Recession is Over

The danger from Greenspan's blundering is past, thanks to prompt action by the Board of Governors to reduce the Fed Funds rate and pull down the short end of the curve.

Without this action, a recession was inevitable. The yield curve was flat for nearly 18 months, from mid 2006 to the end of 2007, usually long enough to stall the economy.

That danger is now past.

Today, the spread between 3 month bills and 10 year notes is fully 250 basis points, a growth signal.

There is still a danger of a continued slowdown in the next few months, but the risk of a protracted recession is past.

This action, when combined with a massive injection of liquidity by the Fed's Open Market Committee to banks and primary dealers, suggests there is little danger of a prolonged recession.

YIELD SPREAD SIGNALS GROWTH
The spread between 3 month Bills and 10 year notes is the best predictor of recession.



Notice the last three recessions were preceded by a flat yield curve.

In Volcker's recession back in the early 80s, the yield curve was negative for an extended periond, signaling an unusually severe contraction.

CURRENT YIELD SPREAD
As the chart below shows, the spread between 3 month bills and10 year notes is about 250 basis points.



This is sufficient to allow for new bank lending and economic growth.

STOCK MARKET CONFIRMATION
The stock market confirms the forecast that the recession is over.

Notice the volume spike back in August of 07. As the effects of a flat yield curve spread throughout the banking and lending communities, the path to recession was clear and the stock market fell below the levels at the volume spike.



The market is now trading above those levels and finding support there.

INFLATION
The problem now is a continued rise in domestic prices both from additional liquidity in the system and from the falling dollar.

TACTICS
Continue to extend the maturity of liabilities to 5 years or longer. Borrowing now will lock in rates for the long term and fuel growth in assets. Be prepared to lock in profitable spreads on new assets.

Money market arbitrage is more profitable than ever. Aggressively raise deposit rates and expand the portfolio. Use the additional funds to acquire high-yield assets knocked down by credit concerns.

STRATEGY
Warn senior management of coming inflation.

Prepare hedging programs to take advantage of any spike in prices to hedge against the future sale of liabilities.

Evaluate credit risks and prepare to take advantage of distressed assets.
Insulate the portfolio from currency risk.

We're All Bankers Now

There's a reason the Fed allowed Primary Dealers access to the Lending Window. With Interest Rate and Credit Default Swaps, Investment Banks do more banking than the Commercial banks.

If the swaps deals fail, as they have recently, it affects banks and then the money supply. The Fed has no choice but to allow these new bankers in the game. We're all bankers now, it seems.

Back in the early 80s the Interest Rate Swap was invented, allowing corporations to provide alternative lending services to each other. When the FHLB of Seattle did the first one with First Boston (now Credit Suisse) I was on the desk.

Since then, the market for swaps has exploded, and these unregulated securities threaten to destroy the world financial system. In the past these types of lending transactions were regulated, either by bank or securities regulators. No longer. The entire market is a mystery.

As the swaps industry progressed, interest rate and credit risk have been diffused across the economy, making every corporation a banker, and making the large investment banks a counterparty to each deal.

There is no doubt that the first task of the new regulators is to define these deals as securities and put the SEC on the case.

Give the Fed an A+

Since 1987 when St. Paul the Tall left the Fed, there has been no one with less respect for the Fed than I.

That's changed.

BERNANKE
Bernanke has saved the US economy from a disaster of immense proportions. Had the credit system melted down, it would have taken commercial bank lending with it, and along with that, the money supply would have collapsed. If the money supply fell, the economy would also face depression, with employment, income, production and tax revenues falling precipitously.

The purchase of hundreds of billions of dollars worth of bad loans by the Fed has postponed that event. As long as the credit markets stabilize, as they are now doing, the US economy is safe.

COLLAPSE IN CREDIT
I never saw this coming. Not at these magnitudes.

As regular readers of this bulletin will remember, and can read in the archives, I advocated getting out of the adjustable rate business back in 04. That advice was prescient far more than I understood at the time.

It seems that everyone in the US had an adjustable rate mortgage, with little equity, and bad credit. But who knew? I didn't.

LESSONS LEARNED
The lesson is prudent asset and liability management. Match the book, and extend liabilities when the Fed starts raising rates.

None of Paterson's clients have been harmed - in the least.

In fact they are all in good shape with short term assets and liabilities in money market arbitrage, lengthened liability maturities, and solid spreads in new business.

This was a close one, believe me.

Subprime fallout continues

Lengthen liability maturities!

