Green Shoots Policy

SPECIAL COMMENTARY

May 4, 2009

Financial Green Shoots Today Induce Policy Contradictions Tomorrow † John E. Silvia, Chief Economist [email protected] 704-374-7034

“These stages are the fundamental principles of the universal process. Each is again, within itself, a process of its own formulation.” -Georg Wilhelm Friedrich Hegel 1

Financial Green Shoots Public policy seeks to resolve certain economic conflicts but such a resolution sets up another set of issues. In the post-WWII period this has been made most obvious by the use of Keynesian stimulus in the 1960s and 1970s which led to stagflation. The latest installation of this story is the mid-1990s effort to stimulate home ownership, which fed upon the globalization of capital markets but ultimately collapsed. The massive monetary/fiscal stimulus today is beginning to work but is setting up its own set of contradictions in the future.

“Recovery Possible in 2009” We would certainly agree with Vice Chairman Kohn’s assessment. 2 Our outlook is for positive economic growth, as measured by real gross domestic product (GDP), by the second half of this year. Yet, our outlook is that the composition of the recovery will be quite different than prior economic recoveries in the post-WWII period. Growth will be led by federal government spending and a modest recovery in consumer spending but this recovery will be below trend for the second half of this year as well as all of 2010. We likely will not witness a V-shaped recovery in housing or consumer durable goods spending as envisioned by some analysts. The composition of the recovery is heavy on federal spending and monetary stimulus, and thus should contribute to economic conflicts ahead.

† Presentation for the Richmond Association for Business Economics, April 23, 2009. Exhibits here are as originally presented and may have been subsequently updated by the source. The author would like to thank Adam York and Kim Whelan for their contributions. 1 Reason in History, edited by Robert S. Hartman, 1953, Liberal Arts Press, Inc. 2 Hilsenrath, Jon, “Fed’s Kohn Says Recovery Possible in ’09,” Wall Street Journal, April 21, 2009.

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

Figure 1

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Figure 2 Real GDP

8.0%

Bars = Compound Annual Growth Rate

Real GDP vs. M2 Money Supply

Line = Yr/Yr Percent Change

6.0%

8.0% 6.0%

Forecast

4.0%

CAGR

25%

8%

20%

6%

15% 4.0%

4% 10%

2.0%

2.0% f

0.0%

0.0%

-2.0%

-2.0%

-4.0%

-4.0%

2%

5% 0%

0%

-5%

-2%

-10% -4% -15% -6.0%

-6.0%

GDPR - CAGR: Q4 @ -6.3% GDPR - Yr/Yr Percent Change: Q4 @ -0.8%

-8.0% 2000

Source:

2002

2004

2006

-8.0% 2008

2010

-6%

Real GDP: Q4 @ -6.3% (Right Axis) Money Supply Growth: Q1 @ 9.7% (Left Axis)

-20% -25% 90

92

94

96

98

00

02

-8% 04

06

08

Federal Reserve Board, U.S. Department of Commerce and Wachovia

Signals for the Recovery Long lead indicators, such as money supply (M2) and the yield curve, suggest a recovery in the next year (Figure 1). Unfortunately, M2—the source of stimulus to the economy today—sets up its own contraction and need for resolution in the future (Figure 2). These leading indicators, however, need confirmation from short-run lead indicators such as jobless claims, factory orders and the ISM index. Jobless claims remain above 600,000 per week and we would expect a decline in this series below 550,000 to suggest recovery. Orders are still declining and the ISM index remains below 40, well below the demarcation line at the 50 level.

Role of Finance in the Recovery Global capital flows and domestic liquidity are two financial phenomena that set the context for the last expansion and the credit crunch of 2007-2008. These same factors are now called upon again to support the pending recovery. Chairman Ben Bernanke, among others, has cited the global savings glut as a source of the easy financing in mortgage and other securitized credits that supported the housing & consumer spending boom as well as its correction. 3 For the past six months central banks have attempted to restart the same credit engines—but with a bit more discipline. But will such discipline be enough to ensure effective policy management in terms of both timing and magnitude?

