The Setting for Ben Bernanke's Speech at Jackson Hole

Anticipation is rising for the annual late summer speech given by the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke.  The basic economic environment surrounding this speech is what I would like to touch on in this post.

This environment along with what the Federal Reserve does…or doesn’t do…is crucial to the possible “macro” position a person could in their investments and in their business decisions.

For example, John Paulson, the hedge fund investor, has apparently started placing his bets with respect to current economic and financial conditions and with respect to what the Fed can…or can’t do.  Mr. Paulson, according to recent regulatory fillings, has been re-arranging his portfolio…increasing his position in gold and reducing other positions…in anticipation of higher future levels of inflation.

Future inflation is certainly a concern and I will discuss this a little later, but there are also other issues that need to be discussed as well.

For example, dominating discussions about the current environment is the rate at which the economy is growing.  In the second quarter of 2012, real GDP grew at a 2.2 percent year-over-year rate.  I am expecting this growth rate to remain around 2 percent for the next year or so.  This expectation is backed up by other numbers, like that for industrial production.  Economic growth has been tepid, is tepid right now, and is expected to remain tepid for the near term. 

There are numerous reasons why economic growth is likely to remain slow.  I have reported on these in many recent posts.  A short list of reasons include continued deleveraging of the private sector; under-employment of eligible labor; residential mortgages being underwater; bankruptcies and foreclosures; commercial real estate losses; health of a large portion of the banking system; the financial condition of state and municipal governments; the uncertainty that exists with respect to government policy and regulation; the European recession and sovereign debt crisis; and the slowdown in other countries like China, Brazil, and India.

I believe the American economy will continue to grow but only at or below a 2 percent year-over-year rate.  This is an environment of stagnation with unemployment and under-employment staying high and capacity utilization of industry remaining historically low. 

Given this basic scenario, interest rates will rise over the next year or so.  There are, I believe, three reasons for this. 

First, interest rates in the United States are as low as they are because of the “haven” nature of US government debt.  Large quantities of “risk averse” funds have flown into American security markets escaping the mess in Europe.  As a consequence, the yield on 10-year US Treasury securities closed at 1.82 percent on August 17.

If one subtracts an “expected rate” of inflation from this figure, let’s use 2.00 percent (which is about what the inflation rate is in the United States using the year-over-year rate of increase in the GDP implicit price deflator).  Then an estimate for the “real” rate of interest is a negative 18 basis points.  This is not too far off the yield on the 10-year TIPS bond, which was a negative 45 basis points on August 17.

And, what “should” this real rate of interest be?  I have always argued that “the” real rate of interest should be somewhere around the level of the “expected” real rate of growth of the economy.  Thus, from the 1960s through the end of the century a 3.0 percent rate worked out to be a good working estimate of the real rate.  If we use my current “expected” rate of growth of the economy, 2.0 percent, then the “real” rate of interest in the United States should be in the 1.50 percent to 2.00 percent range. 

Therefore, as the “risk averse” money leaves United States shores, the yield on TIPS should rise fairly steeply.  Whether or not this rise will be resisted by the Federal Reserve is a question that remains unanswered at this time.  Resisting the rise will just cause to Fed to flood the banking system with more excess reserves, which may cause other problems.  But, this is something that the monetary authorities are going to have to face.

The second reason for a rise in interest rates is that there should be, sooner or later, demand pressure on interest rates due to a pick up in economic activity…or,  Right now, commercial banks are awash with funds while at the same time loan demand seems to be particularly weak.  Thus, there is little or no pressure for interest rates to rise.  This is certainly something we need to watch out for. 

However, we could see interest rates rise for a third reason…a rise in the expectation of future inflation.  This is something many people…like John Paulson…are worried about.  Never before has the commercial banking system had so many excess reserves “hanging around.”  In August 2008, before things fell apart, the excess reserves of the whole banking system amounted to less than $2.0 billion.  In the two banking weeks ending August 8, 2012, excess reserves in the banking system averaged $1.5 trillion. 

The monetary base, the foundation of credit expansion in the United States, was around $2.7 trillion in the banking weeks ending August 8: it was at $842 billion in August 2008!

