Fed’s Kohn: Banks Need to Prepare for Higher Rates

Pretty clear warning. Read again WHEN THE FED STOPS THE MUSIC (II).

The Federal Reserve’s number-two official issued a stern warning to investors, banks and other financial institutions Friday: Don’t be complacent, interest rates are going up at some point and it will cause new market turmoil if you’re not prepared.

“We are in uncharted waters for monetary policy and the financial markets,”Donald Kohn, vice chairman of the Federal Reserve, said in a speech to bankers at the Federal Deposit Insurance Corporation. Rattling off a long list of uncertainties about the outlook – a rising budget deficit, foreign demand for U.S. debt, the strength of the recovery – Mr. Kohn said bankers need to start preparing now for the risk that interest rates could move swiftly in unexpected directions, most likely up.

“Many banks, thrifts, and credit unions may be exposed to an eventual increase in short-term interest rates,” he warned, adding that long-term interest rates could also be pushed higher, in part because large government borrowing to fund budget deficits could crowd out private borrowing. Foreign demand for U.S. debt could also narrow if countries with large trade surpluses shrink those surpluses and thus accumulate fewer dollars.(…)

Full WSJ article


Mortgage Bulls Bid Fed Adieu

The Fed is withdrawing but Treasury has it planned. Freddie and Fannie are there to backstop.

(…) Following a two-day policy meeting, the Fed on Wednesday reiterated its plan to end the program on schedule. (…)

Fed officials believe they can pull back successfully. And a growing group of optimists are joining their camp. They argue that investors, searching for higher-yielding securities, will find government-backed mortgage-backed securities a bargain relative to other investments, like corporate debt, that have rallied for much of the past year.(…)

[MBSBETS]So far, the numbers support the optimists. In recent weeks, the Fed has slowed its average weekly net purchases of mortgage-backed securities from $21 billion to about $12 billion. Despite this slower purchase rate, the "spread" between mortgage-backed securities yields and risk-free Treasury yields is thinner than last September, when the Fed said it was extending its mortgage buying program by a quarter.

To be sure, mortgage prices could suffer when the Fed stops buying. Pessimists worry spreads could rise a full percentage point, which could take 30-year conforming mortgage rates to 6% from 5%, a potentially crippling blow to a still-shaky housing market.

But spreads mightn’t have to widen nearly that much to attract private investors hungry for yield at a time when cash yields nothing.

For one thing, riskier credit investments, such as corporate debt, may have little upside left after rallying furiously for nearly a year. Corporate bonds with an "A" credit rating, for example, yield 160 percentage points over Treasury debt, according to Merrill Lynch indexes. MBS issued by government-backed mortgage agencies, in comparison, yield about 138 percentage points more than Treasurys, according to Kevin Cavin, a mortgage strategist at FTN Financial in Chicago. Even a small widening of that MBS spread would offer investors a similar spread as risky corporate debt, but this debt would be guaranteed by the U.S. government.

The Fed’s purchase program, meanwhile, has likely kept spreads on mortgage-backed securities issued by government-backed mortgage agencies artificially narrow, which has turned off many private investors.(…)

Meanwhile, the Treasury Department in December said it would provide unlimited support to Fannie Mae and Freddie Mac and wouldn’t require the agencies to reduce their $1.5 trillion mortgage holdings, as previously planned, a show of government commitment that has lifted mortgage prices.

[FANPORT]Some analysts even suggest that Fannie and Freddie, now with greater government backing, could eventually buy more mortgages if spreads widen drastically and the Fed declines to help.

"The Fed withdrawal will be a non-event because Fannie and Freddie will step into the breach," said Michael Toporek, chief investment officer at Manhattan investment advisory firm Brookstone Partners Asset Management. "They have unlimited balance sheets to buy mortgage-related assets."

They are quite right. Read Fannie and Freddie Freed To Rescue the Housing Market(!!!)

Full WSJ article


Risks, Hedges and Opportunities

There is no escaping that monetary policy is a very complex subject matter, difficult to apply and much more than a simple idea of targeting an appropriate inflation rate. The monetary authorities are not innocent for they can easily make mistakes and clearly bear a lot of responsibilities for the consequences of their policies on the behaviour of the financial markets and economic activity.

