PUBLIC ENEMY #1 - DEFLATION

Hi guys, this post was originally penned for the Slope of Hope site by Tim Knight. He was nice enough to take my contribution and suggest that you read his stuff daily if you are a trader. As you know, I try to give you the macro view of the economy to set up trade targets for investments that will tend to last longer than 30 days, but Tim's site can help with examining shorter time frames or turns within the month. Please check out the site at www.slopeofhope.com .

In previous posts in my blog www.goatmug.blogspot.com we've outlined the role the Federal Reserve has played in causing each asset bubble in recent memory. Each crisis evokes the same Pavlovian response from our central bankers in that they reduce interest rates and flood the market with easy money. In the most recent economic event our Federal Reserve pulled out all the stops and intervened with unprecedented measures to buttress the financial system and save us from collapse. We heard over and over again that stabilizing housing would save us and all efforts and letters of the alphabet were employed to prop up declining markets with asset purchase programs and low interest rate give aways.

Why does the Federal Reserve seem to desire inflation and fear deflation so much? Please find a 2002 speech given by our own Federal Reserve Chairman Ben Bernanke. If you ever wanted to know the play book of team Fed, here it is. As we read through the text it is now clear that they have used every bullet he described. As investors and traders it is critical for us to understand that the Fed will never give up and accept a deflationary scenario. Even eight months into a dramatic equity market rally, comprehending the Bernake strategy will provide us a concepual foundation for finding trades that will benefit from his unrelenting effort to inflate.
I originally had intended on writing my own text to outline the topic of deflation, but I'll be the first to state that Mr. Bernanke is much more capable to address the topic. Given the availability of his speech, I will make comments and outline themes that need further attention.

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

WHAT IS DEFLATION?
BERNANKE - "The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress."
GOATMUG - HMMMMM SOUND A LITTLE FAMILIAR (Retailers, Auto Manufacturers, and Grocers drop prices)

WHAT IS SO BAD ABOUT DEFLATION?
BERNANKE - Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.
GOATMUG - So, people figure out that the money they save is MORE valuable tomorrow and therefore they opt not to purchase stuff based on a need for instant gratification. (Sounds like that would be real trouble for a consumer-based got to have it now economy doesn't it?)

IS IT A PROBLEM IF CENTRAL BANKERS ATTACK DEFLATION AND TAKE RATES TO ZERO?
BERNANKE - "It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory."
GOATMUG - Is this guy good or what? He was read to open a can of "non-traditional" back in 2002. Wow!

IF WE WERE TO EXPERIENCE DEFLATION IS THE FED POWERLESS?
BERNANKE - "Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
GOATMUG - ooh, ahhhhh, a printing press! I put this in for the gold bugs too. You can just see them brewing a theory that Bernanke is conspiring against gold just by the mention of its name!

WHAT ARE THE CURES FOR DEFLATION?
BERNANKE - "Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities."
GOATMUG - Of course they wouldn't give money to just anyone! You have to be in the right club to receive Fed money! Bernanke has done exactly what he's outlined here. He's used TARP and more to buy assets, he's made low interest loans, provided loan guarantees, and more.
BERNANKE - "If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."
GOATMUG - This is just a truly scary quote. It absolutely sounds like an arrogant guy married to a trade. We all know what happens to that guy. He ends up doubling or tripling down rather than cutting his losses and accepting that it was a bad trade.

WHAT HAPPENS WHEN RATES HIT ZERO, WHAT DO WE DO NEXT?
I call these the extreme measures list -
BERNANKE - #1 "Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
BERNANKE - #2 - Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

OK, SOUNDS LIKE WE'VE DONE "EXTREME MEASURES" 1 & 2, WHAT HAPPENS NEXT?
BERNANKE - To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."
GOATMUG - Try 2, 3 or 4 years worth of zero interest loans.

