In the beginning
Today is May 14th, 2010. Three years ago the 10 year Treasury was trading around a 5.20% level. Then the Bear Stearns hedge funds collapsed and kicked off the Armageddon World Tour. Today the 10-year is trading at a 3.45%. It’s been three years since the Big Bang and I’m still writing updates discussing why yields are low or going lower. Three years. Somewhere in Japan there has to be a fixed income analyst/economist/second rate comedian that understands exactly how I feel.
Along the way we heard Fed Chairmen say that the Sub-Prime problem was contained, that it wouldn’t spread to the general economy. We heard that housing prices had some “frothy pockets” but that they weren’t in danger of a general decline. We heard some real doozies.
Today
Now it looks like the Armageddon World Tour has some dates scheduled in Europe. If European soccer fans get angry enough to burn down their home stadium over a loss to a rival team I can’t WAIT to see their collective reactions once they figure out what’s coming their way over this sovereign debt deal. Gas prices could rise on Molotov Cocktail activity alone.
Perhaps the most interesting news of the day comes from the Fed. The Fed is sending out messengers again this morning and the Minneapolis Federal Reserve President is speaking in tones that sound terribly candid. It almost sounds like he never took the class on “fed speak”. Fed Speak is a bit like the Jedi Mind Trick…it’s the thing where you speak but nobody listening really gets the true meaning of what you just said. Greenspan was a master of this technique. Fed President Kocherlakota didn’t get the memo. He spoke in a straight-forward manner today and much of it lines up with what we’ve been saying for quite a while.
His outlook
Kocherlakota says he is mildly optimistic at this point. He believes the recovery is firmly underway but that it will not be a “V” shaped recovery. For those interested in the different “shapes” of a recovery you can pull up the Market Update from 5/7/09…it goes over the various types of recoveries. It’s a bit disconcerting that a year after I wrote that piece we are still discussing what the shape of this recovery might be. Threats to the recovery include higher future taxes that will be necessary to repay the amount of money we’ve borrowed. Higher future taxes reduce the amount of capital that is available to be invested by the private sector, which leads to lower growth and slower rates of job creation.
It’s important to note that next year Kocherlakota will be a voting member…so here we’re getting a nice glimpse into the way a future voting member views the world. In his statements he leaves no questions about his views on the language “likely to warrant exceptionally low levels of Fed Funds rate for an extended period of time.” He states categorically that he would have voted for that language at the last meeting.
Why would he have voted for the language? Because he sees the economy struggling with the Unemployment Rate remaining high and expected inflation remaining low. Specifically he states that it wouldn’t surprise him to see the Unemployment Rate remain above 9.00% through the end of this year, nor if it remained above 8.00% by the end of next year. Regarding inflation he states that he sees 5-year inflation expectations running at about 2.00%.
In summary he sees a weak economy, very high unemployment for at least two years, no inflation for 5 years, he agrees with the majority of voting members that a zero level on the Fed Funds is appropriate and that he’d vote for keeping it that way for an extended period.
We’re three years into the Armageddon World Tour/quagmire and this soon-to-be voting member of the Fed is laying out language that hints at another two years of exceptionally low rates.
After stating all of this, Kocherlakota goes on to state that it’s all data dependent and the Fed stands ready to raise rates quickly whenever they need to whether it be “3 weeks, 3 months, or 3 years”. This statement reminds me of the old playground threat… “don’t make me”. I hear it occasionally when a big group of kids is outside playing. Invariably there will be a disagreement of some sort and someone will always invoke this vague threat in an attempt to get what they want. It’s always a hollow threat, nobody ever actually DOES anything. It’s just a convenient way to appear like you have some control over the situation when in reality things are very close to uncontrollable.
I find the “don’t make me” phrase to be a nice parallel to Kocheralakota’s statement that he stands ready to tighten in “3 weeks, 3 months, or 3 years” right after he lays out a scenario where he doesn’t see the need to raise rates for at least two years. The Fed can talk all the trash they want about raising rates but it looks like they have no room to do so anytime soon. A Marine buddy of mine used to describe people making these types of statements as having “an alligator mouth and a hummingbirds backside” because they lack the muscle to back up their talk. My friends statement regarding the backside of the hummingbird is a bit more colorful than how I relayed it here…but in the interest of keeping this a family friendly piece I toned it down a bit.
Reducing the Fed balance sheet?
Kocherlakota next addressed the size of the Feds balance sheet and an exit timeline. He sets the bar exceptionally low when it comes to an exit. With regard to the pace and size of MBS sales “we want to be careful not to cause large jumps in long-term interest rates, and especially not in mortgage rates. But I believe that we can do so, as long as we commit to a sufficiently slow pace of sales. I’m optimistic that we can get MBSs off our balance sheet by 2020 at the very latest.”
There you have it…a 10 year exit deadline…way to go out on a limb. I find that strategy terribly amusing. Base case cash flow projections on new issue 30 year 6% MBS show that for every $1 million in principal you buy today, you will have $5,157 in outstanding principal remaining in 2020. That is a 99.48% reduction based on pay-downs alone. I guess I wonder why you’d even bother to issue a deadline…why not just say we’re going to hold them until they have factored down so far that they are insignificant? In a world where words matter I guess his way is better than saying “we’re stuck and we can’t get out.”
Reading between the lines
There is an interesting and important wrinkle in his statement this morning. He states that “Over 2 trillion dollars of those assets are in Treasuries or in mortgage-backed securities issued by Fannie Mae and Freddie Mac. These MBSs are backed by the U.S. government—the Fed faces no credit risk in holding them. However, the MBSs do expose us to interest rate risk and prepayment risk.”
We occasionally get some questions about the safety of debt issued by Fannie and Freddie. There is a mountain of reasons why this debt will never be allowed to go unpaid. The multitude of reasons can effectively be summed up by stating that any failure to pay on behalf of the GSE’s would effectively destroy what remains of the global financial system, and that congress would rather not go down in history as the entity that both created and nurtured the institutions behind such an event.
Today’s statement by Kocherlakota adds just a few more boulders to the top of the mountain of reasons that you shouldn’t be worried about the credit worthiness of the GSE’s. Fed Presidents openly speak about Fannie and Freddie being backed by the US Government and that they have “NO CREDIT RISK”.
Kocherlakota is no idiot. He understands the power of words and he understands the structure of Fannie and Freddie. He understands that the prospectus on Fannie and Freddie debt contains no explicit guaranty by the US Government…but he also understands the reality that there is no other alternative than for the US Government to make sure that the GSE’s make good on that debt…period. He’s not the first official to state it…he’s just the most recent.
If you occasionally field questions from board members on the safety and soundness of GSE debt just add this statement to the file as another piece of evidence that there is nothing to worry about with regard to the credit quality of Fannie and Freddie. I wouldn’t touch their stock but I’d sleep well at night owning their bonds.
In closing
That’s it from Memphis folks. This weekend is the grand finale of the World Championship BBQ competition along the banks of the might Mississippi River. Many bond trading desks send their traders down to mingle with their Memphis cohorts each year during this event so business tends to get lighter as the afternoon approaches. This translates to “if you have any business to do then try to do it early because by 2PM the traders will be down on the river, elbow deep in beer and BBQ.”
As always if you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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