Money Explosion Continues

Growth in the monetary base continues.



Since September, 2008 when the monetary base stood at $870 billion, the Fed has added more than $800 billion to the base.

With stimulus like this, the recession will be shortened by years, bringing the return to growth in the next year or two.

OTHER MONEY NUMBERS
MZM which had been stagnant, is now growing.

Here is the raw data.



Here is the rate of growth data.



M2 Growth Signals Economic Recovery

M2 is a leading indicator, signaling both financial and commercial expansion.



The rate of growth in M2 is soaring, approaching 10%



COMMERCIAL AND INDUSTRIAL LOANS

The problem now is to get banks to lend.



Though flush with cash, thanks to Fed actions, Banks are reluctant to lend to Commercial and Industrial companies for two reasons.

One, the uncertainty of every company's balance sheet in this world of Interest Rate and Credit Default swaps. Until this confusion is cleared away, very few financial institutions will take the risk of lending.

Two, economic uncertainty also brings a halt to lending. As economic activity collapses, even good companies might not be able to pay back their loans.



REAL ESTATE LOANS

The surprising fact is real estate loans are holding up well.



INTEREST RATES AND SPREADS

Credit spreads have stopped widening.



Of all the signs that the credit crisis is ending, this is the one most watched by forecasters.

The drop in BAA yields by 100 basis points is a sign that lower quality credits are finding buyers.

SUMMARY, TACTICS, AND STRATEGY

In summary, the Fed's aggressive expansion of the monetary base has shortened a 10 year depression into a 3 year recession.

Though it is not time to invest or lend yet, that time will soon be here.

Tactics
Continue money market arbitrage, extending deposit maturities to 2 years, and adding high-yield assets.

Spreads of 1,000 basis points on AAA quality credits are not uncommon.

Stragegy
Prepare senior management and the board for continued earnings enhancement thanks to the investment department. Focus attention on finding high-yield assets.

Apology

For the past three months Paterson has been busy working with existing and new clients to avoid the disaster in the credit markets.

My apologies to students, casual readers, and potential clients for the absence of this weblog.

Paterson is back, explaining the situation and suggesting tactical and strategic plans for dealing with the extended downturn.

Inflation and the Bond Market

Bonds sank through support this month and are now back at May's support levels, now resistance for this instrument.



The question now is how low will prices go, and how high will long rates rise?

To answer this question we look at the money supply and the dollar. The first causes inflaton, and the second makes inflation worse.

MONEY SUPPLY
The monetary base is growing, but growth has been slowing for years.



This is a good sign for inflation, showing the Fed's commitment to control the supply of high-powered money.

In recent months, however, growth has accelerated slightly, but not enough to cause inflation.



Bank generated money has grown substantially in the past years, as businesses work their way through the recent Fed-caused disaster.



In recent months, growth in this leading indicator has slowed, leading to renewed confidence in the Fed's management of interest rates and the money supply.

In summary, inflationary pressures are not building, and there is no need to raise interest rates.

INFLATION AND THE DOLLAR
Price rises in the United States are connected to the falling dollar. Import prices are soaring as international demand for primary commodities pulls at suppliers.



The rise in commodity prices is directly related to the fall in the value of the dollar.



Notice the plunge in the dollar in 2006, and the simultaneous rise in PPI.

TACTICS
Prudent A/L managers will continue to lengthen liability maturities, shorten asset maturities, and work for higher spreads in lending.

Money market arbitrage is more profitable than ever, and those clients pursuing this activity have found their yields soaring dramatically.

The key to this business is a careful analysis of credit quality. High quality credits have been pushed off the curve hundreds of basis points, providing opportunities for lenders with excess cash.

STRATEGY
Now is the time to report to senior management and the Board on the A/L condition of the portfolio.

The institution is liquid, carrying good credits, good spreads, and profitable liabilities. In short, we are ready to lend to our existing customers, and prepared to take business from our weaker competitors.

The Asset/Liability department can take a bow.

Credit spreads widen

Credit spreads continue to widen as the Federal Reserve props up the Treasury market while it lowers short-term rates.

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.