Tag Archives: central bank policy

On Gold, Guns, Bread and Cadillacs…

Well, maybe not guns.  This isn’t that kind of post.  But I am going to talk about gold briefly.  One of the more interesting ways to think about the value of gold is its value in purchasing household items.  Because back in earlier times that was exactly how you paid for things.  Gold is money, after all.  Indeed, in the book “Hedgehogging” Barton Biggs refers to gold in such a manner:

The Old Testament recounts how, in 600 B.C., one ounce of gold bought 350 loaves of bread.  As of today, one ounce will still buy 350 loaves of bread in the United States.

Barton Biggs: Hedgehogging

In my area of the country in North Carolina, one ounce of gold will get you 446 loaves of bread.  So when measured in those terms, we’re overvalued even after the action we’ve seen over the past few months:

Today I heard it referred to in another way: gold vis-a-vis Cadillacs.  So first, I have to present to you the definitive video clip on Cadillacs…

And now back to the gold/Caddy ratio.  I stumbled across this post (hat tip: @hedgefundinvest and @FinanceTrends) that looked at the fact that in 1971 with gold pegged at $35 an ounce you needed about 11 pounds of gold to buy a ’71 Eldorado.  Take away the peg and it would’ve been much less gold (at $103 an ounce you need about 5 pounds).

Now?  You can get 2 Cadillac XLR-Vs for the same 11 pounds if you’re taking the $35 per ounce as your starting point.  If you used 5 pounds, well you’re out of luck because you won’t have enough based on Friday’s close at $1193.50.  So the starting point you choose is important.

But as for the overvaluation or lack thereof currently?  At these levels it may still be overbought even though we’ve seen a pretty sharp pullback from $1,250.  But I’d be wary about how much more of a decline we see here because volume has been higher even on up days and the revolt against central banks isn’t over by any stretch.

So in my mind, we’re in for more volatility not less.

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Where the Streets Have No Names, Lights or Signs: A LIBOR Update To Remember

For reasons I’ll explain in a bit, this is going to be a critical week for Libor funding.  But before I get to that, I want to recap what has happened in the Libor markets this past week.  So let’s take a look at the usual suspects charts:

The kink between the 6mth and 1yr Dollar Libor maturities is flattening a touch.

Meanwhile, Euro Libor is shifting out.  Noticeably.

As for Yen Libor, well, just leave it alone.  It’s sleeping so soundly I don’t want to wake it.

But let’s take a look at some weekly snapshots of the Dollar and Euro Libor curves:

Dollar Libor is relaxing some.  Not that it’s relaxing that much, but the acute funding pressure we had seen building has softened a bit.  This shouldn’t surprise us as this move coincides with the Euro move to the upside.  Here I show the hourly chart going back two weeks.  This should tell the story well enough:

Which also shows up in Euro Libor:

What we’re starting to see is a kink formed at the one month point on the curve.  Mid-dated Euro funding is getting bid up while overnight funding remains dormant.  This next chart shows that:

Outside of the two hiccups 35 days apart, that is.

But now, things get interesting.  While I was on the road, zero hedge ran this post about funding conditions in Europe.  I took this screen capture of the ECB’s OMO page:

I circled those two transactions because they settle within a day of each other.  This week.  So within 2 days, we’ll see almost €600bn in ECB reverse transactions settle. What is a reverse transaction?  From the ECB’s General Documentation on Eurosystem Monetary Policy Instruments and Procedures:

Reverse transactions refer to operations where the Eurosystem buys or sells eligible assets under repurchase agreements or conducts credit operations against eligible assets as collateral.

So you can either structure these to take liquidity out of the system, or put it in.  Trust me, these were injecting liquidity in to the system.  But now they’re coming due, and I want to use this to show how inflation is not the issue to worry about and hasn’t been for a while.

How?  Well, take a look at how much is now owed to the ECB:

For the small facility on 6/30:

(€151.5114bn)[1+((7/360)(1%))]  = €151.5409bn

For the large facility due on 7/1:

(€442.2405bn)[1+((371/360)(1%))] = €446.7980bn

In a world where credit costs are minimal (extremely low default rates, good recoveries on collateral, charge-offs almost nil, etc.), this wouldn’t be an issue.  Heck, the facilities wouldn’t have been this well-bid in a good credit environment.  But we’re not in that kind of environment now and the credit cycle still has a ways to go before we can see a true recovery there.  Plus, other assets like sovereign debt securities are having their own issues.  Banks might hold some of these notes, so now you’re talking about a hit on the balance sheet again with the recent credit market action, in addition to the rising credit costs. Oh, and I forgot to mention falling loan demand.  So amidst this backdrop, banks are going to have to come up with this cash.

