Eugene Fama on Fed Tapering: "It's a Net Neutral"

My wife and I are headed to Charlottesville, Virginia tomorrow to visit our daughter Caroline for the weekend. Caroline is a second year student at the University of Virginia.  My next post will be Monday, November 4.

Nobel Prize winner Eugene Fama was interviewed by CNBC's Rick Santelli earlier this week.

In his usual hysterical fashion, Santelli was trying to get Fama to say that interest rates were set to soar once the Fed ends its "Quantitative Easing" (QE) program.

Problem was, Fama doesn't believe it.

As you will see from the interview, Fama notes that he has been doing research on the possible effects on the credit markets once the Fed starts reducing its holdings of longer term Treasurys.

Fama doesn't believe the markets will be as roiled as Wall Street believes once the Fed stops buying.

He points out that the purchases of Treasurys have been financed by the Fed's borrowing activities in the short term market.  Thus, the $4 trillion in Treasurys that it holds have been financed by $4 trillion in borrowing.  Reducing one side of the ledger also reduces the other side, so the net effect should be relatively neutral.

Here's how Business Insider wrote about the exchange:

Santelli asked specifically about the effects of the Fed's quantitative easing program and the risks associated with it.

"What they are doing... the effects are being greatly inflated by the accounts," said Fama.

"What they've doing is issuing a lot of short-term debt — $85 billion a month — and using it to buyback long-term debt with the goal of lowering the interest on long-term debt," he added. "Now they take credit for lowering interest on short-term debt. But in fact what they've been doing should've raised rates on short-term debt."

Fama argued that the Fed was not affecting the economy that much.

Santelli, however, continued to pursue the idea that there are risks associated with the Fed's actions.

"They're basically neutral events," said Fama. "I don't think they do very much."

Read more: http://www.businessinsider.com/fama-to-santelli-qe-is-a-neutral-event-2013-10#ixzz2jD8wilja

The Fallacy of Predictions, Or Saving Investors From Themselves

I have often wondered whether Fed Chairman Ben Bernanke is every tempted to remind his current chorus of skeptics of just how wrong their doom-and-gloom forecasts have been in the past.

Floyd Norris wrote a column for Saturday's New York Times recalling the intense criticism that Bernanke endured when the Fed started its so-called Quantitative Easing program in 2010:

A group of 43 economists, including former aides to Republican presidents and presidential candidates, published an open letter to the Fed’s chairman, Ben Bernanke, saying the program should be “reconsidered and discontinued.” The planned bond purchases “risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment,” the economists wrote. 

The Fed did not back down, and Republican efforts to pass legislation removing the Fed’s mandate to seek full employment were not successful. The next year, the Fed moved on to what became known as Q.E.3, also known as Operation Twist, an effort to bring down long-term interest rates by purchasing longer-term Treasuries. That move was criticized by Republican leaders even before it was announced. “We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy,” the Congressional leadership said in a letter sent to Mr. Bernanke while the Fed was meeting. 

http://www.nytimes.com/2013/06/29/business/economy/dire-warnings-about-fed-strategy-did-not-come-to-pass.html 

Now Bernanke is under attack for suggesting a couple of weeks ago that the economy may be strong enough for the Fed to consider tapering back its intervention.

The irony must not be lost on the Chairman.

Saturday also brought an excellent column in the Wall Street Journal by one of the best financial journalists writing today, Jason Zweig.

In a piece titled "The Intelligent Investor: Saving Investors from Themselves", Zweig noted that many of the columns he wrote over the years were not well-received, especially when they clashed with conventional wisdom.

Here's an excerpt, but I would urge you to clink on the link to read the whole column:

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.

When, in the fourth quarter of 2008 and 2009, I repeatedly urged investors to hold fast to their stocks, I was called a shill for Wall Street and helplessly naïve.
When I took a skeptical look at Congressman Ron Paul’s gold-heavy portfolio in December 2011, angry readers called me “weak minded,” “ignorant,” “pathetic” and a member of “the big bank lobby.” (Gold was around $1,613 per ounce then; it was last sighted this week sinking below $1,230.)

