. But reassurances by government officials aren’t going to expedite this process. What is required is time (for banks and consumers to repair their balance sheets) and price (low enough to make risk/reward decisions less complex.) Until those conditions are met, this deflationary spiral cannot be reversed - only prolonged.

In failing to see this reality, and in insisting that they have more influence over people’s investment decisions than they actually do, Paulson and Bernanke are throwing away their own savings (taxpayer’s savings) by using them to purchase assets that are destined to fall further in value. They are throwing good money after bad. In doing so, they risk prolonging the eventual sentiment shift by shrinking the available pool of capital to invest. Bank of America’s purchase of Countrywide is another example of this, as are the sovereign wealth fund’s investments in banks back in the spring (they are now down 25-50% from that time.) By trying to fight a secular shift in sentiment, the opposite effect is occurring; investors see a smaller pool of savings and therefore a more distant resolution to the problems and the result is more risk aversion - not less. This is essentially a verbatim repeat of the Bank of Japan’s mistakes that have resulted in an 18 year battle with sluggish growth.

So quite apparently, there is a declining appetite for credit risk with no signs of reversing. How can an increase in the supply of money/credit occur under these conditions?

- no increase in the supply of physical currency can offset credit losses
- no amount of credit creation is possible without a change in sentiment
- sentiment cannot change until time & price allow it to change
- the supply of savings is increasingly being wasted in a fruitless effort to support asset prices

Had Bernanke and Paulson done nothing starting in August of 2007, and continued to do nothing, the outcome may have been different. If they allowed major institutions to fail, and for asset prices to then reach fair value sooner, the pool of savings could have been deployed much sooner, and a legitimate recovery could then take root. But they obviously felt that the monster they had helped create (a massively intertwined and overleveraged credit machine) would be forever beyond repair. At that, they may finally be correct on something.

What this means for bonds

To those that view my presentation of the credit markets to be heresy or overly pessimistic, there will likely be continuing confusion to the treasury markets, which have thus far been beating a deflationary drum. Forward expectations for price inflation have fallen to cycle lows and as savers refuse to invest their money in risky assets, demand for treasuries increases. This puts downward pressure on yields. Until I see fundamental changes in the asset markets, I don’t foresee this to reverse any time in the near future. If housing prices or equities prices were to reach much lower levels, perhaps savers will come out of the woodwork. But housing inventories are sitting at all time highs and the US stock market is trading at ~25x reported earnings. So we are a long way off from a potential bottom in terms of asset markets.

The opposite should continue to be true for issuers of corporate bonds who will struggle with risk-averse investors. Rates on the corporate side should continue to rise as delinquency risk rises. Banks still needing to raise capital to continue doing business will likely fail. Borrowing money at 10% and lending it out at 6% is not a winning business model.

In other words, spreads should continue to widen and stay wide for a long period of time. The next move for central banks is likely more rate cuts.

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