As credit problems continue, and as inflationary pressures build, it's only a matter of time before the Fed's actions fail to hold government rates from rising.

When they do, long rates will increase 200 basis point and asset prices will fall again.

Prudent managers will lengthen liability maturities past the 5 year mark if they want to have the ability to make loans and take on assets.

Municipalities are suffering as their auction rate securities lose favor with investors. They will return to the fixed rate market to solve this problem.

FED'S BLUNDERING
There is always a shake out after a 25 year bull market as we've had in interest rates, but it's been exagerated by the Fed's insistence on managing the Fed Funds rate.

Recent actions to auction off $100 billion in short term credit move the Fed closer to a market based solution to short rates. Let's hope they finally stop meddling in the short end of the curve and leave those decisions to the market.

Except for crises like this, the Fed would be reduced to adding high-powered money on a regular basis and leaving the markets alone.

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.

Money Supply Explodes

At this stage of the business cycle, money growth is a confirmation of the growth in economic activity, and MZM is surging. There's no recession in sight.

MZM Surges to 15%



Behind this growth is an exploding loan portfolio at Commercial Banks.

Commercial and Industrial Loans



Real estate loans continue to fall.

Real Estate Loans



CONCLUSION
Economic activity will continue strong for the next 18 months.

Risk comes from a resurgence of inflation. Lengthen liability maturities.

Risk also comes from a deteriorating dollar. Hedge against this risk and emphasize foreign profit centers.

Credit will continue to improve as the Fed lowers short-term rates. Take advantage of Money Market arbitrage.

Another Fed-Caused Disaster

In an astonishing repeat of the real estate debacle of the 1990s and the Internet bubble of the early part of this decade, the Fed has again blundered into another finance disaster.

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.

Spreads Widen in Flight to Quality

In the past month, the debt and equity markets fluctuated widely in the face of economic and financial uncertainty.

Most surprising is the rally in US Treasuries following November's quarterly refunding.



As the chart shows, bond futures rallied from 114 to 119 before retracing to the 116 level today.

At the same time, spreads between Treasuries and BAA Corporates have widened more than 60 basis points.



EQUITY MARKET REACTION
The NYSE composite at first fell dramatically, signaling either a rise in long term interest rates of a decline in earnings.

As did the bond market, the equity market is retracing its steps.



MONEY SUPPLY
While all this is happening, the money supply growth accelerated exclusively from bank lending.

As the chart below shows, the Monetary Base has grown at a relatively mild 3% while MZM is growing faster every month.



INFLATION IS COMING
Money growth in excess of GDP growth causes inflation.

In its attempt to mitigate the damage from the Fed-caused rise in short term rates, the Fed has chosen to reflate the economy and allow banks to pour money into the system. This will cause inflation to rise in 6-18 months.

The Fed will then have to start raising rates again, and will probably push the economy into a recession in order to get money under control again.

SUMMARY
Until then, credit and equity markets will remain confused.

TACTICS
Money market arbitrage will continue to generate solid earnings.

Continue to reduce exposure to long term assets.

Re-evaluate asset pricing spreads to ensure an adequate return on risky lending.

Consider lengthening liability maturities further.

STRATEGY
Emphasize to senior management and the Board the dangers of money growth on inflation and interest rates.

Prepare them for action to lengthen liability maturities.

Discuss trading and hedging policies and procedures in preparation for future increases in long term interest rates.

Another Fed Blunder

The latest reduction in the Fed Funds target is a disaster waiting to happen.

DON'T BUY LONG BONDS FOR THE NEXT TWO WEEKS.

Wait till this auction settles before taking on long term assets.

FED MOTIVATION
Why on earth would the encourage banks to create more money? MZM is growing fast enough to fuel inflation without this help.



Gold is making new highs. The last time gold was up here, the Fed was still increasing the Funds target.



The bond market is facing a quarterly refunding next week where investors will have to choose between long bonds at 4.75% or short-term instruments at the same rate. Any fear of inflation will make this auction a disaster.

TACTICS
Stay with money market arbitrage.

Extend the maturity of liablities today. Don't wait.

Bond futures are at resistance. This is the time to sell bond contracts.

Do not take on long term assets.

STRATEGY
Warn the board that inflation is coming.

Corporate/Treasury Spreads Widen

In a further confirmation of the problems in US debt markets, corporate bonds are being pushed farther off US Treasuries.

As the chart below shows, BAA bonds are yielding more that 200 basis points more than similar maturity Treasuries.



As recently as July of 2007 spreads were 40 basis points lower.