And to make matters worse?  Consider Spain:

Spain faces a confluence of events in July, whereby it will need to finance 21.7 billion euros within a single month. This combines shortfalls in its budget and a wave of scheduled government debt redemptions.

via Spain’s Debt Maturity Wave Hits Next Month And It’s Already Obvious They Don’t Have Enough Cash.

The problem here is two-fold: first, there are the questions about what the cost will be – i.e. how much will the spread to German bunds be.  Second, consider this (emphasis mine):

It goes without saying that the government’s priority will be smooth and well-bid auctions (see calendar below), with local banks playing a crucial role.

So Goldman obviously expects banks to be bidding on these notes.  Below is the Spanish debt auction calendar in question:

The 5yr bond auction takes place the same day the monster ECB facility expires. Can this get any crazier, or what?

Looks like the Euro Libor market is becoming less and less certain, of well, a lot.  Take a look at the spread term structure:

Dollar/Euro Libor spreads are widening a bit, but not for the right reasons.  It seems now that the increases in the term structure of Dollar/Euro Libor spreads are being driven by uncertainty over the June 30/July 1 settlements.  Given the nature of the activtiy in the funding markets, I’ll probably write something before next week on this (i.e. look for a post later in the week as we approach month end).

Because as of right now, this like driving in a foreign country where no streets are named, numbered and there are no traffic lights or signs.

But the sad thing is, we’re not driving.  We’re standing in the middle of the intersection while everyone converges from all 4 directions at death-defying speed.

There’s only one way I can see this ending “well.”  The ECB will have to announce a new facility to roll all of the collateral that has been pledged and the banks can keep the Euros the ECB lent them.  For now, anyway.  But there has been no indicator they’re working on this.

Better find something to hold on to and brace for impact…

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That Squeaky Sound You’re Hearing is the Liquidity Spigot Being Shut…

If it sounds like there’s a squeaky faucet getting tightened, you’re not hearing things. Liquidity is going to start becoming a rarer commodity.

Honestly, I should’ve spent more time discussing this. Because interest rates are at the heart of almost everything in the capital markets. But with all the attention on sovereign credit risk, commodities, and currencies, nevermind the regulatory stuff, it’s hard to maintain focus in this Ricochet Rabbit day and age we live in.

But let’s refocus. Over the past month, there has actually been a lot of activity out of China in stemming the tide of excess liquidity. It all started shortly after the first of the year, which I covered here. A 4.04 basis point upside surprise in yield on 3mth bills caught investors off-guard. Happy New Year, folks.

The next week, China raised the yield on its 1yr securities by 8.29 basis points, which signaled to the market their intention of guiding yields – and thus rates of return  – higher. In doing this, the Chinese are looking to slow the deployment of capital, and slow growth.

But that’s not all. There’s the 50 basis point increase in reserve requirements that the banks must meet.

The Chinese are much bigger users of reserve requirements than other countries, but as the People’s Bank of China explains it:

The PBOC considers reserve requirement adjustments a ‘fine-tuning’ of existing monetary policy rather than any shift in its overall stance. Raising the ratio is aimed to prevent the excessively fast growth of monetary and credit aggregates. Lowering the ratio is aimed to ease credit.

So as you can see, the push to drain liquidity is on.

But for all of the liquidity draining going on in China, the real question is what/how the liquidity drain setting to commence here will affect the markets. As was pointed out in various places, today saw the end of a multitude of Fed liquidity facilities. From today’s Real Time Economics blog:

Today, much to the Fed’s relief, several of these programs were put to rest and nothing bad happened. Stocks and Treasury bond prices rose.

The programs produced an alphabet soup of funny names, like the Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF). For the most part, the programs did what the central bank was designed to do when it was created in 1913 — act as a lender of last resort which provides emergency credit to firms during a liquidity crisis. And as it promised it would do last year, the Fed has stopped doing them now that the markets have calmed.

This is one exit strategy Mr. Bernanke can check off as being executed fairly seamlessly.

Indeed. However, the folks at Real Time jumped the gun in calling the exit a success. Hell, to even call any of those programs successful is to not know the definition of success.

I mean, does this look like a success?

And the PDCF: of the primary dealers it was intended to help, one was taken under, one went bankrupt,and the other was merged into a bank. These are not stellar marks.

But the real issue, the success of the exit, can’t be determined yet. For your consideration, I offer two charts: one of the daily standard deviation in Fed Funds, and the other is the daily quote of the effective Fed Funds rate, but with a twist I’ll explain later.

Let’s look at the standard deviation chart:

I circled the area post fall ’08 for a reason. Remember, this is a measure of the daily standard deviation, which is an expression of volatility. Notice the dampening after the Fed’s switch from declaring a target rate to a target band. The effect? Brings the vols way down.

