OPEC supply cuts will not match demand declines

OPEC did not agree cut production this week-end. The cartel members could not find common ground and decided to wait until December. OPEC cut production quotas in October by 1.5 million barrels or 5.2% of daily demand. That has had little impact on the oil price decline.

There are two major problems. One, the demand decline has taken the market by surprise. The global economies are falling faster than expected and look like they will continue to decline in 2009. Second, and more importantly, OPEC countries have been aggressive with their economic expansion plans and they do not feel like cutting production to stabilize prices. will help with increasing revenues.

The classic problem of cartels is that you have cheaters. And there are some major cheaters in the world. Venzeula gains 90% of its export revenue from oil. The majority of government revenue is tied to oil and President Chavez needs every last cent to stay in power. Russia was planning for $95 a barrel oil so they will have to produce flat out to meet revenue targets. Iraq needs the revenue for capital building. Iran has internal economic problems which need more money. We have not even started to discuss the other Arab countries.

Right now there is little reason to see prices going up. Let's not forget that oil was $10 a barrel ten years ago.

Non-standard monetary policy is becoming our new standard

It is now evident that the Fed is flowing a policy of quantitative easing. Unfortunately, they have not been willing to be explicit in announcing there policy change. Now, some may argue that we are premature about making this announcement since the Fed funds rate is still at 1% bu the latest round of Fed announcements of buying commercial paper and MBS and GSE debt is all but stating the obvious.

This should not be surprising given that Chairman Bernnake has researched this issue extensively all the way back in 2004 in "Monetary Policy at the Zero Bound: An Empirical Assessment" with Vincent Reinhart and Brian Sack. In that important paper, Bernanke and company discusses the policy alternatives when rates start to reach zero. There are three major policy alternatives, communication, quantitative easing, and balance sheet policies. It could be argued that the Fed is engaged in all three of these alternatives right now.

First, the Fed has made clear that they will provide significant funds through a number of programs to provide the market with liquidity. They have also made clear that they are will to provide funds even if this lowers the Fed funds rate below the target.

Second, the Fed has engaged in actively increasing their balance sheet through providing lending facilities. It has provided more repo lines, the dealer lending facilities and other programs which have increased the Fed balance sheet to above $2 trillion. They have been providing funds to offset the delevering by private sources.

Three, the Fed has been willing to take on credit risk in order to provide liquidity and to affect the yield curve. The outright purchase of GSE debt and MBS is similar to earlier policies like Operation Twist to use its buying power to affect longer-term rates and rates that seem to be out of line relative to historical relationships.

The good news is that three prong attack to affect the economy is right out of their policy choices discussed in the 2004 paper. Unfortunately, the bad news is that the impact of these policies may take some time so no one should expect monetary miracles over the next few weeks. The size of the liquidity problem outstrips the impact that was modeled in the 2004 paper.

Global monetary policy zero limit bound problem

Most of the G7 central banks will have policy meetings in the first half of the December. All of the central banks are facing slowing economies and lower inflation. In fact, there is a growing concern about deflation. The key issue will not be whether there will be easing but how much. This leads to the bigger question of what will happen when you force rates closer to the zero limit bound (ZLB).

Now we will not dwell on the deflation issue. Core inflation for most countries are still within their targeted zone after excluded food and energy. Much of the decline in CPI and PPI is a reversal of the short-term commodity spike. The spike was not an inflation problem as much as a price shock issue. It now seems obvious that inflation taregtting is out the window and economic stimulus is the problem.

The issue for many central banks is that we still are relatively early within the recession cycle and interest rates are falling to extremely low levels. Major cuts in many of these countries will take short rates down to levels where there will a concern about what some have called the ZLB problem. What are the policy choices of the central bank if we you are or approaching zero interest rates?

The problem is facing a number of central banks this month. Japan has seen a growing decline in economic growth. Rates are at 30 bps and have limited room for further decline after rates were cut 20 bps in October. The Fed has rates listed at 1% but another Fed cut is expected to bring the Fed funds target down to 50 bps. The Fed funds rate is already trading below one percent. The Fed seems to have changed to a quantitative easing policy. The Swiss National Bank has a target rate set at 1% but will meet again in December under a declining environment. Bank of Canada has argued earlier that the economy is still doing ok, but the tight relationship with the US and its commodity focus will place further pressure to lower rates. Bank of England is behind the curve with an economy that is growing worse every month. The same could be said for the ECB.