Few people believe that the Fed can withdraw a major part of these funds from the banking system once banks start lending again…and inflation starts to increase.  Inflation and credit expansion go hand-in-hand.   And, the lending could pick up even if real economic growth does not pick up.

A further question exists: how can the Federal Reserve withdraw funds while the federal government is still running annual budget deficits of $1.0 trillion or more?

So the third reason for interest rates to rise is that as inflation accelerates in the United States, the expectation of future inflation will also rise.  When this will begin and how fast will it take place is, of course, the big question.

There are other possible “macro” effects surrounding this picture.  For example, what will happen to the value of the dollar given this view of the world?  These will be addressed in future posts.

Does one get a sense of potential “stagflation” in what is written above?  Slow economic growth, rising inflation, and rising interest rates.  How does a central bank combat such a situation?

The situation that Mr. Bernanke and the Fed face is a very challenging one.  It is a situation that they have helped to create.  But, getting out of it will not be much fun for them.

As far as the private investor is concerned…a situation like this presents a ton of possible “investment” opportunities.  And, one should always ask, “How can I make money from a situation like the ones described above?” 

As one reads a book like “More Money than God” by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes.  The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes.  However, these “tools” are not available to most people.  Maybe that is why the distribution of wealth in the United States has become so skewed.    

What Are the Bond Markets Trying to Tell Us?

What are investors in the bond markets trying to tell us?  To me, we must give some kind of interpretation to where current yields are in order to get some idea about where financial markets believe that the economy is going.

Historically, one could take an estimate for the expected real rate of interest and add to this one’s expectation for inflation and come up with a projection for what the nominal rate of interest on United States Treasury should be. 

In today’s environment this is problematic.  In the past a good proxy for the expected real rate of interest was the expected long-term growth rate of the economy. (Equating the expected real rate of interest with the expected long-term growth rate of the economy has the backing of the accepted economic growth theory and has worked on a practical basis.)

Whereas in the past one could estimate the expected real rate of interest at around 3.00 percent since the expected long-run rate of growth of the economy could be around this number. 

Being a little more conservative let’s say that the expected real rate of growth of the economy in the near term will be around 2.25 percent. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage) Given the rule presented above this means that we could expect that the real rate of interest in the economy should be around 2.25 percent.

Now, the current year-over-year rate of increase in the GDP implicit price deflator is 2.1 percent.  Again, to be conservative, let’s assume that our expected rate of inflation is just 2.0 percent.

This would mean that our estimate for the yield on the 10-year US Treasury bond would be 4.25 percent even given our very conservative estimates of the real rate of interest and inflationary expectations. 

This forecast is problematic because the current yield on the 10-year US Treasury bond is around 2.00 percent. 

 The problem that we are dealing with at the present time is that the United States is experiencing an inflow of funds from the rest of the world due to a “flight to quality” coming from the continent of Europe.  In this “flight to quality” investors are not looking at earning a sufficient amount of return to earn themselves an inflation protected real rate of interest.  These investors are looking primarily for a “safe haven” in which to place their funds and earn something more than they would earn keeping their funds in cash or very short-term securities. (http://seekingalpha.com/article/507891-u-s-treasuries-still-a-safe-haven-and-yields-on-tips-remain-negative)

 

This “flight-to-quality” has driven the yield on the 10-year US Treasury security to around 2.00 percent.  This “flight” is the dominating force in the bond market these days.

This “flight” is even dominating whatever the Federal Reserve is doing these days.  The interpretation here is that the supply of funds coming into the US market is keeping these interest rates so low allowing the Fed to do next to nothing in keeping US interest rates so low.  (http://seekingalpha.com/article/519961-don-t-expect-qe3-from-the-fed-this-week) This, of course, is taking some of the pressure off Fed Chairman Ben Bernanke. (http://seekingalpha.com/article/542361-economic-growth-for-the-first-quarter-good-scenario-for-bernanke)

Bond holders, however, want to be protected from the deterioration of the real value of their bonds so they are still asking for protection against the inflation they expect to face in the future.  That is why the yield on 10-year inflation-protected Treasury issues (TIPS) have been paying a negative yield.  This negative yield is around 0.30 percent. 

