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Commentary
Our View on Today's "Butterfly Effect" Economy
What some refer to as the Chaos Theory, we like to call the “Butterfly Effect,”
which is essentially the theory that seemingly small and inconsequential actions
can have far reaching—and sometimes disastrous—unintended consequences. Just as
the proverbial butterfly flapping its wings in one part of the world can cause a
chain reaction of events leading to (or averting) disaster elsewhere, the Fed’s
response to this summer’s credit market meltdown has produced some unexpected and
potentially disastrous results. While some positive developments—such as more stable
credit markets—immediately followed the Fed’s action, some trends have emerged that,
while painful in the present, may have long-term positive results.
Following this summer’s subprime debacle and the ensuing credit market collapse,
on September 18 the Federal Open Market Committee of the Federal Reserve Board unanimously
eased the target overnight Fed Funds rate by 50 basis points, to 4.75%. This action
reversed the Fed’s three-year campaign to rein-in monetary policy and unwind the
(arguably over-hyped) threat of deflation following the dotcom bust and the attacks
of September 11, which resulted in 17 consecutive increases in the target interbank
lending rate, from a historical low of 1.00% in June 2004 to 5.25% in June 2006.
With the housing recession, mortgage market disruption, and general credit market
turmoil over the summer, Wall Street and Main Street both clamored for an interest
rate easing, but immediately following the cut, some market participants felt as
if they had asked for a glass of water and got a drink from a fire house instead!
Since September 18, LIBOR has receded, some liquidity has returned to the mortgage
market, and the stock market has generally been stable (until this week). Ironically,
however, interest rates have been on the rise throughout the yield curve (like stocks,
until late this week), the dollar has plummeted, and commodity prices have soared.
Chairman Bernanke’s response to his first real crisis since becoming Fed chairman
in February 2006 resurrected the ghost of the “Greenspan Put,” which is the belief
that the Fed will detour from its dual mandate of price stability (inflation targeting)
and full employment in order to bail risk-takers out of losing bets if the problem
threatens to become systemic. The Fed believed the threat of the credit market freeze
was substantially severe to impact the broader economy, so they acted boldly. Some
others believe that the Fed may have inadvertently left the economy teetering at
a Hobson’s choice between recession and inflation.
When the Fed eased in September, it ended years of yield curve flattening and inversion—the
result of tighter monetary policy increasing short-term rates while unprecedented
demand by foreign central banks for safe, long-term assets pushed down long-term
rates. It also shifted the primary risk assessment from inflation to growth. While
intending to indirectly provide liquidity to stretched mortgage borrowers, the Fed
actually increased the yield on the 10-year Treasury—the pricing benchmark for 30-year,
fixed-rate mortgages—as investors expressed concern that lower interest rates will
ignite inflation, which eats directly into their fixed returns on Treasury bond
holdings.
Since September, the Treasury market has more or less remained locked in an uninspired,
range-bound, and directionless drift, following other markets as opposed to leading
the price action on Wall Street. Although a steeper yield curve is not the panacea
for mortgage borrowers looking to refinance their way out of onerous loans, it does
provide institutional investors in traditional spread product (e.g., agency debt
and mortgage-backed securities) an opportunity to reload the ubiquitous “carry trade”
in which they can once again borrow short (at lower rates) and invest out the yield
curve (at higher rates) to capture a positive spread.
In addition to the steeper yield curve, which can be a blessing or a curse depending
on your view, the Fed’s easing has accelerated the precipitous decline in the value
of the U.S. dollar, especially against the surging euro. The dollar’s status as
the world’s benchmark currency is under threat as developing economies around the
world mature and European economies expand and become more productive after years
of dormancy. The Fed’s decision to ease rates has only hastened the trend of the
declining greenback, as lower interest rates make dollar-denominated assets less
attractive to foreign investors. A manifestation of the dollar’s relative underperformance
against rivals was clearly seen in the August Treasury International Capital (TIC)
report, which showed international investors were net sellers of U.S. securities,
by –$69.3 billion, as foreigners stampeded out of U.S. stocks and corporate bonds
due.