To look at it in a different light, consider the next chart,which shows the daily effective Fed Funds rate. But I also layered in the high and low measure of each day’s Fed Funds trading, because there’s a point I want to make:

Note the high and low at the left. Now compare the way that part of the graph looks compared to the right. The volatility has been brought way down, and the only thing worth asking is this:

How long can that last?

We’re going to find out…

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Tough Central Bankers and What Should’ve Been Done to AIG

Last week I was out sick and took the day off on Wednesday, so I ended up listening to Tim Geithner give his testimony at the House Oversight and Government Reform Committee‘s hearing on AIG. I’ve never been a fan of Geithner, and I probably never will be.

But for a second, let’s assume that something should’ve been done to aid AIG for systemic reasons. What should’ve the response been? What would’ve it have looked like?

So I started trying to look for the loan agreement information that’s out there. First, there’s the news stories that were flying around:

The Federal Reserve will provide a two-year loan, take 79.9 percent of the New York-based company’s stock and replace its management because “a disorderly failure of AIG could add to already significant levels of financial market fragility,” according to a statement by the central bank late yesterday.

via Fed Takes Control of AIG With $85 Billion Bailout (Update4) – Bloomberg.com.

And over here at the Federal Reserve’s website:

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

via FRB: Press Release–Federal Reserve Board, with full support of the Treasury Department, authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG)–September 16, 2008.

So at first blush, it sounds like a pretty stout loan agreement. All of AIG’s assets are being held as collateral, including the stock. They could’ve put a compensation covenant in the loan agreement (it’s been done before) as well as mandating some asset sales (which are going to be needed anyway).

To get an idea of what this all amounted to, I started looking at the balance sheet. Below is the financial supplement from 3Q ’08. Page 9 has the company’s balance sheet:

There’s a trillion dollars in assets on that balance sheet. If you were going to lend $100bn or even $200bn against all the assets on the balance sheet, you’d be overcollateralized by a wide margin. Even if you marked everything down by half to two-thirds, you still had a margin for error to the deal.

But the discussion always makes its way back to the New York Fed’s commitment to purchase the CDOs and the CDS contracts at par.

100 cents on the dollar. For assets that are so obviously not worth 100 cents on the dollar.

Looking at the loan structure and the CDO/CDS settlement decisions, you can see the issue isn’t the loan structure. The issue then is, the administration/monitoring of the loan. And the November ’08 restructuring letter proves it. Look at page 2:

That’s what I call “letting them off the hook.” A loan agreement like the one that was originally negotiated (with a couple of tweaks) probably would’ve sent a strong message to the market that if you’re asking Uncle Sam for a loan, he’ll give it to you. But he’ll have a lead pipe in his hand when you sign the loan agreement. And that’s the way it should be.

So when I started reading this article from Reuters, I couldn’t help to think about what happened with AIG:

The main challenge facing central banks is how to keep economic growth going without inflating the next bubble. Put starkly, that means jacking up interest rates from their current nonexistent levels, as Australia, Israel and Norway have now done.

It also means halting the spread of cheap money, which has turned out to be the financial equivalent of crack cocaine.

Weaning the world off the liquidity drug won’t be easy. The two most important economies, America and China, are moving at different paces, perfectly exemplifying the two-speed recovery that seems to be taking hold.

via Davos 2010 » Help wanted: tough central bankers | Reuters.co.uk.

I think they’re on the right track, but I also think they miss the mark. There’s a fetish among central bankers to tinker and meddle with interest rates. Like they have some special ability to predict what rates should be or something. Funny thing is, I don’t remember there being a class in rate forecasting on offer at Hogwarts or at the Jedi Academy. So it’s not like central bankers really know any better than you or I what interest rates should be, but the media and many others believe they do. Even though, some of their thoughts and behaviors are just bizarre.

The truth is, there’s another way to conduct monetary policy, which is to control the money supply and let interest rates take care of themselves. Volcker did it and was immensely successful.

Which brings me back to who/what we need as a central banker. Maybe it’s someone less professorial. Less Papa Smurf.

And more like Dog the Bounty Hunter. Hey, would you want to take a loan from this guy?

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Federal Reserve earned $45 billion in 2009 – washingtonpost.com

Is it really a profit if you’re the only buyer in the market?

Much of the higher earnings came about because of the Fed’s aggressive program of buying bonds, aiming to push interest rates down across the economy and thus stimulate growth. By the end of 2009, the Fed owned $1.8 trillion in U.S. government debt and mortgage-related securities, up from $497 billion a year earlier. The interest income on those investments was a major source of Fed profits — though that income comes with risks, as the central bank could lose money if it later sells those securities to reduce the money supply.

via Federal Reserve earned $45 billion in 2009 – washingtonpost.com.

Let’s just see how much the Fed gets for these when they actually try to sell them. Bernanke is fond of saying the Fed “always gets its money back.” So let’s see if they can actually book the profit on the spreads they tightened with their purchases.

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