Credit woes push CDs farther off Treasuries

Markets are giving us a good estimate of the cost of borrowing for CD issuers.

As the chart below shows, CD rates are relatively constant over the past year or so, while yields US Treasuries have fallen substantially.



Spreads have widened to more than 150 basis points in the past few months as investors have bid up Treasuries.

The question investors will now be asking is "Will the spread continue to widen?"

Stock market surges following record volume

The NYSE Composite Index is bumping against record highs following record volume back in August of 2007.

As the chart below shows, stocks are still in a bull market, begun back in early 2003, and will continue higher until the Fed signals the end of monetary expansion by raising short-term rates again.



INFLATION AND THE STOCK MARKET
If inflation is coming, as we forecast in a previous weblog entry, stocks will outperform bonds by a substantial margin - perhaps as much as 10% - until the Fed realizes how badly it's blundered and starts raising the Fed Funds target again.

As inflationary pressures push into the economy, businesses will use this opportunity to raise prices on all goods and services, fattening income, earnings, and dividends.

INFLATION AND THE VALUE OF THE DOLLAR
Inflation is also lowering the value of the dollar against most trading-partner currencies, making imports more expensive, and raising domestic US prices.

The lower-valued dollar will also make exports cheaper, boosting the sales and stock prices of major US exporters.

ASSET ALLOCATION
For all these reasons Paterson Financial has moved a portion of the portfolio out of two year notes and into the NYSE composite.

The fraction of assets held in fixed income securities should be reduced to no more than 30% of assets and aggressive managers might go as low as 10% in fixed income securities.

Very aggressive money managers will consider dividend-free equities as typified by the NASDAQ 100.



Notice the index has more than doubled since the lows of 2002 and will lead the way as stocks trade higher.

If the index doubles again in the next 4 years prices will approach the highs seen last in the year 2000.

CONCLUSION
Until the Fed sees the error of its ways, prudent money managers will reduce fixed income holdings past the two year note, and will continue money market arbitrage.

STRATEGY
Asset managers must re-introduce growing inflation into their models.

The board must be notified of the potential for increasing input and output prices, interest rates, and the stock market.

Senior managers must review lending policies and procedures to make sure to place a sufficient spread in all fixed income business, and ensure a match of asset and liability maturities.

Hedging programs must be examined for opportunities presented by occasional spikes in long term debt prices.

TACTICS
Extend the amount and maturity of liabilities.

Prepare bond offerings and use the CBOT in advance of bond sales if prices spike upwards.

Increase spreads on all loan transactions.

Be aware of Treasury refundings and take advantage of price changes.

Begin active hedging on a small scale, selling into overbought US Bond futures.

Fed Makes Another Mistake

If there is any doubt the Fed is completely incompetent, their recent action to lower the Funds target to 4.75 will dispel the confusion.

The bond market fell, the gold market rose to new highs, and currencies rose. These markets quickly gave their opinion of the Fed's actions: this is an inflationary bungle of monumental proportions.

These markets are now stabilizing, and waiting for the next phase in their move to confirm the error of the Fed's actions.

With money (MZM) growing at better than 10% per year, mostly fueled by loan growth, this action will only encourage lending by banks, leading to further money supply growth, more inflation, and higher long term interest rates.

Prudent money managers are now extending the maturity of their liabilities, locking in long term financing at these levels.

BONDS
Let's look at the weekly chart for 30 Yr. US Bond Futures.



Notice the recent price action. After testing the old highs for the contract, the market began to fall in preparation for the Fed meeting.

Once the Fed made the decision to lower rates, the decline accelerated, and only this week has stabilized, four points lower.

It looks like there will be a steady decline back down to the 104 level, where we'll find temporary support.

GOLD
The gold market also moved well in advance of the Fed's actions.



Notice prices were at the $715 per ounce level before Fed action, and immediately punched through resistence, making new highs near $750 per ounce.

Record highs are not too far above us, now, and this market will certainly test those levels.

FED FUNDS
The last time gold prices were at these levels, the Fed was still raising short term interest rates, trying to slow money growth.

Note the date on which gold prices peaked and compare it to the date on which the Fed stopped raising rates.

Gold prices peaked in May of 2006 and the Fed stopped raising rates a few months later.



This action says to most participants that inflation - in the form of gold prices - is a primary concern of the Fed.

Will the recent spike in gold prices cause the Fed to reverse itself again and start raising short term rates again?

If so, what will this do to the US economy?

