May 2003

The X Games

The X Games...As you may know, May is the month in which the global X Games championships will occur.  Extreme skateboarding, biking, snow boarding, Moto-X, etc. events will take place in both Whistler, BC, and San Antonio, Texas.  Top athletes from across the planet are scheduled to participate in this first ever global championship event.  Simultaneously in central banking offices stateside, another group of competitors are gearing up for their own X Games championship to come.  A championship event sure to be of great importance to the domestic economy, to say nothing of the larger global macro financial and economic system.  This financial X Games will possibly feature such events as inducing further extremes in yield curve steepness (also known as going vertical), creating negative real returns at the short end of the Treasury yield curve (dead man's drop), and facilitating the expansion of the money supply whenever possible (aerials), to name just a few.  As a possible surprise, a number of FOMC members are rumored to be preparing for some freestyle showmanship such as attempting to purchase longer dated Treasuries outright without the use of a brain bucket (helmet).  

Given recent experience in the domestic and global economy, the Fed and the Administration appear to have little choice but to participate in a monetary and fiscal X Games championship tournament of their own, because heaven knows that have already given it their all in normal competition.  They have already gone well above and beyond the call of normal duty during this special cycle, but have not yet attained the success and glory to which they have become so accustomed in post-war economic history.  What lies ahead for this determined bunch, the thrill of victory or the agony of defeat?  At least at the moment, the data is suggesting it may be the latter.

Hang Time...For many folks in economic and investment circles these days, belief in the Fed's ability to ultimately reflate or reliquify the system runs relatively high.  And it's really no wonder given Greenspan's track record to date.  He's already won many a regional championship when it comes to the rigors of monetary stimulus.  But given his recent statement of willingness to sign on for another tour, he appears to now be facing the challenge of his career.  Although Greenspan has taken a lot of heat for fomenting a financial (and economic) bubble prior to what we expect to now be this championship level reflationary event, what really matters for us as investors is what happens ahead.  Although we are in no way trying to suggest that the Fed is guilt free in what has happened in this country over the last decade, our personal thoughts regarding the Fed's prior actions are meaningless.  What matters most is how the financial markets perceive the quality and potential effectiveness of the monetary and fiscal X Games championship events ahead and whether they are willing to stick around and participate in the entire tournament.  At least up until the very recent past, the Greenspan led Fed has proven themselves very able competitors.  Up until now, they have dominated the global stimulus and reflation events.  No other central bank on the planet has been able to touch them.

Sometimes when it comes to extreme financial sports, style and attitude are more than half the battle.  Since day one of the Greenspan regime, the Fed has defined itself as being masters of banking system liquidity hang time.  In the following chart, you are looking at a picture of net free reserves in the banking system.  It's a picture of the potential ability of the banking system to make loans (create credit and ultimately money) based on the liquidity at its disposal.  Anything above the zero line is excess liquidity in the macro banking system.  In terms of hang time above the zero line, no central banking regime of the last half century at least even comes close to team Greenspan.
        

As is plainly obvious in the chart above, liquidity in the banking system during the Greenspan tenure has been quite different than any Fed regime in the 30 years prior to Greenspan.  Based on history since the mid-to-late 1980's, the markets know and expect nothing less from team Fed.  The markets do not have to worry about a possible diminishment in the financial liquidity ultimately necessary for potential credit creation.  It's clear that the Fed is at the top of its game in terms of vertical liquidity hang time.

To be honest, the world has changed a good bit over the last 15 years.  Evolution of the capital markets have been such that a good amount of systemic credit creation now happens outside of the banking system itself these days.  Away from the direct control of and supervision by the Fed and banking regulators.  Nonetheless, as the chart above displays, banking system liquidity today, as measured by free reserves, has possibly never been greater over the last half century.  In a nutshell, the Fed has provided the ammunition for the banking system to be a significant credit generator at the moment.  Whether that credit is generated or not remains to be seen.  It's a big part of warming up for the reflationary X Games championship.  Just think of it as financial carbo-loading.  Game on.

