Bill Gross, storied bond investor and head of PIMCO, a fund manager with nearly $700 billion under management, made an important observation in a Financial Times comment, namely, that interest rate policy is having a very different impact on businesses and consumers. While the two groups were (most of the time) similarly affected, now interest rate levels that are highly stimulative for corporations and investors are problematic for individuals.
This conundrum exacerbates the Fed’s policy bind. Further rate increases will damage a weakening housing market, but cuts to help homeowners will put a perky corporate sector and debt happy investors into overdrive.
Gross surmises that the Fed will keep watching to see how the data falls out to see which side to favor. Interestingly, he still believes that rates will be cut. Hhm, is this the real reason that bonds rallied Wednesday?
From the Financial Times:
For while there may be only one policy rate at any particular point in time, its disparate effect on two different segments of the US economy is showing. The result has been, and may continue to be a freezing of fed funds at 5.25 per cent until . . . well, until Ben counts to three and this cool cat starts to go – in one direction or another. Let me explain.
My primary thesis is that globalisation and financial innovation have enormously complicated the job of central bankers in recent years. Whereas in prior decades a “one-size-fits-all” policy rate may have coincidentally and democratically affected households and corporations alike, the 21st century seems to have ushered in an “innovation” revolution favouring corporations with global investment opportunities as opposed to individuals with daily bills to pay. The same 5.25 per cent rate does not and cannot be “neutral” for both sides in today’s US economy.
A company such as tractor maker Caterpillar, for instance, views the fed funds rate from its perspective in Peoria, Illinois, much differently than a homeowner on Main Street in the same city. For CAT, the almost unlimited ability to borrow at around 5.5 per cent in the domestic money markets affords it enormous opportunities for arbitrage profits.
It sports a 16 per cent return on investment, can deploy funds either domestically or internationally to take advantage of the most attractive labour, or can simply choose to buy back its own stock at an earnings yield of nearly 8 per cent. There seems to be nothing neutral about the current fed funds level to chairman Jim Owens in Peoria. To him, it’s a godsend.
Homeowner Jane Doe on Main Street, however, sees it differently. Real wages at the CAT headquarters have been stagnant in recent years thanks to outsourcing of production, and Ms Doe had to refinance her home in 2002 in order to send the kids to college.
The problem is that the 4 per cent adjustable rate mortgage that permitted her to extract “equity” and keep her monthly payments at nearly the same level is now about to adjust upward. Fed funds were approaching 1 per cent when she took out her loan and now they’re more than 400 basis points higher.
A neutral 5.25 per cent rate? It’s the rate from hell for Jane and millions like her across the US. In 2007 alone, nearly 2m mortgages will adjust their yields and required monthly payments skyward by an average of 250 basis points. Similar hikes loom ahead in 2008.
So what’s a Fed chairman to do? Hike rates in order to slow CAT’s stock buybacks and cool the stock market, or lower rates so that homeowners can continue to afford to live a frugal existence while directing mortgage payments from Main Street to Wall Street?
One policy rate, two constituencies – where does the cool cat go? It’s not an easy answer, clouded in many respects by the Fed’s public focus on consumer inflation and the real economy. Globalisation and financial innovation have also introduced new complexities.
These changes have created investment opportunities for corporations and, in some cases, excessive borrowing by households that have led to asset-price bubbling and perhaps asset-bubble popping if the fed funds rate moves too far from “neutral” for either constituency.
While Greenspan’s – and presumably now Bernanke’s – Fed professed to speak, see, and hear no evil from exuberant asset-price trends, there’s no doubt in my mind that home and stock prices are on their minds.
And if housing prices were to fall by 5 per cent or more over the next 12 months? The real economy might not stand tall under such circumstances – as witnessed by Japan during their commercial property deflation of the 1990s. If so, the Fed must cut. Stock prices up by 15 per cent or more over the next 12 months? The real economy may be over-fertilised. If so, the Fed must raise rates. Until then, until Mr Bernanke gets ready to go, he waits, and the static 5.25 per cent rate poisons vulnerable, over-levered homeowners and stimulates resplendent, opportunistic US corporations.
The wait is excruciating, and in some cases painful, for investors who are long volatility and pay daily option costs in hopes of any sign of a shift. When the drummer hits the third beat, however, and our Elvis in disguise finally is forced to move, my money is on the side of the American homeowner and lower short-term rates.
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“Gross surmises … Fed will keep watching to see how the data falls out to see which side to favor. Interestingly, he still believes that rates will be cut.”
Nope, not at least from what you clipped from the FT. Gross believes, as do I, that the Fed is caught in a double bind: Damned (by one constituency else the other)if they raise rates, damned if they don’t.
Gross: “…if housing prices were to fall by 5 per cent or more over the next 12 months? …the Fed must cut. Stock prices up by 15 per cent or more over the next 12 months? …the Fed must raise rates”
My questions: What happens if we get both? What happens if either “fix” is effected? Speculative fever is not easily abated. Depressions last a long time. Trouble everywhere.
The Fed is pretty much caught like a deer in the headlights. This problem should have been addressed in the mid-1990s. It was not. Now we are likely to have to endure some hell in the wake of indecision, incompetence, bad finance theory and practice, etc.
Or maybe I, along with Michael Panzner (Financial Armageddon), Nassim Taleb (The Black Swan, Fooled by Randomness), and a host of others are just plain stupid, blind, or otherwise deluded.
Dave,
If you read to the very last paragraph, Gross says his bet is that the Fed will favor homeowners and cut rates. That may not be based on his view of what is correct, but on the history of the Fed since Greenspan of having a pronounced bias towards being accommodative.
The Fed has become unduly concerned with asset price preservation (Greenspan was obsessed with the stock market, which is not the Fed’s job). But I have been saying that this liquidity creation has to end badly. Too much capital is going into speculative activity and dubious investments (which in some cases are otherwise good investments at excessive prices).