It's Still The Economy, Stupid

Thursday, July 08, 2004  

Put on the cuffs, you're going for a ride

Some inspired verse from Roger Ailes (the good one).

The Fed raised the target Fed Funds rate 1/4 point to 1.25% last week. This was the least unexpected move in history, so unexpected that 10-year Treasury yields fell by nearly a quarter point to 4.5% after the announcement.

There are two self-equilibrating forces at work in this economy. The first is in mortgage finance. On one side you have the homeowner. They might pay 6% on a 30-year fixed mortgage, but after the tax-deduction the effective rate is more like 4-5%. Most consider it an expense like rent, so the perceived rate is probably much lower than that. As long as prices appreciate faster than whatever that rate is, buying a house is a very profitable investment. In fact, with 0% down, the rate of return on equity is infinite. Not too much gonna beat that.

On the other side is mortgage and structured finance. They make money by playing the yield curve. At the low end you have money market and Fed Funds around 0-1.25%, and at the other end are mortgage loans earning 5-6%. The steeper the yield curve, the more money the industry can make. Not surprising then that the big players had their best years ever in 2003. Citibank alone made a cool $10 billion, Freddie Mac made $5 billion, Fannie made about $8 billion...and so on.

And the more you leverage, the more profit you make. Let's say you're a hedge fund. You borrow $100 million in capital (at 6%) and use it to short $1 billion of 10-year treasuries yielding 4.5% and buy $1 billion of mortgage-backed securities yielding 5.5%. The spread on this trade is 1%, and your interest costs on capital is effectively 0.6% (1/10th of 6%). The profit is $.004 on every dollar invested, so if you've got $1 billion hedged that's $4 million. There's nothing stopping you of course, from doubling that to $2 billion, or $4 billion, except the nerves of the people financing you (which in the case of JP Morgan or Citibank might just be a call down to Fred and Ginger in finance, or your golfing buddy Desiree over at Salomon Brothers).

You can cut your borrowing costs and increase profits by shortening the term on your loans. Maybe keep rolling over 90-day notes at 1.5%, which increases profitability to 0.85% (1%-0.15%).

The best part is that the whole system is self-equilibrating. The economy tanks, people flee stocks into Treasuries and rates go down and a new flood of homeowners rush to refinance, and everything gets restructured (you take profits on the mortgage-backs your long, too). The economy improves, and you know the Fed has pegged the low end of the yield curve, which gets steeper and more money for everyone!

The second system is between the U.S. importer and its foreign creditors (mostly East Asia). Low interest rates and rising asset prices mean we don't have to save, so the Japanese provide all the lending we need and we buy their products. If the dollar is in danger, the central bank prints Yen and buys all the dollars necessary to fix the exchange rate, as well as purchase all the debt we can issue. The central bank has infinitely deep pockets and can keep the process going, regardless of how "doomed" the U.S. currency appears. Of course, the numbers may get pretty big and start to alarm people after awhile, but if the U.S. economy improves, so does the dollar and the pressure is off East Asian central banks to protect the dollar. Contrary investor has a pretty good rundown in their July MO.

From the article, it's pretty easy to see the consequences of the Fed hike will not be decreased physical investment. Not a lot of that is going on. The effect will be on the yield spread, which is going to cut the amount of money available to the financial sector. This is why the Fed has to move deliberately and telegraph their moves well in advance. They cannot raise interest rates 1/2 point when the previous move was to announce inflationary bias, because that would cause volatility in the various spreads and crush some poor souls working with 20-1 leverage and 0.4% margins. It has to be one step at a time. With the latest employment report and another one due before the August Fed meeting, Alan and Co. will make the next decision just as painfully obvious as the last one.

Instead the worry is that someone will have to stop the credit creation machine. Maybe inflation impinges on consumers so much they can't afford to push up housing prices enough to make it profitable. Maybe enough people start moving money out of the low end of the yield curve that creditors can't leverage as much. As interest rates rise and the yield curve flattens, money is draining out of a system that was swollen with leverage by this most recent panic stimulus. The only question is who will starve for income and begin de-leveraging, and when. The Fed is acutely aware of this, so any excuse to not raise another 1/4 point in August will be seized upon.

The latest tightening may already be too much. There is simply no room left for error, because the behavior of players in this game has not been to correct errors, but take any advantage the Fed makes available. Rather than de-leverage, the financial system reacted by expanding at an exponential rate. Prices rose exponentially, lending, and so on. Every marginal move, therefore, is toward contraction and agents will react at the margin. We're at the peak of the roller coaster. Commence holding breath now.

posted by Teddy | 7:29 AM |

Wednesday, July 07, 2004  

My favorite economic event, next to "Hearing Test Thursday"

The BLS Employment Situation, that is, showing June employment growth of 112,000, far fewer than anticipated.

Pretty much down the line this report is a retracement of previous strength in employment growth. Manufacturing had reversed a five year trend years of job losses (3.25 million since early 1998) in 2004, but June showed the first decline (-11,000) of the year. All gains came from service industries as construction and mining employment was flat in June.

Job gains were in (surprise, surprise), temporary help services (+12,100), health care and social assistance (+29,500), accommodations and food services (+13,300), membership associations (+11,400, probably gearing up for the elections), and transportation and warehousing (+19,200, of which 5600 was "couriers and messengers"). Outside of McJobs, there wasn't a whole lot of job growth in June.

In fact, I'm really surprised at how few industries in the entire economy outside of health care show any sustained growth. Very few industries had any significant change in either direction. That temp services has popped back up to the top gainers list indicates that despite recent profit growth, nobody is really all that keen to begin hiring in earnest.

Billions in tax cuts and no follow through in employment. And real hourly earnings have fallen over the past 12 months, the first time this has happened since 1995. If housing ever started to look anything but stellar, people might start to worry about how they were going to make the payments.

posted by Teddy | 8:52 AM |