Expect to see further rate cuts across the board but there will be more discussion about quantitative easing and non-standard monetary policy. We know the global economies are in recession so there will be more focus on what will be the monetary and fiscal stimulus alternatives in the coming weeks. The equity markets will sell-off on anything other than strong easing.

Bank of Japan quantitative easing - lessons for the Fed

In the depth of the Japanese "lost decade", the Bank of Japan changed monetary policy to try the radical approach of quantitative easing. It actually was the only alternative to a liquidity trap from a deflationary environment where rates were at zero. The Bank of Japan had moved to zero interest rates in March 1999, but the policy of just keeping rates at zero was not enough.

The BOJ Quantitative easing set current account balances, the equivalent of excess reserves, to a quantitative target which would be maintained until CPI was greater than zero on a year over year basis. The policy started on March 2001 and lasted until March 2006. The current account balance initially moved from 1 trillion yen to 5 trillion yen, but the target was increased nine times from from March 2001 to December 2004 for a target pf 35 trillion yen.

The Fed seems to be on similar path so it seems important to discuss whether the BOJ quantitative easing was a success. The answer is that its success was only marginal. First, the size of the increases was much larger than anticipated and the impact of trying to stop deflation took longer than expected. Investors in the US should recognize that there will not be an quick fixes even if we have started quantitative easing much sooner than the Japanese.

Studies of the Japanese financial markets show that the the BOJ easing was able to effect longer rates and bring them down slightly. However, empirical studies suggests that a 10 trillion yen expansion was able to only bring down three and five years interest rates by less than 20 bps. There will not be a significant reduction in US rates if we use the Japanese case as a benchmark.

The BOJ found that there was no overall stimulation of lending from their quanttitive easing. Research did find that the easing policy reduced the standard deviation of CD rates across Japanese financial institutions. That is, the lower quality financial institution were able to reap a benefit from the increased reserves. However, some have concluded that the lowering of risk for those firms of lower quality actually delayed structural reforms. Poor institutions lasted longer than they would have until normal policies.

The Fed is moving to quantitative easing but it is not clear that this will be a panacea for all what ails the US economy. Now there may be limited choices and quantitative easing may be the only alternative, but this alternative does not mean that we will have a quick cure to our problems.

Monetary policy and credit quality cross purposes

The Fed has taken steps to directly buy up corporate assets through the high quality and ABS commercial paper markets and through GSE mortgage debt. The Fed rationale is to unlock the liquidity crisis in the short-term lending market and try and push down mortgage rates. The objective of the Fed is to provide liquidity while taking a minimum of credit risk. We thought the mortgage purchases were going to be a TARP objective but things change but that is another issue.

These purchases, which promote the quantitative easing Fed policy, could lead to unintended consequences. If the Fed is willing to finance all of the good quality assets which are rated A1/P1 how is poorer quality paper going to be financed? There are only two choices. The firms of lower quality will have to go under or they will have to find a price that will entice buyers of the paper. The Fed will crowd out the banks for higher quality paper which will have serious portfolio balancing effects.

So who are the potential buyers of lower quality financial paper? They will either be money market funds or banks. Both these groups have either a back-stop or deposit insurance but it comes at a cost. Deposit insurance does not mean that banks and money funds are going to take on riskier credits. Money funds will take on any asset which has the potential to break the buck for the funds.

So what are the alternative scenarios for the banks? They could buy this lower quality paper and have it become a larger portion of their loan portfolio or they could walk away from the market and take deposit reserves at the Fed at the Fed funds rate. The first alternative could hurt earnings and equity. This will force banks to take capital from the Treasury and thus loss control of their firms. The second alternative allows for positive earnings while still maintaining control of their institutions. Credit risk is limited.

The choice seems simple. There will be less lending to those who may need it most at any price. A two-tiered system of Fed lending to high quality firms and no lending to those that do not meet the Fed criteria will further develop. There is no solution in the short-run for this problem if the objective is to solve the liquidity crisis as quickly as possible.