This is the nightmare scenario that's talked about in financial strategy sessions throughout the world.

TACTICS
Extend the maturity of liabilities to five years. Lock in rates at these levels, because inflation will raise long term interest rates.

Make no new long term loans for at least 6 months.

Retain all loan servicing.

Continue money market arbitrage.

STRATEGY
Senior managers must be warned of the potential for future inflation and increases in long term rates.

Senior managers must warn the Board of Directors of the potential dangers of continued money growth.

The Asset/Liability committee must review its plans for an extended period of instability in the long term credit markets.

Hedging programs must be prepared to allow the institution to take advantage of temporary spikes in bond prices and sell futures in anticipation of bond issuance.

Spreads must be widened on all loan transactions. Add fifty basis points today, and consider adding another fifty as bonds trade lower.

Correction

What I meant to say was bond YIELDS declining.

In the previous post, I stated the opposite.

I'll Be Damned - Gold Loses its Luster

Pondering the latest market news - described below - I finallly came to the conclusion that the gold market is out of synchronization with the rest of the financial markets.

The only explanation that makes sense is massive selling of gold.

In the decades since Paul Volcker destroyed and bankrupted the Hunt Brothers when they attempted to corner the silver market back in the 70s and 80s, the world has changed.

No one thinks inflation is coming back, and that's what the gold market is telling us.

Inflation is deader today than ever before in human history.

No longer will a flood of bullion lead to inflation as its done for thousands of years.

Now that money is a pure fiat with government control, and now that money growth is published weekly, the monetary authorities will never again fool the markets about inflation.

So, what we're observing is the sale of gold.

That's it.

As soon as the markets realize this, we're off to the races again, with bond prices declining, and stock prices rising.

The only question is whether the Fed will now lower short-term rates.

STRATEGY
Be very careful here, and be prepared for the Fed to lower rates.

Bond and Gold Prices Plummet

This is a puzzle.

Money is growing more rapidly with each passing week as banks expand lending.

This should send bond prices lower - they are.

Stock prices should fall - they did.

But, gold prices should soar - they didn't.

What is going on?

Here are the relevant charts.

MONEY SUPPLY


BOND FUTURES


GOLD FUTURES


WHAT WILL THE FED DO?
The markets are confused, and not telling a consistent story.

Unless the Fed is about to raise short term rates. That's the only answer that makes sense.

Stay tuned.

TACTICS
Prudence is still the watchword. Reduce the size of the book, put all new money in the short end of the curve, and expand money market arbitrage.

Long term assets must have a profitable spread, or don't do it.

STRATEGY
Tell the Board and Senior Management we're in for a long, difficult period.

Reduce expectations, and build capital.

Bonds Break Support

As the chart below shows, sellers are dominating the bond market right now.



Gold is still in a trading range.



Money is still growing.


Bonds have broken support and must be sold.

TACTICS
Continue to shrink the book, and put all new business into Money Market Arbitrage.

When making long term loans, make sure of both spread and credit quality.

Don't expect the Fed to lower short-term rates any time soon.

We expected the Fed to consider easing sometime this Summer, but with bond prices falling, there is little chance the Fed will lower the funds target.

STRATEGY
Warn the Board. Something is driving long rates up.

Stock markets making new highs

In the month since the end of the correction, all major stock market indexes have surged to new highs.

The bull market is intact and will move higher in the months and years to come.

Get long and get rich.

STOCK PRICE INDEXES
First, the New York Stock Exchange Composite



Second, the S&P 500


Finally, the Nasdaq 100


GOLD
Gold prices are a puzzle. I would expect them to be surging with bonds falling.




BONDS
Bonds are at major support. The gold charts suggest this is the time to buy bonds.

Bank Lending Surges

The basic money number, MZM, continues to surge, growing faster each month.



The Fed is not the problem, for a change. As this chart shows, the monetary base is not growing, so it must be bank lending.



At some point, the economy will slow, and so will lending, but for now, the Fed cannot lower rates or willl risk reigniting inflation.

GOLD PRICES


Gold prices are finding resistence at $700 an ounce - the highs of July 2007 - and should punch through with these latest money numbers. It's time for caution.

The old highs of $780 an ounce are easily within reach.

If gold surges to new highs, the Fed will be tempted to raise - not lower - short term rates. They will have no choice.

BOND PIRCES
Bond prices bounced these past weeks, but are in a longer term decline, signaling inflation worries.



This is just another indicator of the problems the Fed is facing. Raising short term rates must be in the mind of every inflation fighter on the Board of Governors.