There is an upside, however, to a weaker dollar, and that is the benefit it brings
to U.S.-based exporters, which has generally helped to support the stock market.
The stock market, which had been on an upward trajectory since the Fed’s ease, skidded
this week as poor earnings renewed recession fears. Foreign markets continue to
become more vital sources of income for domestic companies, so growth abroad has
offset some the slow-down at home. And prior to this week’s turbulence, traditional
growth stocks had been benefiting as corporations profiting from exports, were paid
in foreign currencies, which they converted back into more dollars. The U.S. labor
market could ultimately become a benefactor of the weaker dollar if Eurozone manufacturers’
plans to transfer some production to the U.S. materialize. Already, U.S. tourism
is thriving as foreigners flock to take advantage of favorable exchange rates and
the increased purchasing power of their native currencies.
Staying with the positive theme, the trend of more exports and fewer imports from
a weaker dollar is also starting to shrink the current account deficit, which, broadly
defined, is the monthly trade gap. The trade deficit shrank to –$57.58 billion in
August, to hover around 5.0% of GDP on an annualized basis, and is showing signs
that it will continue to close as we export more and import less.
Unfortunately, the dollar’s decline in response to lower interest rates is also
pushing already lofty commodity prices even higher. Commodity prices were already
ebullient from the global commodities boom over the last few years, in which demand
for energy and raw materials in the developing world and a global construction boom
soared, increasing costs for everything from grains to copper. The “alpha” commodity
everyone is watching is, of course, the one we can’t live without: black gold, which
is up about 50% since the beginning of the year.
Much of the price appreciation in oil is, of course, owed to strong global demand
amid inadequate refining capacity, unpredictable supply and price controls (compliments
of the OPEC cartel), and geo-political instability in the Middle East region. However,
since the world oil price is set in U.S. dollars, a weaker dollar has placed upward
pressure on the commodity’s price, as producers seek to recoup the loss of the dollar’s
global purchasing power. Because oil is such an essential, inelastic good, escalating
prices directly impact consumers’ pocketbooks and generally dampen consumer spending,
which accounts for 2/3 of the economy. On the positive side, increasing oil prices
can also drive innovation and lead to development in other industries (e.g., biofuels).
Finally, the Fed’s action has brought some much-needed stability to the corporate
debt markets. As the credit markets froze in August, leverage buyout activity, which
depends heavily on the availability of cheap debt, ground to halt, leaving Wall
Street banks saddled with billions of unsold leveraged “bridge” loans. (This, in
addition to subprime CDOs, was a major source of recent losses at a number of high
profile banks). Meanwhile corporate debt issuance slowed to a trickle with only
a modicum of supply from only the most highly rated names, and debt spreads and
the cost of insurance against default (i.e., credit default swaps or CDS)—both ballooned.
Since September 18, some buyout financing came back on track, and debt spreads and
the cost of credit protection have both fallen. This suggests that the market is
reducing risk premiums, and investors, who are gaining confidence in the resiliency
of the economy and the credit markets, are beginning to rewet their appetites for
taking risk.
A great deal of the recent economic growth and prosperity of the U.S. has been due
to the “kindness of strangers.” While the rest of the world has been saving and
lending, Americans have buying and borrowing. But the U.S. economy may have been
forced into a point of inflection to realize that the strength of foreign economies
and the vulnerability of ours could have some positive long-term outcomes. The events
of this summer were a collision of years of easy money, runaway housing prices,
and a complacent view of risk. Chairman Bernanke, looking to garner creditability
as a strong and decisive leader, took bold action. As a result of a battery of disappointing
corporate earnings (especially banks), the futures market—at least as of today—is
predicting nearly a 100% chance of a 25-basis-point easing on October 31. So, the
Fed will have to continue to weigh the threat of inflation against that of recession
and consider that any course of action will likely have some painful unintended
consequences.
By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.
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