Thus, if one subtracts the yield on TIPS from the yield on the 10-year issue from the yield on the 10-year Treasury bond, one comes up with the market’s current estimate for future inflation.  At this time expected inflation is around 2.30 percent, a little above the current rate of inflation cited above. 

Note that the yield on TIPS became negative in early August 2011, when the European sovereign debt crisis picked up once again specifically relating to the events in Greece.  The concerns over Europe continue with the emphasis now shifted to Spain.       

In terms of the future, I would argue that the negative yield on TIPS bonds will not become positive again until the European situations eases enough so that funds will start returning to “riskier” debt in Spain, and Portugal, and Greece, and Italy.  As these funds begin to flow out of the US Treasury market, yields will begin to rise and historical relationships will return. 

What I am saying here is that if TIPS rise to around 1.00 percent, the level of earlier 2011 as seen in the accompanying chart, and inflationary expectations remain at even 2.00 percent, the yield on the 10-year Treasury issue should rise to at least 3.00 percent. 

If the economy continues to grow at a rate in excess of 2.00 percent and inflationary expectations remain at the 2.00 percent level, the yield on the 10-year Treasury issue should rise to at least 4.00 percent.

The European debt crisis is having a major impact on US bond markets and yield relationships and will continue to do so until European officials really resolve their fiscal problems.  Thus, look for what happens to the yield on TIPS in the near future.  That will provide information on what the financial markets think about European prospects.

Given this scenario, the next pressure point for the Federal Reserve will occur when the Europeans do resolve their financial issues.  Then the Federal Reserve will be faced with having to deal with rising interest rates and this will make its life just that much harder.   

TIPS Auction Still Negative

The TIPS auction that took place yesterday continued to place inflation-protected yields in negative territory.  The yield on the issue was -0.089 percent and the ten-year yield closed to yield -0.111 percent. (http://www.ft.com/intl/cms/s/0/ba90c7f2-7443-11e1-9e4d-00144feab49a.html#axzz1pwQWCSw3)

The negative yield on these inflation-protected securities does not mean that investors will not make any money on their holdings because the principal of these securities will increase if inflation rises. 

The yields of the TIPS are negative because the yields on the US Treasury yield curve are so low.  And, the yields along the yield curve are so low because of the amount of money that has flowed into this market through a “flight to quality” arising from the debt problems faced by Greece and other eurozone countries. (http://seekingalpha.com/article/446881-treasury-bond-yields-will-continue-upward-climb)

The 10-year US Treasury bond closed to yield 2.28 percent yesterday.  If one takes the difference between this bond yield and the yield on the 10-year TIPS issue as an estimate of inflationary expectations, then one can state that investors are expecting that inflation will average about 2.4 percent over the next ten years in the United States.

That is, if 10-year bonds are yielding around 2.30 percent in the market and the inflationary expectations of investors are approximately 2.40 percent, then the TIPS yield must be around

-0.10 percent to fully incorporate the possible effect of inflation on the real value of the bonds.

In the latter part of January 2012, when the last auction of TIPS came to market, 10-year US Treasury bond yield was around 2.00 percent and the yield on the 10-year TIPS issue was around -0.15.  The relationship between the two yields implied that investors expected inflation to average around 2.15 percent over the next ten years.

At the end of December 2011, inflationary expectations were around 2.00 percent, calculated in the same way.

The most important conclusion that can be drawn from this is that, in the financial markets, investors are now building more inflationary expectations into their future projections than they were several months ago. 

The actual rate of consumer price inflation, year-over-year, was 2.9 percent. (Note that this rate of increase is down from a near-term peak of 3.9 percent in September 2011.)

Inflationary expectations, as reflected in the bond markets, tend to lag behind actual inflation.

The auction yesterday reflected strong investor interest as Wall Street dealers, who underwrite the Treasury auctions, were left with only 39 percent of the offering, which was down from the 50 percent they received in January’s auction.  Also, this was the second lowest share of the 10-year TIPS auction for dealers since the market began in 1997.   

If one is looking for some evidence of when the bear market for US Treasury securities might begin, then this, I believe, is a good place to start.     