3 Chairman Ben Bernanke, “Four Questions about the Financial Crisis,” Speech at the Morehouse College, Atlanta, Georgia, April 14, 2009.

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

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Figure 3

Foreign Private Purchases of U.S. Securities 12-Month Moving Sum, Billions of Dollars

$600

$600

Treasury: Feb @ $259 Billion Corporate: Feb @ $39 Billion Equity: Feb @ $11 Billion Agency: Feb @ -$58 Billion

$500

$500

$400

$400

$300

$300

$200

$200

$100

$100

$0

$0

-$100

-$100 98

99

00

01

02

03

04

05

06

07

08

09

Source: U.S. Department of the Treasury and Wachovia

As illustrated in Figure 3, foreign purchases of U.S. securities, especially corporate bonds (which includes many securitized products) and equities, took off after 2005 only to crash over the last year. Since 2007, purchases of agency debt have declined while foreign investors have increased purchases of Treasury debt as a safe-haven. The global savings surplus of the 2002-2007 period set up the means of its own correction as risk became under-priced and yields failed to account for the risk of economic and credit underperformance. Yet, as we look at Treasuries today we can also see the case for a repeat of the cycle of too much money chasing Treasuries. Over-paying for the flight to quality today presents a possible risk that low returns today fail to account for inflation, currency and supply risks ahead. At the short-end of the credit curve the actions of the Federal Reserve appear to be very successful. We can see this in the decline of the TED spread over the past six months since the failure of Lehman Brothers (Figure 4). In this way, the markets support Vice Chairman Kohn when he asserts that the Federal Reserve has been effective in easing financial conditions. 4

4

Governor Donald Kohn, “ Monetary Policy in the Financial Crisis,” Nashville, TN, April 18, 2009.

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

Figure 4

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Figure 5 TED Spread

Aaa and Baa Corporate Bond Spreads

Basis Points

450

450

Over 10-Year Treasury, Basis Points

700

TED: Apr @ 95 bps 400

400

350

350

300

300

250

250

200

200

150

150

100

100

50

50

0

0

2004

Source:

2005

700

Baa Spread: Mar @ 560 bps

2006

2007

2008

Aaa Spread: Mar @ 268 bps

600

500

400

400

300

300

200

200

100

100

0

0

-100

-100

1960

2009

600

500

1965

1970

1975

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1995

2000

2005

British Bankers’ Association, Federal Reserve Board and Wachovia

In addition, the Fed has been very effective in lowering private market rates such as the rate on commercial paper and thereby improving the liquidity of money market funds. However, Vice Chairman Kohn also recognizes the limits of such success. He asserts that the Fed is “not trying to favor some sectors,” but in our opinion, it would be effectively impossible not to favor certain asset markets where the Fed is purchasing securities in contrast to asset markets where the Fed is absent. In this sense, the Fed is acting as a policeman that stations himself on one corner and witnesses very little financial crime (narrow credit spreads). Yet, crime (wide spreads) continues where the policeman is not present at another corner. 5 This is contrasted, for example, in Figure 5 with the lack of spread improvement in the corporate bond market. In recent weeks, we have seen some improvement even in the corporate bond market. High grade bond issuance (Figure 6) has been solid and high yield issuance (Figure 7) has started to improve as well. These improvements are part of the green shoots that suggest credit markets are beginning to be supportive of economic growth. Figure 7

Figure 6 Investment Grade Corporate Issuance

High Yield Corporate Issuance

Billions USD, 3-Month Moving Average

$120

$120

$60

$60

$30

$30

$0

$0

Source:

$18.0

$15.0

$15.0

$12.0

$12.0

$9.0

$9.0

$6.0

$6.0

$3.0

$3.0

$90

$90

2004

Billions USD, 3-Month Moving Average

$18.0

2005

2006

2007

2008

2009

$0.0 2004

$0.0 2005

2006

2007

2008

2009

Wachovia Securities and Wachovia

There is also the issue of the exit strategy. How and when does the Fed remove itself from such targeted lending and what is the impact on the market as the Fed 5 John E. Silvia, “State of the Global Economy: The Intersection of Economy and Credit,” Presentation at the Credits Markets Symposium, Federal Reserve Bank of Richmond Conference, April 2, 2009.