On the one hand, should the monetary stance be easy at a time when it is tight, market prices of risky assets would rise, government bond yields would increase, the value of the home currency would decrease in term of gold, and inflationary expectations would increase. On the other hand, should the monetary stance be tight at a time when it is easy, market prices of risky assets would decline, government bond yields would decrease, the value of the home currency would increase in gold terms, and inflationary expectations would decrease. Of course, the longer the conduct of monetary policy, and the more far away it is from what it ought to be, the more dramatic will the unintended consequences be.

To properly judge the effect of monetary policy on things that matter to investors, one must know and understand that monetary policy is not asymmetric but somewhat chaotic. A much better way to judge which monetary stance the central bank should conduct is to have the common sense of taking a more macro economic approach.

Based on historical repetition, monetary policy should be neutral when prices are stable, fiscal budgets are in balance, the balance of payments is viable, employment is full and economic growth in nominal terms equals closely, population and productivity changes. There is ample empirical evidence and theoretical validity that for any given deviation in the above factors it should tilt the monetary stance away from even keel. If it`s not done, the Central Bank is not counteracting the pro-cyclical forces of finance, thus creating risks or opportunities to investors.

Palos Management’s US monetary policy index which takes into account all of the aforementioned factors calculates that the monetary stance of the US Fed should be slightly on the tight side of even keel. On January 22, 2010 the index stood at 115. Neutral is 100 and less than 100 is easy. Yet, the US monetary stance is clearly easy for the yield curve is steep, the federal fund rate is way below the rate of inflation and the FRB has flooded the banking system with a massive expansion of the monetary base. If it had not been that the economy was in the throes of writing down huge amounts of bad debts, the money supply (MZM) would have doubled.

Theory predicted correctly the debasement of the US dollar in gold terms, the surge in the market prices of risky assets, the rise in government bond yields and the increase in inflationary expectations in 2009 and the early weeks of 2010. The question is will the monetary stance of the FED turn in 2010. If the FED does not, more of the same can be expected. But, should it adopt a tighter stance, as we believe it will, than a more sober market for risky assets, a more stable US dollar and more increases in government bond yields can be expected.

Consequently, the beginning of the exit from super-expansionary monetary policies will be one of three dominant global macro themes in 2010 along with fiscal and global imbalances. The last weekly letter dealt with US fiscal deficits and next weekly letter will address the global imbalances between the US and the rest of the world. I’m of the opinion that the monetary stance will be gradually moving toward neutrality in 2010 and to an even keel position in 2011. Investors should watch what might happen to quantitative easing for that’s the 800 pound gorilla in the room. The FED, in our opinion, is likely to stick to it’s stated plan to end purchases of mortgages at the end of March and roll back emergency lending programs in February.

The FED will be saved by the private sector and China in that they will take up the burden of financing government budget deficits. Private savings will substantially increase over the next few years because of the ongoing de-leveraging process of households, financial institutions, commercial real estate and non-financial corporations. The private sector could buy as much as $1000 billion of US treasuries in 2010.

The monetary authorities in China abruptly reversed course last Tuesday in a clear sign that they have turned their attention to controlling the repercussions on of a credit explosion by raising reserve requirements on banks and yields on short term bills. The money supply in China is up 35% on a year to year basis. These changes mark stage one and the turning point of China’s exit from emergency policies. Because China, for all intents and purposes, is under a fixed exchange rate in that its currency is linked to the US dollar; a tighter monetary stance should lead to upward pressure on the Yuan and, therefore, lead to more accumulation of international reserves in the form of US Greenbacks. China and other foreign countries may buy as much as $500 billion worth of US treasuries in 2010.

What these two sources of financing means is that the FED will be able to follow a monetary stance that will be more in tune with what it ought to be. The US economy may have ended 2009 with a bang, but the anticipated change in the fiscal and monetary stance means that the 2010 outlook will be mute for a post recovery year.

Hubert Marleau, Chief Investment Officer

Palos Management Inc.



Good piece by FT’s Lex column

Markets are like dominos – tip one over and others topple. Consider then the potential effect of President Barack Obama’s plan for a 15 basis point levy on banks’ non-deposit funding. This could upend the $3,800bn US repo market – a crucial but underappreciated source of short-term funding for banks and investors, and a significant lubricant of the Treasury market. The levy could drastically reduce activity in the low-margin repo market – where a bank stands between a fund lending cash secured by securities, and an investor wishing to borrow against securities – reducing access to financing. Another domino to wobble could be the money market mutual fund industry.