As I have argued earlier, the yield on the 10-year US Treasury security is currently as low as it is because the United States Treasury market still has a lot of funds that are there for “safety” reasons.  My belief is that this yield should be above 3.00 percent if the “flight to quality” money was not in the market. 

Thus, the yields on US Treasury securities, in my mind, need to rise just in order to get back to a range that is more consistent with where the United States is in the economic cycle. 

But, the next concern of the investors seems to be about a coming “bear” market in bonds.  This “bear” market is to come once the economy begins to grow faster…more than the 2.0 percent to 2.5 percent rate of growth now being experienced…and when all the money the Federal Reserve has pumped into the banking system starts to really impact prices in the economy. 

 My suggestion is to watch the spread between the yield between the 10-year Treasury bond and the yield on the 10-years TIPS issue. 

As real economic growth begins to pick up, the TIPS yield will have to increase to reflect the growth of the real economy.  This yield will not be determined the way it has been determined in the recent past.

And, if the real yield on the TIPS issues rise the yield on the 10-year Treasury bond must rise as the investor’s inflationary expectations get added onto the yield they are getting on the TIPS.  If the real yield on the TIPS issues rise to, say, 1.50 percent and investors expect inflation to be in the 2.5 percent range, the 10-year bond should yield at least 4.00 percent. 

As expectations of the real rate of return rise and inflationary expectations rise, the yield on 10-year bonds should be off to the races.  Then one can say that the bear market had arrived.    

Economic Recovery: the Good and the Bad

The economic recovery began in July 2009.  Since then we have been plagued by a plethora of good economic news and not-so-good economic news.  David Wessel, in the Wall Street Journal, captures this continuing saga in “An Economy Poised Between Flight and Fright.” (http://professional.wsj.com/article/SB10001424052702303863404577281210187996478.html?mod=ITP_pageone_1&mg=reno64-wsj)

It has become obvious to many that the current experience is not that of a conventional business cycle.  The economy is recovering but the pace is extremely slow and the fragility of the recovery is obvious to almost everyone.

Major focus has centered on the banking system, the housing and the household sectors, and labor markets.  These worries translate into issues of solvency and deleveraging. 

On top of this is the tension over Iran, Syria, Afghanistan, the rising price of oil, and the financial difficulties of the eurozone. 

The important thing, to me, is that the economy is recovering.  The second most important is that the major problem areas the world is facing have been identified.  Given these two factors, the major policy issue faced by the monetary authorities…and the fiscal authorities…is to avoid further unexpected shocks to the system.

For one, the Federal Reserve is dealing with a very fragile banking system.  Last year, 240 commercial banks left the banking system or were closed.  The pace of bank departures seems to be less this year, but the number of banks in existence still seems to be declining quite rapidly. 

The Fed has been keeping plenty of liquidity in the banking system so that the FDIC can continue to oversee the continued decline in the number of banks outstanding in a smooth and continuous way without disruptions or shocks that could cause a further unsettling of the financial system.

With all the restructuring going on in the banking industry, coupled with the new load of banking regulations banks are facing, loan growth had remained tepid or non-existent until just recently when banks started to extend credit at a faster pace.  I take this as a good sign and an indication that the bankers are growing a little more confident. (http://seekingalpha.com/article/426601-finally-some-real-loan-growth-at-the-banks)

But, deleveraging in the private sector, especially in the United States, has continued.  Major debt cycles take a long time to unwind.  We can be thankful that major debt cycles only occur about once every century for the working off of debt overloads can take a extended period of time and distract attention from productive activities like manufacturing and construction.

This deleveraging is taking place and, I believe, will continue to take place.  Martin Wolf, in the Financial Times, gives us a good summary of how deleveraging is unwinding. (http://www.ft.com/intl/cms/s/0/07b419ac-6c39-11e1-8c9d-00144feab49a.html#axzz1pCcr5QXS)

The major takeaway from these examples is that things are improving and the economic recovery is coming along.  Sure, there are going to be bumps along the road.  Sure, there could be some surprises that could sidetrack us.  But, it seems as if people are focused on what things could go wrong and are over-compensating for these possible events so as to avoid surprises.  That is, major attention is being given to identify “known, unknowns” so as to minimize the “unknown, unknowns.”  It is the “unknown, unknowns” that are the most dangerous things, the things that can really divert the economic recovery.    