THERE CAN'T POSSIBLY BE OTHER TOOLS IN THE TOOL KIT CAN THERE BEN?
BERNANKE - The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
GOATMUG - Foreign debt? Currency swaps? Really?

COULDN'T THE PURCHASE OF FOREIGN DEBT AND OTHER INSTRUMENTS IMPACT OUR CURRENCY?
BERNANKE - I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.
BERNANKE - Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.
GOATMUG - DID HE JUST SAY THAT INTERVENING IN THE CURRENCY MARKET CAUSED ONE OF THE BEST YEARS IN THE STOCK MARKET! He also failed to mention what happened in 1937 didn't he?

WHAT IF HOUSEHOLDS JUST DON'T STEP UP AND BUY STUFF?
BERNANKE - "Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."
GOATMUG - Are you getting this guys? The low rates in savings accounts and everywhere else are a mechanism to make you, me, and Grandma increase risk and buy assets we'd normally wouldn't purchase in this situation. The Fed is forcing you to move your money or you'll lose your purchasing power.

WHAT MAKES JAPAN'S SITUATION DIFFERENT (remember he's speaking in 2002)?
BERNANKE - First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.
GOATMUG - Anyone want to bet me that there are some Japanese central bankers that are quite happy to see the USA right now given the tone of these types of comments?
GOATMUG - He goes on to say that political will didn't exist to clean up the messes of deflation in Japan.
There is a tremendous amount to digest there. To summarize his thoughts, Ben Bernanke will do almost anything to avoid deflation. Deflation is nasty. People lose money and a deflationary environment tends to feed on itself as folks resist spending money on anything. To his credit, Bernanke has completed in some form all of the measures he discussed in this speech. Mr. Bernanke is absolutely confident in the Fed's ability to use the device called a printing press to avoid deflation.

SOME WILL ASK, "GOATMUG, ARE YOU IN THE DEFLATION CAMP?"
The answer to that question is quite simply yes. Does that mean that I'm short the market since 670 on the S&P? NO! Clearly we are in the grips of a deflationary environment and we are experiencing the same issues that Japan was facing in Bernanke's speech. He said that Japan had a crippled banking system, troubled corporate sectors, and a large overhang of debt. I see a significant amount of similarities here even AFTER the heroic measures taken by the Federal Reserve.
Despite my belief that we are still locked in the grips of a long term deflationary spiral, I believe strongly that we need to position our investing and trading assets in vehicles that will profit from the efforts of the Fed as they attempt to rescue our economy from their worst fear. The strategies employed by the FED have had a HUGE impact in the financial markets as we only need to examine the 60% rally over the last 8 months.

Personally, I use this information to help me find swing or momentum trades that may last two months or longer. By understanding Bernanke's mindset, arrogance, and belief that the solution can be found in limitless printing, I can begin to develop strategies that play on the manifestation of inflation or simply the expectation of future inflation.
I find it very interesting that Bernanke addresses the USD and currency intervention in this speech. I believe that the Fed and Treasury viewed currency manipulation as the last option. I also believe that they have found it to be extremely useful in bolstering "confidence" and dealing with the cost of the bailouts. My opinion is that we have reached the end game where dollar devaluation is now the only reasonable course of action. The Fed, Treasury, and administration have their hands tied as political acceptance for more bailouts is low. As our deficit grows they will see that the only choice is a managed devaluation.

Although Bernanke didn't quite suggest that there are limits to our ability to wage war on deflation, I think he might confess that we are limited in how quickly they can devalue the currency. Our creditors will become more vocal in their protests as our policies create losses in their US treasury holdings and as we further damage exporting nation's economies. In my next post we'll discuss how the Fed and Treasury will continue to implement their plan to counter deflation through the use of currency devaluation, despite the protests of our creditors. We will also discuss specific trading strategies that anticipate the Fed's long term moves to devalue and also their mild and short term attempts to placate our international friends.

Goatmug

BATTLE STATIONS - CENTRAL BANKS TAKE AIM AT OUR POLICIES

Breaking News
Just wanted to update you on some breaking news related to currency and overseas investing.