Money market funds, whose investments must have a short average maturity, are large lenders in the repo market. Yields on such funds have fallen virtually to zero, causing investors to pull money from the $3,200bn market. If repo bid-offer spreads of perhaps 5bp increase, potentially by 15bp, that would likely induce those borrowing or hedging positions through repo to finance elsewhere, such as the swaps market. That could distort Treasury and mortgage markets. It would also mean less opportunities for repo lending by money funds, lowering their returns.

Some money funds are obliged to invest only in Treasuries or Treasury-backed repos. But others grappling with pathetic yields would seek other investments. This is an industry already in post-crisis limbo, awaiting new regulations and a twice-delayed presidential report on its structure. New rules aimed at reducing risk are likely to shorten the average allowable maturity of investments. In contrast, Obama’s bank tax – which only seeks to raise $9bn a year – could further the incentive, where possible, to increase risk by seeking longer-dated investments, say in the commercial paper market. Dominos only take a tiny push to start falling.


China Raises Key Interbank Rate

China’s central bank unexpectedly raised a key interbank market interest rate Thursday for the first time in nearly five months, signaling a change in its policy focus toward pre-empting inflation risks in the new year.

The tightening move, in the form of a higher yield in its weekly bill sale, came less than a day after the People’s Bank of China hinted its priorities had shifted toward managing inflation expectations and away from single-mindedly supporting economic growth.

It also shows the PBOC still prefers using liquidity management tools, rather than policy interest rates, to guide market funding costs gradually higher before inflation becomes a real threat, analysts said.(…)

The comment on price stability was a departure from recent rhetoric from Beijing that it will strike a balance between maintaining growth, restructuring the economy and reining in inflation expectations.(…)

The central bank also said Wednesday it will employ moral suasion to ensure reasonable money-supply and credit growth this year, and strengthen its management of liquidity through managing its choice of policy tools.

I would guess that “moral suasion” has a somewhat different meaning in China than in the Western World.

Full WSJ article

From Dennis Gartman:

This shall be the first of many more tightening efforts by the Bank, for if we have learned anything in more than three decades of watching central banks in action we have learned this: once they change direction, they move in that new direction far longer in time and take rates much farther in number than almost anyone wants to believe
possible or even likely when the change is made. 4 bps this week shall be 4 bps next month and 4 the month after and 4 the month after that, although we use the number “4” as a symbol, not as a hard fact.The point is that rates have been “guided” higher.” They will be “guided” higher again and again and again.

Also, this shall likely mean that the Renminbi shall now begin to strengthen relative to the US dollar and the EUR, getting Washington and Frankfurt off of Beijing’s economic back… at least for the moment.



Here is a nice buy low/sell high chart.

The yield curve has been the subject of an increasing amount of chatter in recent weeks, as long-term interest rates rise and short-term rates remain low.  Some stories have suggested that the curve is at record highs, but based on the official definition from the NY Fed, while the yield curve spread is extremely high, it is not quite at a record.

According to literature from the NY Fed’s website, the yield curve is defined as, "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill."  On a historical basis it has been "a valuable forecasting tool…in predicting recessions two to six quarters ahead."

Using the Fed’s definition of the yield curve, the chart below shows the historical spread between the yields on the 3-month and 10-year US Treasury (in basis points).  As shown in the chart below, the current level of the yield curve is nearly two standard deviations above its historical average.  The only other time that the spread got this wide was back in August 1982.

Yield Curve123009

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Volatility Will Increase, US Will Lead in 2010: Marc Faber

(…) "I think 2010 is a year when capital preservation will be more important because I expect a lot of volatility up and down," he added.

(…) "My feeling is that the US market will outperform emerging economies in the first six months of 2010," he said, adding that it remains to be seen whether that will be in a context in which markets continue to move up or because emerging markets will give up their gains faster than the US.(…)

"I believe that we could have a rebound (in Treasurys) for, say, one to three months," he said.

But longer term, Treasurys prices are likely to come down.

"I’m sorry to say, I don’t see much deleveraging… the government is leveraging up," Faber said.(…)

In five to 10 years, stock prices are likely to be higher than they are now, but the dollar will be lower, according to Faber.

Gold, the depositary of trust when central banks print money, is also likely to be higher, he added.

Full CNBC.com article



While long-term interest rates in the US are on the verge of breaking out to multi-month highs, a look at long term rates in other countries/regions shows that the rest of the world isn’t following suit.  As shown below, 10-year government bond rates in the US (3.60%) are currently well above the Euro region (3.25%) and Canada (3.42%) but still below UK rates (3.88%).


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