I believe that the Greek debt restructuring went as well as it did because most of the “unknowns” were on the radar of the participants of the financial markets so that the financial markets reacted smoothly to the settlement that took place.  In essence, there were no surprises. (See my post “The Greek Situation: The Financial Markets Do Not Like Surprises” which was posted on March 12, 2012, http://masefinance.blogspot.com/.)  It doesn’t mean that everything is settled, it just means that nothing disruptive happened.   

So, I continue to argue that the economic recovery will continue, but the growth rate of real GDP in the United States will remain below 3 percent for a while as the deleveraging continues to take place at a reasonable pace.  Whether it will be between 2.5 percent to 3.0 percent as projected by the Federal Reserve or remain around 2 percent or below, as forecast by the Congressional Budget Office, is anyone’s guess.

As I mentioned above, however, the modest increase in commercial bank lending is the most positive sign I have seen for a while.  Right now, I am leaning toward something above 2 percent but below 3 percent through 2013.  Good, but still not robust. 

Given this picture, the major problems I see on the horizon are two.  First, I am worried that people in Washington, playing for a political advantage, will still feel the need for additional budgetary stimulus in one way or another.  I believe that this would achieve very little in the way of greater economic growth because the private sector will continue to deleverage and so the multiplier of any additional government programs would be less than one. 

Second, the Federal Reserve must deal, at some time, with all the excess reserves it has injected into the banking system.  The dilemma here is that the banking system is still fragile and the FDIC needs further time to help the banking system get smaller in number of banks in existence.  On the other side of the equation, however, is the fact that at some time the excess reserves can turn into kindling for the inflationary fires.  That is, loan growth could become excessive.  In this latter instance, given the current state of the economy, I can see inflation becoming more of an issue without any consequent improvement in the rate of growth of the economy. 

The economic system is still very fragile…but the economy is recovering.  For now, I believe this is the best that can be achieved.      

Mr. Bernanke Stands Pat

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System gave his “Semiannual Monetary Policy Report to the Congress” this morning.

Mr. Bernanke basically said nothing. 

The stock market dropped…apparently any hopes for an additional round of quantitative easy were dashed.

What can one say?

The Fed’s forecast for the growth of real GDP: between 2.2 percent and 2.7 percent, slightly higher than the rate of growth experienced in the second half of 2011.

The Fed’s forecast for the inflation in the prices related to consumption expenditures: between 1.4 percent and 1.8 percent, about the same as the annual rate of increase in the second half of 2012.

Unemployment is expected to stay around the level it achieved in January 2012…around 8 percent since economic growth is expected to remain slightly below its long-term trend.

Where does the risk lie in the economy in the future?  It seems that there is still “persistent downside risks to the outlook for real activity.” 

The job market “remains far from normal.”

The fundamentals for household spending “continue to be weak.”

The housing sector is giving off mixed signals, at best.

Manufacturing is improving and real business spending for equipment and software seems to be picking up.

However, the European situation remains a concern.  We are told that the Federal Reserve is “in frequent contact with our counterparts in Europe and will continue to follow the situation closely.”

And, given this environment, the Federal Reserve will continue to keep the target range for the federal funds rate in the 0 to ¼ percent range.  The Federal Open Market Committee “expects economic conditions to warrant exceptionally low levels of the federal funds rate to at least through late 2014.”

There you have it.  Economic growth is expected to continue at a rate that is slightly below its long-term trend of about 3.0 percent through 2013.  Inflation is to stay below the Fed’s target of 2.0 percent for the near future.  And, the risks inherent in the current financial and economic environment continue to be on the downside with the European situation being the main worry.

The banking system will remain flush with excess reserves.  The larger banks will continue to grow larger and take over more and more of the financial system.   Small- and medium-sized commercial banks will continue to fail or be merged out of the banking system. And, regulatory reform will continue to lag behind what is happening in the real world.

That is, there is nothing new to report. 

Thank you, Mr. Bernanke!