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

SPECIAL COMMENTARY

withdraws this liquidity? In this sense we can see again that the actions taken to solve one problem—the post Lehman liquidity squeeze—have now set up conditions for another test of the market as policy makers act to reverse the earlier solution. Such action reversals will also apply to the Fed’s diminution in its purchasing of Treasury, agency and mortgage-backed securities. As the recovery begins to take hold, rising interest rates are likely to be the market implications of the unwinding of these Federal Reserve positions in Treasury, agency and mortgage debt. Rates are likely to move even higher as the housing recovery begins. Unfortunately, the timing of these unwinds are not likely to fit the economic cycle nor the political cycle. For investors, the implications of less than perfect timing and magnitude of policy changes are greater volatility and higher interest rates than are currently discounted in the marketplace.

Two Faces of Federal Reserve Policy Traditionally, monetary policy is characterized by the simple reference to the federal funds rate. This is often an oversimplification but in today’s environment the reality is that the funds rate does face the lower bound of a zero policy rate. Facing this zero bound, the Fed has pursued a different solution to the recession and credit crunch. Again, today’s solution to the credit crunch will generate new problems when the recovery appears. Today, the Fed’s credit policy takes several forms. First, the Fed is lending directly to banks and primary dealers through the Primary Dealer Credit Facility (PDCF) as well as the Term Auction Facility (TAF). Such lending is very short-term and we believe would not present a major problem when it is time to turn off the tap. Our concerns are more focused on the extent of the decline in spreads in agency and asset-backed security markets. For agencies, we have seen a decline in spreads over the last five months to levels reminiscent of early 2007. So far the Fed has bought just $60 billion or just over ten percent of the total benchmark debt currently available for purchase. If the Fed does indeed purchase its targeted $200 billion then spreads are likely to narrow significantly further and indeed will likely attain levels associated with the credit bubble period of 2005-2006. This suggests we are about to repeat the same narrow spreads that were criticized for the failure to account for risk. Is the solution to the credit crunch today bound to recreate the conditions for another overextension of credit ahead? For asset-backed securities we have witnessed a rapid decline in spreads, for example CMBS, as illustrated in Figure 8. Spreads have also declined sharply in recent weeks for prime auto credits, subprime auto credits and credit cards. Our expectation is that spreads will continue to narrow given the commitment by the Federal Reserve. However, is the extent of the improvement too much given the state of the economy? Have we simply overcompensated for the credit crunch by again creating conditions that will only lead to another correction? Is there just too much credit chasing too few credit-worthy deals? Fundamentally, Fed intervention in these markets creates the possibility that price discovery has been obviated in favor of economic stimulus and that the over supply of credit by the Fed in selected markets today is creating distortions that will require a further reaction down the road?

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

Figure 8

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Figure 9

5-Year and 10-Year AAA CMBS Spreads Basis Points

1600

5-Year AAA CMBS: Apr @ 1,025 bps 10-Year AAA CMBS: Apr @ 825 bps

1400

Growth of Securitization Markets 1600

Yearly Securitized Issuance, Trillions of Dollars

$2.5

1400 $2.0

1200

1200

1000

1000

800

800

600

600

400

400

200

200 0

0 2005

2006

Source:

2007

2008

$2.5

CMBS CDO Non-Agency Student Loan Home Equity Credit Card Auto

$2.0

$1.5

$1.5

$1.0

$1.0

$0.5

$0.5

$0.0

$0.0

2009

90

92

94

96

98

00

02

04

06

08

U.S. Department of Commerce, U.S. Department of the Treasury and Wachovia

To see the extent of the correction and the degree of disequilibrium that could be present in securitization markets we turn to Figure 9. Here we can see the rapid runup in securitization between 2003 and 2006 and then the dramatic correction after that. But, if $2 trillion is too much and $300 billion too small, where is the equilibrium? Moreover, should the markets or policymakers decide?