Dead Man's Drop...Although further extremes in the competition of stimulus may lie ahead, a number of championship tricks have already been executed and engineered by the Fed, despite the fact that the crowd has yet to respond in what would be considered adequate fashion.  It's not been often over the past three decades in this country that the real return on short term money has been pushed into negative territory.  Since late last year, what we find is that the Fed Funds rate is below the rate of inflation as measured by the headline CPI.  As you can see in the chart below, this has been nothing short of a rarity over the past two+ decades.
      

One might argue that a negative funds rate is clearly possible when energy prices are rocketing skyward, given energy's affect on the CPI measurement, as certainly was the case in the mid-to-latter 1970's.  But the fact is that even ex-energy, core CPI rose 1.69% year over year in the recent March period.  It's a pretty simple argument to make that the real Fed Funds rate today is purposely negative as the Fed is fully aware that an extreme posture is a necessity if it hopes to win top honors in the reflationary competition.  

As you can tell in the picture above, periods experiencing a negative real Fed Funds rate have been ultimately stimulative for the economy as a whole when looking at results in subsequent timeframes.  During mid-to-late 1970's, an on again/off again negative funds rate was ultimately followed up by the economic expansion of the 1980's.  A period coinciding with the beginning of a significant equity bull market.  We will admit that the late 1970's was a bit of a special period when examining real rates.  Energy prices and inflationary pressures in the economy were increasing so fast that the Fed was continually behind the curve in raising interest rates as a means to potentially cool inflationary momentum.

In more recent experience, the Fed Funds rate went modestly negative in 1993.  A period in which the Fed was determined to reliquify the domestic banking system.  Maybe the unintended consequence of Fed action at the time was that the incredible credit stimulus unleashed system wide really became the initial liquidity foundation for the economic and financial bubble that was to eventually unfold.  As you know, it was only three short years later that Greenspan uttered the infamous "irrational exuberance" characterization regarding the equity markets.  And so now we find ourselves with a Fed Funds rate more deeply negative than that seen in the prior early 1990's episode.  Already the Fed is taking dramatic steps to stimulate the system.  The chart above tells us that for all intents and purposes, the championship round has already begun.

Going Vertical...There's been a lot of chatter recently about another drop in the Funds rate by the Fed.  A number of respected economists have been calling for another 25 to 50 basis points of the current Funds rate to be lopped off in short order.  It's no wonder given the ISM reading currently resting at what has been a historically recessionary level of 45.4.  Moreover, stripping out housing and the quarter over quarter minor contraction in the trade deficit leaves us with a 0.2% 1Q GDP as opposed to the 1.6% reported.  We recently brought up a number of potential money market fund infrastructure implications in one of our discussions should another drop in the Funds rate occur.  Certainly we will have seen nothing like this in terms of extremes over the post-war economic period should the Fed Funds rate be lowered below 1%.  But what many folks may not realize is that the Fed is already pushing the extremes of vertical as it applies to the Treasury yield curve spread.  

Most popular analysis tends to look at the Treasury yield curve with respect to absolute yield differentials.  At the moment, the spread between longer maturity yields, as characterized by the 10 year Treasury, and short term yields, as represented by the 2 year Treasury, is merely pushing the level seen during the last episode of a negative real Fed Funds rate in 1993.  Viewed in this context, relative to experience of the last three decades, the yield curve spread is wide, but not alarmingly so by any means.
          

We've been here before.  But looking at the above, one would assume that the Fed has not yet gone for "big air".  Alternatively if we view this differential between long and short maturity yields a bit differently, revealed is something much more vertical in nature.  In fact, maybe the current yield curve relationship is more extreme than anything witnessed in three decades at least.  Instead of comparing absolute yield differentials, the world looks a whole lot different if we compare the magnitude of the differential.  Instead of subtracting the 10 and 2 year yields, we can divide these yields to get a better sense of comparative proportion given the current level of total curve yields.  As you can see below, yield curve conditions today look nothing like the experience of the early 1990's, let alone anything witnessed over the past three decades.
         