Please read the following story from CNBC regarding the Brazilian government preparing to levy a 2% tax on all financial capital inflows.



http://www.cnbc.com/id/33357363/site/14081545/for/cnbc/

You Don't Want Our Currency --- Really!
Why would a country do this? What would make Brazil, the shining star of Latin America, take drastic steps to stem the tide of money flowing to their country? They were just given the "honor" to host the 2016 Olympic games, and now they are declaring war on inflows of money?

Well, let's examine the strategies we've highlighted for the past several months. At the end of each monthly analysis I end with the same commentary. "Watch the dollar. If it continues to go down, buy commodities, invest overseas, and buy other currencies." There have been no other themes since my first post here in August.

What are the implications of millions of investors in the US and the world following those exact instructions in one concerted herd-like effort? Simple, as investors shun USD assets like stocks, bonds, and savings accounts that yield nothing, in an attempt to devour off shore investments, we must convert our USD into the foreign legal tender of that nationality. As more and more of our like minded friends pile on, the foreign currency (Real in this case) begins to appreciate in value in comparison to other currencies.

Your Demand for Our Currency Hurts!
Why is this a problem for a country like Brazil? This increase in value of a national currency is a problem for countries like Brazil and Japan because they have many industries that export manufactured goods and raw materials throughout the world. These countries begin to suffer when their currency increases in value because importers that purchase the goods must pay more than they otherwise would for that same good.
A good example is a Japanese company like Toyota. Because the Yen has gone up 20% or more relative to the USD, the Japanese price for the car has technically increased by 20%. Will the US consumer care if a car is 20% more expensive? Heck yes! In reality, Toyota doesn't have a floating car price, so what happens is that the appreciating currency actually causes a loss to Toyota in Japan if they sell a car when those USD are converted to yen. The other solution Toyota has found is that they simply have begun manufacturing cars here in the US to mitigate some of this currency translation issue. Still, if Toyota HQ repatriated ALL of the USD housed here in the United States, the company would take a massive currency loss on the conversion.


Ok, so we can see that if we are a large oil producer or steel producer in Brazil, a rising currency hurts business and slows purchases down as foreign importers begin looking for alternative suppliers. Making matters worse is that the United States also is devaluing its currency on purpose! Emerging markets countries like Brazil get the double whammy as they are suffering from the inflows of all the "created" money looking for a home and the US keeps clobbering its own currency. Do you think many US buyers are actively seeking out purchases of goods and materials in Brazil? The answer is no.

Is It All Bad?
Is it all bad for Brazilians to have a strong currency? No, if they are purchasing imported goods or overseas goods, they seem to be on sale because the purchasing power of their currency is elevated. Think about Europeans coming to New York and Florida buying real estate. The currency exchange rate makes our property seem like it is on cheap.

Let's go back to the article now. What did Brazil suggest that it was going to do to curtail these inflows? Brazil will add a 2% tax on all incoming currency flows. This could slow, if not halt the influx, maybe.

Investment Implications
How exactly might the 2% impact us as investors? If you are an investor in EWZ (Ishares Brazil ETF) you might notice that after hours trading shows that the etf is down $2 or more. While this story is just breaking, I can speculate that new monies flowing into the etf may soon be subject to this 2% tax!!! The ETF takes your investment dollars and purchases ADRs (American Depository Receipts) and stocks in Brazil. It will be quite tough to continue investing directly in the country if every dollar receives an up front 2% hit. Talk about an extraordinary expense ratio!

Does this change mean you run like crazy from EWZ? Perhaps, but it may also mean that we short EWZ for a possible draw down on the news. Even as I type this post, I am not seeing any new news listed under the ticker symbol for EWZ. In addition, any reversal in the dollar will hit EWZ as well.