Fiscal Policy: Stimulus and Resource Allocation? Although increased infrastructure spending should stimulate the economy, at least in theory, the longer run problem is fiscal discipline. Is there an exit strategy for reducing federal spending down the road? Failure to pursue a reasonable program of reducing Treasury finance may well have negative implications for the dollar and interest rates. 6 At the microeconomic level of resource allocation, potential tax increases to pay for such spending would carry significant negative microeconomic incentives that could partially offset the macro boost from higher government spending. Not only could higher taxes on dividends, capital gains and higher income individuals provide a disincentive to work, they could provide incentives for investment and production to move abroad. Figure 11

Figure 10 Federal Government Spending Ex. Interest Payments

Federal Budget Surplus or Deficit

Year-over-Year Percent Change, 12-Month Moving Average 30%

30%

As a Percent of GDP, 12-Month Moving Average

4.0%

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0% -5%

-5% 1970

Source:

1975

1980

1985

1990

1995

2000

2005

4.0%

Surplus or Deficit as a Percent of GDP: Dec @ -5.9%

Spending Ex. Interest Payments: Mar @ 27.1% 2.0%

2.0%

0.0%

0.0%

-2.0%

-2.0%

-4.0%

-4.0%

-6.0%

-6.0% 70

75

80

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95

00

05

U.S. Department of Commerce, U.S. Department of the Treasury and Wachovia

In addition, a more interventionist government in terms of regulation and direct government allocation of real economic resources would alter private risk/reward calculations. If these allocations did not reflect the careful economic calculation of 6

6

“Mr. Wen’s Debt Bomb,” Wall Street Journal, March 18, 2009.

Financial Green Shoots Today Induce Policy Contradictions Tomorrow May 4, 2009

SPECIAL COMMENTARY

costs and benefits, such political interventions would lead to economic outcomes that are inconsistent with those achieved in a purely private calculation of returns. For example, tougher regulation of financial firms, which will increase the cost of capital for borrowers, suggests that the price and availability of credit will be limited relative to previous expansions. In sum, the microeconomic implications of proposed policy initiatives could be more significant in their impact on the economy and investors than the broad aggregate macroeconomic “stimulus” programs that are frequently the focus of conventional analysis. The incentives implied in policy proposals under discussion raise both the short-run costs and risks associated with implied economic adjustments. Such implications are negative to growth and investment returns, and, in turn, suggest greater fiscal deficits than currently projected.

Exit Strategy: Perfect Timing and Magnitude—Too Much to Ask? Over the last year the Fed’s balance sheet has risen dramatically from $800 billion to over $2 trillion today while the money supply, M2, has grown 14 percent over the last six months. Meanwhile, fiscal deficits are estimated at nearly $2 trillion over the next two years. Such policies are not likely to be sustainable over time without significant changes in inflation, interest rates, the value of the dollar and the pace and character of economic growth. As economic “green shoots” appear more frequently and a consensus develops that recovery is coming, will policymakers make a graceful exit from the stimulus stage? Or, will they stay too long, and thereby generate policy contradictions from too much stimulus when stimulus is no longer needed. The challenge of the timing and perfect execution of an exit strategy from extremely easy monetary and fiscal policy should be clear. The execution of a solution is less so.

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Wachovia Economics Group Diane Schumaker-Krieg

Global Head of Research (704) 715-8437 & Economics (212) 214-5070

[email protected]

John E. Silvia, Ph.D.

Chief Economist

(704) 374-7034

[email protected]

Mark Vitner

Senior Economist

(704) 383-5635

[email protected]

Jay Bryson, Ph.D.

Global Economist

(704) 383-3518

[email protected]

Sam Bullard

Economist

(704) 383-7372

[email protected]

Anika Khan

Economist

(704) 715-0575

[email protected]

Azhar Iqbal

Econometrician

(704) 383-6805

[email protected]

Adam G. York

Economist

(704) 715-9660

[email protected]

Tim Quinlan

Economic Analyst

(704) 374-4407

[email protected]

Kim Whelan

Economic Analyst

(704) 715-8457

[email protected]

Yasmine Kamaruddin

Economic Analyst

(704) 374-2992

[email protected]

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