This time, the Fed's policy of managing interest rates caused the disaster. After holding interest rates too low for too long, the Fed started raising rates in fear of inflation. Gold prices were climbing and until they stopped rising, the Fed continued to raise the Fed Funds target.
Once gold peaked - at $800 an ounce in mid-2007 - the Fed stopped raising rates. We are now feeling the effects of the Fed's actions.
Adjustable rate mortgages are getting killed.
Lenders should have been switching borrowers out of these types of instruments and into fixed rate loans. Instead, everyone hoped the problem would go away.
Once home values stopped rising, and began to fall, a payment problem turned into a collateral problem. Investors holding hundreds of billions of dollars of real-estate related paper are looking at billions of dollars of losses, and for some, bankruptcy.
SPREADS: US TREASURIES VS. BAA CORPORATES
In recent months, US 10 Year Treasuries have fallen a full percentage point while other debt instruments - Baa Corporates - have remained constant or increased in yield.
In a flight to quality, Treasuries lead the way.
Short rates also fell. Here is a chart of the CD-Treasury spread to illustrate similar changes in the short end of the yield curve.
And here an isolated look at the spread.
Notice that spreads between Treasuries and CDs have widened a full hundred basis points. For financial institutions, this can be a windfall, an opportunity to increase the return to money market operations.
Consider switching out of Treasury securities and into other instruments, increasing the yield on the Money Market portfolio.
When trading out of treasuries, select carefully the money market instruments replacing treasuries, with an eye on credit, exchange, and trading risk.
Yield curve steepens.
Markets are faced with a substantially steeper yield curve, allowing bank lending if they choose.
MONEY SUPPLY STOPS ACCELERATING
The news in the money supply story is the collapse in real estate loans at banks. Except for this activity, money growth signals a continued expansion.
Here is a graph of real estate loans.
After growing at a 15% rate for all of 2007, growth is barely above 5% today. Here is the real worry for financial institutions and the Fed.
If a bank wants to use these securities for collateral, there will be a significant hair-cut on the value.
Basic money supply - MZM - is still increasing in dollar terms.
Here is a chart of MZM's percentage change.
Notice the recent change in growth patterns.
The monetary base growth is around 2% and falling.
We conclude the Fed is doing all it can to restrain money growth.
C&I loans are growing at a robust 20% rate.
Banks are still lending to businesses.
M2 is growing at a 5% rate.
In summary, basic money growth is within the bounds of continued expansion.
For the past few months the Fed has lent money to banks on this troublesome collateral. Recent announcements indicate this policy will remain.
STOCK MARKETS
Here is the first indication that something's wrong with this economy. The NYSE Composite has lost 15% in the past two months.
Notice massive volume in early January. Traders will be buying this market for short term gains, and hoping for a retracement to the lows of this move to establish long term positions.
From the perspective of a business cycle investor, this is the time to add to positions.
The problem here is potential inflation. The market can't decide if recent Fed action will cause inflation in the months to come, and will be watching price indexes very carefully.
Treasury bond prices are rallying, and provide a sense of comfort that inflation is not coming back.
GOLD PRICES
Gold is telling a different story, shouting INFLATION as loud as it can.
Perhaps this is just a function of the collapsing dollar, but the collapsing dollar usually heralds inflation. This is cause for worry and vigilance.
SUMMARY
This is a delicate time. Be careful and pay close attention.
Money growth is not accelerating. Treasury prices are rising. Stocks have fallen dramatically and are stabilizing.
TACTICS
Continue money market arbitrage. This has been a successful plan for years.
Continue to lengthen liability maturities to be in position to make longer term loans.
Re-evaluate hedging and pricing policies to ensure good spreads and timely coverage. Notice the decoupling of Treasuries from other credits.
STRATEGY
Trumpet the success of the Asset/Liability department.
The portfolio must be carefully watched for interest rate and credit risks.