Why is this important for the United States?
I keep posting on the the weakness of the dollar because it has huge implications for us as investors. Our policy of a weak dollar, (the Fed says we believe in a strong dollar, I know), will have international implications. Brazil is not the first to act as Korea and a few other exporters last week attempted to buy a few billion dollars worth of dollars to reduce the value of their own currencies. Personally, I think the Korean approach is a waste of dollars as I believe strongly that our Fed intends to take our currency much lower. I think t he Brazilian approach is unique and interesting. I'm not sure it will work, but you are really starting to see foreign central bankers try to take action to address the US tactic. Economically speaking, the US is "attacking" these countries and putting pressure on them. You will begin to see increased hostility from exporting nations directed at our country.

Goatmug

PART ONE - STEP ON THE GAS!

I have been sent several email questions over the last month about inflation and deflation and why our Federal Reserve would "print" all of this money. This blog entry may be a bit long (I've had to break it into two parts), but I feel it is important that we all understand the motivations of the players (central banks) in this economic turmoil. For an introduction into how the Fed and administrations have acted, please review the first four paragraphs in the blog back in August where I discuss asset bubbles created by cheap money in Proof that this Recovery Has Been Engineered.



IT ALL COMES DOWN CREDIT.

Let's quickly review a description of inflation and deflation. While most of us think inflation is a measure of rising prices, it really is a measure of an expansion of the money supply and credit. Once a bank lends you money, you can spend it or invest it as you please. Because banks only need to maintain about 1/10 of the dollars deposited with them in their reserves, we get significant growth and expansion of available money when banks actually lend. Think about it. When a company or account holder deposits $1,000,000 in a bank, the bank can then lend out $900,000 of that same money to someone else. If that borrower then deposits that same $900,000 in an account, the bank can lend out $810,000 to another borrower. Do that over and over again and you see the impact of the original $1,000,000. Fractional reserve lending is very stimulative and pushes significant dollars into the economy.



Once those dollars enter the economy through creation new money supply and credit, they tend to find assets like houses, cars, commodities, commercial real estate. These additional dollars often burn a hole in people's pockets and this extra demand allows retailers and suppliers to raise prices. This is how we often believe that inflation is the same as pricing increases.



Well, that's easy enough to understand right? When folks borrow from banks to build a house, add a pool, or create a business they trade those dollars for a service and the recipient of those dollars deposits that same cash in their bank account and the magic money creation machine keeps churning out opportunity for all. This scenario is in fact exactly what happened for years in 1996 to 2001 and then from 2003 to 2007. Keep one other thing in the back of your mind. fractional reserve lending requires the guy that borrows the money to spend it and repay it. In fact if your thought is that it sounds a lot like a ponzi scheme, guess what, you are right!



PLANET REALITY

If this situation is so good, what could be the problem with all of this lending and borrowing? Nothing really, unless you complicate this scenario with something called "reality". In real life, banks are often required to examine the credit worthiness of borrowers. The bank loan officer takes into consideration if the borrower has a job, has good credit history, and also if they have any assets. Finally, a good loan officer examines this picture of the borrower and should demand a suitable rate of interest for the loan. If a potential borrower has good collateral, a great project, awesome credit history and is well capitalized, they should be charged a lower interest rate for the amount they desire to borrow as compared to a riskier prospect. In fact, riskier borrowers should be charged significantly higher rates or be declined. So one of the first things a lender must evaluate is the ability of a borrower to repay the loan and the appropriate price for that loan.



Ok, sounds good. What could possibly go wrong? To save time I'll just bullet point these next items and then make just a few comments.

• Mispricing of risk at the lender level - What if the loan officer has a bad day and he doesn't notice that the borrower has poor credit history. This error can result in charging too low of a rate for the loan. Other issues could be that the collateral of the loan was in bad condition or the borrower didn't make enough income to justify the amount requested. This mispricing of risk could be detrimental to the bank as they don't get paid enough for the risk they take or take on a loan that will ultimately default.


