First, we review the Fed's recent policy of lowering short-term rates.
In a clear indication of the disaster of the policy of slow-and-steady short-term rate increases since 2004, the Fed has lowered short term-interest rates in a panic.
In the next chart below, we see the effects of the Federal Reserve's policy of pulling down long-term interest rates by purchases in the open market.
While this is occurring, credit spreads for other types of securities continues to widen. The latest casualty in this episode are auction-rate securities. In several recent episodes, auctioned securities have exceeded 15%.
This data carries a clear implication: Lengthen the maturity of liabilities. Had these institutions lengthened liability maturities, as Paterson has repeatedly recommended, they would not be in this situation.
LENGTHENING LIABILITY MATURITIES
When the Fed stops supporting US Treasuries, as it must, and interest rates rise in response to a weaker dollar and rising inflation, the yield curve will steepen and long-term interest rates will soar, adding two-five percent to liability costs: between $20,000 and $50,000 per million per year.
This is a potential increase of 40-100% of liability costs!
DOLLAR DETERIORATION CONTINUES
Paterson finds a continuation of the loss of purchasing power of the dollar, making exports more competitive, imports more expensive, and foreign earnings more valuable to US companies.
The chart below shows the trade-weighted value of the dollar.
Given Fed policy, Paterson sees no reason for this to change and for the dollar to continue to lose value.
TRADING RISK
After the multi-billion dollar loss by a French trader, one would think that trading rules and monitoring would have precluded unauthorized trades. It is not so.
In the recent debacle, a trader in wheat lost more than $100 million. In a bull marktet! Where was the supervision?
Though these problems are not specifically related to interest rates or monetary policy, they are an effect of fluctuating prices.
TACTICAL ASSET AND LIABILITY MANAGEMENT
Increase liability maturities, shorten asset maturities, and work money market spreads for income.
The debacle in the bond market is generating extraordinary returns on high-quality credits which can be funded with matching maturity liabilities. Some clients have experienced a 10% rate of return on select securities over a 6 month horizon.
Credit hedges must be evaluated daily during this time.
Currency hedges must be extended and widened to include currencies with low money growth.
STRATEGY
Though Paterson did not foresee the extent of the credit debacle, we can react to it with prudent actions.
First, the policy of money market arbitrage has proven to be a solid earnings gain.
Second, the policy of eliminating variable rate assets has insulated the portfolio from credit losses.
Finally, the policy of lengthening liability maturities has strenghted the balance sheet with fixed rates.
Senior management must keep the board informed about the deteriorating bond market and be prepared to hedge interest rates, credit risk, and currencies.