Quite simply, we suggest that what you seen above is extreme accommodation at the short end of the yield curve.  The Fed hasn't just gotten big air in terms of monetary accommodation over the past few years, they are also setting multi-decade records.  Over the last few years, the Fed has raced ahead of movement in the longer end of the yield curve clearly attempting to stimulate the economy (and the financial markets, whether intentional or not).  

We've heard many a Street prognosticator lately suggest that investors prepare to play the "reflation trade" ahead, as if the Fed has only recently started to get serious about the financial X Games.  We humbly submit that it seems questionable to only now prepare to play the reflation and reliquification trade when it sure appears from all of the the data above that the Fed already began its reflation efforts in substantial earnest many moons ago.  Reflation and reliquification events haven't already been ongoing for quarters now, but rather years.  We already find ourselves in an environment of accommodation that can only be described as extreme.  Just what is the supposed nature of the further reflation effort to come?  What new events will be unveiled at the monetary X Games championships that have not already been seen by the general public?  Just maybe, the smarter money is getting ready to play the fact that the reflation and reliquification trade has not been working as per the historical script.  At least not up to this point.  

X Games Groupies...The X Games championships in Whistler and San Antonio will be a smashing success if enough fans pay to watch the events (both in person and through various forms of media).  Alternatively, the financial X Games championships will certainly not be a success at all unless the fans actively participate in the competition.  Although there may be a few monetary and fiscal surprises yet to come from the Fed and the Administration in terms of stimulative prowess,  it's starting to become pretty darn clear that the sports fans are becoming disinterested in the program.  Despite the extremes in accommodation efforts shown above, certainly disconcerting to the promoters of the financial X Games championships has to be the fact that the rate of change in money supply growth is contracting.  Money growth slowing directly suggests a certain level of lack of interest in system wide credit expansion.  At the current level of the game, one would expect the demand for borrowed funds to be going through the roof.  Outside of mortgage credit, demand for borrowed funds is slipping at the margin.  Recent year over year money supply growth (as characterized by M3) is a little over 6%, down over 50% in terms of year over year growth rate over the last eighteen months.  Although still substantial on an already huge nominal dollar monetary base, the growth rate in money supply has been declining over the past year-plus despite significant reflation and reliquification prodding.  In one sense, the "reflation trade" has already been a bad bet for a good while now.  

As a quick tangent, we've included the measure of velocity along with M3 rate of change in the following chart.  Simplistically, velocity is GDP divided by M3.  This measure gives us a sense of economic growth or production per unit of existing money supply.  The greater the number, the more productively money is being put to use.  In a fractional reserve banking system, borrowed money put to economically productive use would theoretically build plant and purchase equipment to meet a certain level of end user demand.  This would hopefully provide for an increase in salaried employment to run the new plant and equipment, which would hopefully further increase both final demand and savings, which would hopefully provide for more jobs and additional productive investment, and so on.  When spent productively, money can multiply through the system.  Alternatively, when borrowed funds are put to less productive use in terms of macro economic stimulation, velocity can fall.
              

It is very interesting to note in the above chart that while velocity was increasing from the mid-1980's through to the mid-1990's, there did not appear to be a need for significant money supply growth to stimulate economic advancement.  In the same breath, once velocity began to decline from what was a pretty significant height, year over year money supply growth began to accelerate more than noticeably.  Although we may be stretching for a relationship here, could it be that money supply growth can remain under prudent restraint when borrowed money is being put to very productive and stimulative economic use and that unproductive use of borrowed money (margin lending, funding dotcoms, stock repurchases, etc.) must be compensated for by increasing money supply growth in order to keep the economy moving forward at a reasonable pace?  We believe that may be a good part of the explanation for what you see above.  