• People lie - Imagine that people in this process didn't tell the truth! If the lender didn't take the time to verify an applicants income or credit history, the integrity of the entire process could be in jeopardy. In recent times, lenders gave loans to people with "stated incomes" meaning that they simply said an amount that they made.


• People lose their ability to repay their loans - In the current economy we can easily see that a borrower could lose their job. If an applicant loses their ability to pay, often they cannot keep their homes.


• Collateral values decline - In recent history from 1996 to 2007, home prices and other asset values always rose. One of the problems in lending evaluation methods was to assume that prices would not drop. Unfortunately we've realized that prices of homes and collateral can drop and may do so all at once over large regions of our country.
• Government Intervention - We also had a situation where the government told lenders that they needed to lend in certain regions of cities and states. Typically these were areas where borrowers were less credit worthy
  

ARE THERE ANY OTHER PROBLEMS INVOLVING CREDIT THAT WE'VE FAILED TO DISCUSS?

Of course! When we borrow using our credit cards from banks we usually have our loans tied to some benchmark rate. You've heard of LIBOR (London Inter-Bank Offer Rate). This is the interest rate that one bank will lend to another. When you borrower, you generally must pay the LIBOR rate plus some percentage rate. Other benchmarks could be the 10 Year Treasury Note rate. These benchmark rates are important because central banks can control or direct the price of these rates. Our Federal Reserve sets the overnight bank lending rate called the Fed Funds rate. By raising and lowering this rate, the Federal Reserve can influence interest rate costs globally. Yes, some will argue that these are overnight funding rates, but the reality is that the Fed Funds rate does have an impact on other credit interest rates in the market.

What would happen if the Federal Reserve significantly lowered the Fed Funds rate? The impact of a lowered Fed Funds rate would be that other rates would fall as well. From this simple example you can see that the Federal Reserve has some ability to change interest rates and in this scenario lower borrowing costs for banks, companies, and borrowers.

WHY IS THE FED'S INFLUENCE A PROBLEM?

A central bank's role is a tough one (in the USA at least). They must try to create a perfect balance between growth and recession. The Fed uses its control over the Fed Funds Rate to stimulate and restrain the economy (think of it as an accelerator pedal on a car). As we covered earlier, when rates are low, people are incented to borrow. Their borrowing is used for investment and an expansion of the economy often results in pricing increases due to the availability of ample credit. When the Fed over does the credit available, borrowers are flush with cheap money and they tend to buy everything in sight and prices result. Using this concept of mispricing, we can therefore see that when the "Fed over does it", it really has mispriced rates and created too much demand and too much easy money!

If you are a banker you are subject to pricing your loans off of a benchmark rate. If a potential borrower barely qualifies for a loan you examine rates of your benchmark and add a premium or mark up over that rate based on their credit. The real issue here is that if the Federal Reserve has driven rates lower during this period, (artificially controlled them and pushed them lower), then the banker has really priced his loan too low for this borrower. The impact of the Fed's decision to make cheap credit flow is that they have heaped on additional risk into the banking system in an effort to expand the economy.

Perfect, what happens when the Federal Reserve raises rates? Just like taking the foot off of a gas pedal, raising the Fed Funds rate cools off the economy by removing additional credit stimulus. Rates go higher and investors and borrowers costs rise. Imagine if you were going to build a pipeline or factory. Increased borrowing costs negatively impact your rate of return and make investments and projects seem less appealing than when rates were low.



ARE THERE RECENT EXAMPLES OF THE FED MAKING CREDIT AVAILABLE THROUGH THESE TECHNIQUES? WHAT WAS THE RESULT?

Absolutely. Recall the fears that all computers would crash as a result of the Y2K bug in 1999. (When computers were going to switch to the year 2000. Many computers tracked dates with only 2 digits before this). The Fed responded by flooding the market with liquidity (lower rates and buying treasury bonds). As the market was awash with credit and money, guess what happened? All of that money found its way into our technology sector and the internet mania began!