The new dollar negative regime from quantitative easing

There is a clear regime shift that is starting to take place and will be the major theme of 2009. It is the switch from a quasi-Taylor rule – inflation target Fed stance to a quantitative easing policy. This change in policy by the Fed which has become increasingly clear in November will shift the focus from flight to quality to flight to alternative forms of purchasing power.

The quantitative easing era is upon us. The Fed has now consistently announced further purchases of GSE and corporate liabilities to solve the banking crisis and has moved further away from the use as interest rates as a solution. This is evident because the actual Fed funds rates has been falling consistently below the target level for weeks even with the change in policy to pay interests on reserve balances. This is becoming very much like the zero interest rate policy of the Bank of Japan which started in March 2001. The impact of flooding the market with reserves without regard to interest rates was very clear on the currency, depreciation. This same type of impact should be seen with the dollar.

The only argument against this unequivocal decline in the dollar is that the policy easings of other countries are still occurring. The declining interest rate gap between the US and the rest of the world will continue. The rates in some many countries are falling close to zero there may be global quantitative easing. Japan and Switzerland are the most likely places were rates will close to zero.
The risk aversion story of delevering with moving money to the US will dissipate. There will be less dollar buying from rebalancing hedged positions and global sell-off of other equity markets will slow. This will reduce the upward pressure on the dollar.

The biggest oil declines are behind us and there will be less dollar strengthening head winds from the energy markets which has been a consistent linkage. A decline in oil downward momentum will be dollar negative.

The European economic slowdown surprise is over. We know that Europe is in bad shape. The US growth, after holding up with tax relieve in the second quarter is looking worse so there is less dollar strengthening head winds from a fall-off in growth from other countries.

The key focus will be on the unique and extreme monetary stance of the Fed and that is dollar negative.

The economic forecasters got it wrong – looking at the specifics

Economic forecasters got it wrong over the last year, but it is important to focus on what specifically was missed and what are the implications of those misses for the future. There have been some clear down trends in asset markets over the last few months because forecasters have been consistently less negative than the actual data has shown. The forecasts were wrong not only about direction and size at the beginning of the year, but consistently got it wrong throughout 2008. In 2008, the future was truly unknowable once we go out a few months or when faced with a unique event that has not had a precedent. As Karl Popper stated,” to predict the creation of the wheel is to invent it.”

This year’s forecasting problem was fourfold. One, forecasters missed the liquidity and banking crisis of 2008 based on faulty assumptions concerning the housing market. Two, the forecasters were off on predicting the commodity price shock and its disruptive impact. Three, the forecasters got the money demand, wealth effect, and consumer confidence wrong. Four, forecasters were wrong the asset quality problems because of poor private information on firm asset.

The banking and liquidity crisis problem was hard to forecast for the simple reason that there have not been that many banking crisis to look at for comparison. The Scandi crisis is the best comparison from the 1990’s but in that case, the financial failures were relatively self-contained. The Japanese “lost decade” was never used as a model for what could be the problem in the US. We are now thinking otherwise. The premise of the Japanese crisis was that government was unable to effectively deal with the bursting of their real estate bubble. There has been an over optimism that the Fed and Treasury would get this problem solved. Look at the fact that the stock market hit highs after the initial crisis in August 2007. It was the unraveling of the GSE’s in July that tipped the scales against a contained crisis.

The extreme commodity price shock from high demand was not predicted. The start of the credit crisis in 2007 was at much lower commodity prices. The run-up in agriculture and energy prices continued unabated through the first half of 2008 as everyone thought rising prices and shortages would be the problem. This shock started to change consumer confidence and investor behavior. Forecasters did not find a strong link between rising commodity prices and falling financial asset prices. Economists never saw the strong run-up in prices so they were consistently behind in predicting the impact on consumers.

Some of the basic linkages in the economy were not predicted to change. First and foremost, there was never the prediction that money demand would slow so strongly. The falling velocity of money caused by banks not lending shut down the financial oil in the economic engines of many countries. Economist will have to rethink how they look at money demand given this extreme.