When, only a few weeks ago, I warned that any hints of a tighter policy from the Federal Reserve could crush recently trendy assets like real-estate investment trusts, high-dividend stocks and “low volatility” stocks, readers protested that I didn’t even know the difference between a rise in interest rates and “tapering,” or a decline in the rate at which the Fed buys back bonds. I know the difference – but, with many of these assets down by up to 10% since then, it isn’t clear that all investors knew the difference.

Every columnist knows that if you ever write something that didn’t make anybody angry, you blew it. People don’t like having their preconceived notions jolted, and doubt and ambiguity are alien to the way most investors think.

http://blogs.wsj.com/moneybeat/2013/06/28/the-intelligent-investor-saving-investors-from-themselves/

Take a Bow, Mario Draghi

Bullish sentiment has gotten so widespread in recent weeks that even the Fed is concerned.

Here was an excerpt from a Bloomberg article earlier this week:

Federal Reserve officials are voicing increased concern that record-low interest rates are overheating markets for assets from farmland to junk bonds, which could heighten risks when they reverse their unprecedented bond purchases...

Now, as central bankers boost their stimulus with additional bond purchases, policy makers from Chairman Ben S. Bernanke to Kansas City Fed President Esther George are on the lookout for financial distortions that may reverse abruptly when the Fed stops adding to its portfolio and eventually shrinks it. 

“Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels,” George said in a speech last week. “We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances.” 


http://www.bloomberg.com/news/2013-01-17/fed-concerned-about-overheated-markets-amid-record-bond-buying.html

The article goes on to note that Bernanke has set up a new department at the Fed (with the pithy title of "Office of Financial Stability Policy and Research") specifically to monitor asset prices and possible areas of "irrational exuberance".

It so long ago, but it was only last year that many policy makers and economists were convinced that we were on the verge of another global economic collapse.

Then European Central Bank (ECB) head Mario Draghi came to the rescue.

When the President of the ECB vowed last summer that it would do "whatever it takes" to save the euro, many were skeptical, and doubted that Draghi and the euro block had the resources and the will to act.

But it worked.

Here's how Bloomberg Businessweek described it in an article published this week.  The article notes that so far at least it has been Draghi's words alone that turned the tide in Europe.  No funds have been needed, only Draghi's "bluff":

Against long odds, Draghi’s bluff worked. Bond markets rallied on the belief that the ECB would deliver on its promise. The market’s surge fed on itself, adding to Draghi’s credibility...

Amazingly, the ECB has not had to follow through and buy a single euro’s worth of Spanish or Italian bonds. The open-ended commitment to do so was enough to get private investors to buy. Borrowing costs in the two countries are affordable once again. As the global elite convenes in the Alpine resort of Davos, Switzerland, for the World Economic Forum on Jan. 23-27, the European economy looks a good deal less scary than it did a year ago. For that, Europeans can thank the unassuming moneyman they call Super Mario. Even Germans are impressed. “I was way more critical—I have to admit that—in September than I am today,” Nikolaus von Bomhard, chairman and chief executive officer of reinsurer Munich Re, said in a Jan. 15 interview.

http://www.businessweek.com/articles/2013-01-17/how-mario-draghi-found-a-way-to-rescue-the-euro

Even Spain - which last summer was roiled by protests against the ECB-imposed fiscal cutbacks - has found markets eager to buy their debt.

Here's how what the New York Times reported yesterday:

January is turning out to be a bumper month for Spain and some of the euro zone economies most in need of debt financing, with governments and companies flooding the market with bonds that have sold at significantly lower interest rates than just a few months ago.
 

On Thursday, the Spanish Treasury sold €4.5 billion, or $5.9 billion, of debt, including bonds with a maturity of as much as 28 years. The average interest rate paid by Madrid on two-year bonds was 2.71 percent, down from 3.36 percent in December — a level not reached since March of last year. 

The interest rate on the benchmark 10-year Spanish bond stood at 5.03 percent Thursday. Last year that rate spiked above 7 percent — a level that many economists believe places an unsustainable burden on governments. 

http://www.nytimes.com/2013/01/18/business/global/18iht-spaindebt18.html?ref=todayspaper&nl=business&emc=edit_dlbkam_20130118 

The sustainability of today's bull markets is still being questioned, but there is no question that the sense of fear and panic has left the capital markets around the world.