As the Fed began raising rates after Y2K, we suffered the bursting of the internet bubble.



After the tech crash and the September 11th attacks the Fed again began lowering rates to fight the economy's recession. What happened next? Credit found its way into the hands of real estate investors and speculators. The ingredients of a new real estate bubble were combined and areas in Nevada, Arizona, and California enjoyed 100% growth in real estate prices in the course of one or two years. Clearly the free flow of credit as a result of low rates bought us a ticket to Planet Credit Fantasy. As the good times were rolling, the Fed began to raise interest rates in an attempt to manage price inflation in 2003 and continued to slow the economy through 2006.



HAS THE FEDERAL RESERVE BEEN GOOD IN ITS ABILITY TO TIME ITS RATE DECISIONS?

Unfortunately, the answer is flatly no. Typically the Fed's tools like Fed Fund rate changes and open market operations are slow working. The influencing mechanisms work through the economy and are difficult to start up and stop. Many often use the analogy of trying to turn an oil tanker when describing the amount of control the Fed has in making adjustments to the economy. I'm highlighting this because we have had very low rates for a significant amount of time. As our credit bubble burst in late 2007 and early 2008, the FED stomped on the accelerator and eventually lowered the Fed Funds rates to .25%.



So to wrap this up, we entered a credit led bubble in 2003 that artificially created a real estate blow up waiting to happen. Credit lenders mispriced risk and the Fed purposefully mispriced risk to stimulate the economy. As the wheels were coming off beginning in August of 2007 we faced many "unforeseen" circumstances.

1) A recession was forming and people were losing their jobs
2) Because folks were out of work, they were not making their home payments.
3) As payments were missed, banks began foreclosing on homes in record numbers.
4) Investors and lenders began to understand that home prices don't typically go up every year.
5) People began to doubt each other. Banks failed and lenders tightened up lending standards considerably.
6) The Fed reacts to the collapse of Bear Stearns and Lehman Brothers (securitization of mortgages) and takes FF rates from 1.50% to .25% in two months.
7) Congress passed the $700 Billion TARP funds bailout and other scandals. They end up adding trillions to your debt and you don't even know it. Your debt is used to keep failed banks alive and prevent write downs and destruction of credit...... in other words, your balance sheet and future income was used to stave of DEFLATION, which is the destruction of credit.



WAIT A MINUTE! LET ME GET THIS STRAIGHT!
Ok, so you say that the Fed helped create this mess by lowering rates and now their response to this crisis is to what? LOWER RATES!!! You got it! When you are a hammer, everything looks like a nail. Each crisis the Federal Reserve is involved in will evoke the same reaction, lower rates!

Ok, why would the Fed do this if it knows that another bubble will form? The real question is what will we find if another bubble is NOT formed.

Presently, the Federal Reserve has been able to lower the cost of a 30 year mortgage to 5% for a borrower with good credit! A 30 year US government bond is paying only 4.16%! This is even cheaper than when we were in the throws of the real estate boom. Why are cheap rates essential? Our leaders have just told us if we can stabilize real estate prices that will bolster demand for furnishings, dishwashers, cars, and more. In other words, in the eyes of your government, if you perceive that your house value is not dropping you'll get out there and spend more than you have and put it on credit cards and you will save the economy. It is staggering that 70% of our annual GDP is comprised of us buying stuff rather than production and manufacturing stuff in the USA. Now you can understand that if there is a situation where Americans don't spend, the economy of the USA grinds to a halt.

In the next post we'll cover what deflation looks like and what the Federal Reserve plans to do about it.