Similarly, the falling consumer confidence from the financial fall-out was not adequately predicted. The link between Wall Street and Main Street is tighter than what many have imagined and should be the main reason for bailing out Wall Street. What happens in the canyons of lower Manhattan matters to the person at the suburban mall.

Finally, the elusive wealth effect is real. Perhaps the link has not really changed but the size of the decline has caused the wealth effect threshold to be crossed. You hit the housing assets and financial assets of most Americans and they will react. Slower housing may be one thing but you mess with retirement funds and consumer behavior changes.

Finally, the information gap during this crisis has been huge. This caused a significant error in forecasting the hit to asset values. The information shortfall started with financial firms which could not provide a good idea on the valuation of their assets and continues with policy-makers who could not send clear signals on what are the policies that will be followed in a crisis. The focus has been on the regulatory environment when the key to a well-functioning economy is the information gap. Big gaps of knowledge and uncertainty will cause conservative behavior, the flight to cash.

So how do we solve these problems? The banking crisis is moving forward under the growing perception that we are faced with a Japanese style problem. We have now seen a more explicit move to quantitative easing. The commodity shock forecast problem has not been solved as much as reversed. The discussion of deflation may be premature but the tax of higher energy cost has been eliminated. The money demand confidence problem is now realized though we have not found an effective means of making banks lend. The information and uncertainty gap is still present and needs to be closed. Overall we have made some headway to identifying and solving the forecasting problems and we should see better estimates and some pullback from the economic freefall.

Liquidity as an illusion

Comments on market liquidity by Keynes taken from Pimco’s Paul McCulley, “The Paradox of Deleveraging will be Broken”.

I will not present the McCulley argument other than to say that liquidity or the assumption of liquidity will be the number one issue for investment management in 2009. Every investment idea will be placed under the microscope of whether there is liquidity and what will be the exit strategy. This will mean that all strategies with less liquidity will have larger risk premiums and will provide greater opportunities for those that do not need immediacy. Additionally, there will be more focus on the exit strategy. The discussion of any idea will revolve as much around how do you get out as how or why you get in.

"The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

"For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

"So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money."

The paradox of liquidity is that everyone cannot have liquidity at the same time, so there is no such thing as liquidity for the economy as a whole. You only have liquidity for those things that others want, so liquidity is only given to those who are contrarians. Nothing will be attractive except for those investments which the buyer has a comparative advantage relative to the rest of the market and those are usually few and far between.

More Fed action - the leverer of last resort

The Fed and Treasury announced another new lending program that will reach $800 billion. The new program will be include $600 billion of purchase of debt issued by the housing GSE's. The second part will be $200 billion of lending to support consumer and small business loans through the Term Asset-Backed Securities Loan Facility. The Treasury will provide $20 billion of credit protection on the lending facility. This would represent 10% of the total lending pool. The Fed is using its special power to lend directly in consumer market.

This is an interesting set of new policies. The $600 billion for GSE is a statement that the housing market cannot support or will not support the purchase of these bonds. The Fed has to step in the the GSE's go without funding. Credit has to be rationed because there is not a price that will make this work. The $200 billion to consumers tells us that banks are not willing to make the loan from their own balance sheet. For all of the work the Fed has done to date for banks, they will still not lend money.

There is an interesting paradox of delevering. To get the private market to delever but not cause a panic, there has to be more leveraging of the public balance sheet through the Fed and the Treasury. Right now o keep the economy afloat we have to substitute public for private lending. We have to socialize credit risk. The credit risk of the economy has to be spread across taxpayers in an effort to support the economy. The choice is not being made by the investor but by the government.

Keynes and bubbles

Keynes provides a good bubble analogy that fits in today's markets.

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

The bubble of financial speculation has moved over to the enterprise side of the economy. While not being a fan of a bail-out of the auto companies, part of their dilemma is related to the banking problem. Banking is still the oil that moves the economy and right now the engine is running rough because there is insufficient oil.

The consumer confidence has been battered by the financial markets and that is spilling over to the real economy. Now this does no mean that we should turn our attention to the real economy and avoid the tough work in the financial sector. We still have to get the housing problem fixed. We still have to find buyers for mortgage assets. This is not glamorous but must be done.