Although the Fed would like to see the money supply expanding more rapidly as a sign that various sectors of the economy are willing to borrow and spend in order to support the total economy moving forward, they cannot will it to happen.  They can only provide the venue and the entertainment, but ultimately can't force their fans to participate in the games of extreme financial competition.

The Heartbeat Of America...Although consumer and corporate America have been very enthusiastic supporters of the financial X Games in the past, interest appears to be waning.  Interest that is necessarily critical in a global championship tournament.  Corporations have for some time been relatively indifferent about extremes in macro financial reflation and reliquification gamesmanship, preferring to sit at home nursing their ailing balance sheets.  It isn't about the cost of capital anymore, but rather the protection of capital as it applies to every dollar expended.
         

And who can blame them?  As you know, capacity utilization rates are currently threatening to make a new low for this cycle.  Incredibly enough, this is happening while actual capacity has already been shrinking.  After all, what better a setup for forward rate return on total corporate assets over the last few years than to eliminate capacity?  Despite cost of capital that may be influenced by the relationary X Games, do corporations immediately begin to borrow and spend anew, essentially exacerbating the current capacity problem?  Not likely.  Excluding a transportation spending related pop in 4Q, nonresidental fixed investment (capital spending) has been contracting for 10 quarters now.  It's an understatement to suggest this is serious stuff.
          

At least for now, spending by corporations does not seem to be influenced by cost of funds, but rather by potential rate of return on capital invested.  Unlike many other sporting events, corporations do not appear interested in sponsoring the global championship reflationary X Games.  And they certainly do not want their names on the stadiums.  After all, this practice has been pretty darn effective in projecting future bankruptcy candidates over the last few years.

As you know, it's really been domestic consumers that have been the most ardent financial reflationary devotees over the last few years.  Jumping at the chance to partake in extreme events of sporting leverage.  But recent data suggests that like their corporate brethren, the US consumer is also becoming a bit immune to a heightened level of stimulus extremes.  From our perspective, it's a darn good bet that continued borrowing and spending will be a necessity if reflation of what is really a consumer dominated economy is to be accomplished with the help of households.  What is clear is that recent household revolving and non-revoling credit expansion has slowed markedly relative to experience of the past few years.
          
     

One has to venture back close to a decade to find month over month consumer credit expansion as slow as what has been seen in the past six months.  Certainly there has been some substitution of mortgage credit for consumer credit, but initial signs that a post blow off peak in refinancing activity may now be behind us.  As interest rate dropped during the period in which the Iraqi conflict approached, mortgage refi app activity went vertical.  But in the past month, we have watched mortgage rates drop and mortgage refi applications contract.
       

We suggest keeping a very sharp eye on mortgage refi activity.  Refi's outnumber new purchase mortgages roughly 13 to 1 at present.  At the recent peak in the chart above it was 27 to 1.  Refi's are where reflation or reliquification will either be successful or fall flat on its face ahead, at lest as far as the household sector is concerned.

Lastly, as we talked about in an open access discussion a few months back, it appears to us that households are beginning to react to the fact that employment conditions are not yet improving.  Unless labor markets begin to heal in pretty short order, will households also begin to lose interest in the cost of capital X Games as their corporate counterparts appear to have done?  It's a good bet.  In the following chart we look at employment experience of the last four major post recessionary periods.  The numbers have been indexed to mark the bottom in payroll experience for each cycle.  Extremes in stimulation to come or not, it seems an understatement to suggest that the character of payroll employment in the current recovery differs from what was seen in recoveries past.
      

Is the crowd up for a global championship round of reflationary and reliquification X Games to come, or have they already seen enough for this season?  Despite the fact that the data suggest a certain measurable lack of interest, it's probably fair to say that the financial and economic stimulus X Games championships will be played out come rain or come shine.