Also, a quick thank you to Michael Shedlock for his comments on this post and the clarification he suggested. You can read his views on the broad economy here. He has the number one financial blog in the world with over 28,000,000 visits to his site and I believe that he is a must read daily. I frankly am flattered that he commented on this post.

http://globaleconomicanalysis.blogspot.com/

October Summary

OCTOBER - TRICKS OR TREATS

Unemployment Data - http://www.bls.gov/news.release/pdf/empsit.pdf

Unemployment numbers for September were higher than anticipated and this helped shake the markets. The truth is that the trend of lower losses is continuing and the market is still focused on everything getting less bad. While the data was worse than expected, we need to look at these numbers as 1 or 2 month averages and there is clearly and improving trend.

Rail Data -
Rail traffic looks flat as of the last part of September. Optimists will say that we are turning south and pessimists will suggest that we aren't improving. As we enter this season we should begin to see shipping and transport data ticking up because we are entering into the part of the year where Christmas inventory and orders are being stocked. If we don't begin to see an uptick in these charts as we normally would we will have our first indications that the rally may be ending.

Lumber and Crushed Stone are indicative of the pipeline for growth in commerical and residential real estate. No trend changes are apparent in these items. As we've stated before, no matter how high banks, REITs, and home builders go, we would avoid them.

Financial Conditions Index - Source / Bloomberg

The Financial Conditions Index continues to maintain it's trend of improvement. There has been a slight dip over the course of the last week, however we won't do much more than raise an eyebrow at this metric unless we see other data that confirms this warning. Index numbers over 0 (zero) indicate that the economy as measured through fixed income and money market liquidity metrics is growing and expansionary. We are not going to signal the end of the recession, but possibly could as we near zero.

Source - http://www.bloomberg.com/apps/quote?ticker=DXY%3AIND

CFO OPTIMISM - Source Duke Fuqua School of Business - http://www.cfosurvey.org/
Duke released its September CFO survey results again. CFO's believe that things are looking better for the overall economy and their own firms. In general they are more positive. This change is not overwhelming, but given that most CFOs are going to more conservative than their CEO or COO counterparts, we should take heed here to recognize the potential for real growth during earnings season (starts later this week) and then next two months.

WLI Data
The Weekly Leading Indicator data from ECRI shows sustained improvement. Admittedly 50% of the data that comprises the WLI Data is "Fedcentric", meaning that it has more to do with the amount of money that the Federal Reserve has sloshing around rather than real economic improvement. Having said that, the flood of money sloshing around is making an impact and we cannot ignore it or discount the impact that those dollars will have when they chase assets. Source - http://www.businesscycle.com/resources/

AAII Sentiment -

The AAII Sentiment numbers continue to remain in no-mans land. Remember, when sentiment reaches an extreme (bullish or bearish), we usually want to do the opposite. In this case there are a mixed number of folks that believe in this rally and an appropriate amount of investors that are bearish. The confusion confirms exactly what we are seeing with big up and down days as traders attempt to sort out the direction of the market.
Source - http://tal.marketgauge.com/dvMGPro/charts/charts.asp?chart=AAIISR

US DOLLAR INDEX -

Anyone seeing anything familiar here? We had a couple of days worth of a head fake last week that was just enough to ensure that we were on our toes. This has merely provided us an opportunity to buy more of the types of holdings we've discussed in the last several months. "Carry on, nothing to see here!"

Source - http://www.bloomberg.com/apps/quote?ticker=DXY%3AIND

Home PX Index -

I've left the home price index graph up here simply as a placeholder since it hasn't been updated yet. Why is it important? It is important for several reasons. First, home price stabilization is the basis for much of this rally. If you recall, Ben Bernake and Hank Paulson repeated told us that if we can simply stabilize the home market, we'll see the economy recover. In their efforts to stabilize home prices they have become the mortgage lender of choice for most of the deals getting done. Directly you ask? No, but lenders are being supported as the government backstops the entire mortgage market. By buying these mortgages and also controlling treasury rates, the fed has created an artificially low interest rate environment.

What else is going on here? We are hearing that banks continue to pile up foreclosures on their books, but refuse to release them for sale on the market. Other stories highlight that many ex-homeowners still remain in homes they haven't paid a mortgage on for many, many months. How can they stay and not pay? By keeping foreclosed properties in "defaulting" status rather than taking receipt of the properties, banks don't have to recognize the huge losses they are saddled with. Our regulators sit idly by as banks game the system and overstate the assets on their books and earnings. The hope is that by controlling the flow of foreclosures coming to market they can extend the period until the market recovers.

Is it working? Well, according to the graph, it might be. I would guess that as soon as there is a noticeable stabilization or increase in pricing a new wave of sellers will come to drive prices down. No matter what, banks and the government are both giving it all they have to keep prices afloat. Their ability to sustain this is a key driver to the continued resurgence in the market.

Are there still concerns in the housing market? Yes, people continue to lose jobs and people continue to stop paying mortgages. We are coming into more trouble as a new barrage of bad loans are due to reset to higher interest rates. These are the option ARM loans. Many of these loans were "interest only" loans for a period of 5 or 7 years. Borrowers took these loans out with the assumption that they would have increasing home values they could then use as equity to refinance with, or they were used by folks that needed low interest loans because they were maxed out and didn't have the ability to pay more. These loans are due to reset in 2010 and should unleash a new wave of homeowners that cannot afford to own.

Ok, so everything is possibly negative, does it impact our trading? No! Why would reality impact the way we trade? Of course I'm being silly here, but the reality is that the numbers are showing that the pricing data is turning north and this alone will be the basis for optimism in the market. We need to be constantly watching for further improvement to reinforce our short term bullishness. If we get socked with negative news, it is another warning shot across the bow that we need to exit long trades and be more conservative.

Great, Now what? - Summary for October

Given the data we've presented lets summarize it like this.

Unemployment - Bad, but getting less bad

Rail Data - Unchanged

Financial Conditions Index - Still Improving

CFO Sentiment - Improving

WLI Data - Getting Stronger

Trading Sentiment - Mixed (no real trend here but uncertainty)
US Dollar - Declining. It took a pause and now continues its retreat.

Home Prices - Improving

Other items - Consumer Sentiment has still not improved as much as the rally in the market would suggest. We need to continue to eye these figures. Government's entire strategy is that stabilizing the housing market will cause a rebound in consumer spending which is 70% of our economy. If the consumer remains on strike and buys less and demands lower prices, the planned recovery will fail.

Earnings Season - I eluded to earnings season starting this week. I believe that most company reports will beat handily the lowered and managed expectations. We may have continued upward movement here to celebrate how "great" these firms are doing. I say take it while they are coming, but we need to watch carefully for a "sell the news" reaction as we close down earnings seasons. Next quarter's earnings will be easy to beat as well and this is the reason I continue to look at February and March of 2010 as really critical months. These certainly could be the months when the euphoria wanes and gravity reasserts herself after a 9 month vacation.

OK, How do we play it?

It seems pretty simple doesn't it? Keep doing what we covered the last three months. Watch the dollar and invest in base metals, commodities, foreign / overseas countries and etfs, and buy other currencies if you are sophisticated. Silver and Gold have been big recent winners along with Brazil. The Dow Jones Industrial Average has actually lagged in performance the other assets I watch with the exception of corporate bonds. High yield bonds though have continued to outperform. Dollar strength will indicate a turn, but at this point I don't believe that the Federal Reserve desires to change the dollar's direction or they would have already intervened. I think that they will allow for the USD Index to fall another $2 or $3 before supporting it. Therefore, we continue to believe that the types of trades we have on will perform well and I am adding more of my money in the market. Remember, I look at these trades on a daily basis, so my trades probably won't look like yours. Many are invested in mutual funds and are locked in for 30 days when buying. This time requirement should give you pause as you think through the possibility of a sudden reversal. Am I saying don't do it? No, but you can lose money and you need to be aware of the risks!

A couple of last words.

Energy and Utilities have also lagged lately, they may be areas to examine and enter as well.

Have a great month and watch the dollar!