by Gary North
The stock market rose sharply on the final day of February and the first Monday in March. Here's why:
http://www.stls.frb.org/docs/publications/usfd/page2.pdf (Note: charts from the St. Louis Fed are constantly being revised, but their Web addresses remain constant. All charts for this essay are dated before March 5, 2002.)
The Federal Reserve System is now pumping in new money at over 20% per annum. The St. Louis FED tracks the adjusted monetary base (AMB), which is the one monetary component that the FED's Open Market Committee can control. This is the statistic of the actual holdings of monetary reserve assets by the FED. Milton Friedman calls this "high-powered money" because it serves as the base for all of the other market-generated monetary units.
Because this is the one monetary component that the FED can control directly, this figure is the best indicator of what the FED's monetary policy is. The other monetary figures are the results of money-holders' allocation of assets into or out of the banking system.
The St. Louis FED not only graphs the AMB figure, it provides the numerical rate of growth in the box beneath the chart. Since December 26, the increase has been 20.3% on an annual basis. Since late February, 2001, it has been 9.7%. Since July 25 — before 9/11 — it has been 13.3%
There is no doubt that the FED is in full-scale inflationary mode. It is not just in double-digit mode, but 20%. I will be surprised if it stays this high for very long, but it is clear that Greenspan is willing to keep the rate above 10%.
I don't think Greenspan has increased the money growth rate to 20% in order to give a boost to the U.S. stock market. The stock market was not falling sharply, although it was heading down. He is concerned about the overall economy. He gets blamed for recession. We were in a recession last year, contrary to the financial press at the time. He has inflated us out of it. The manufacturing sector of the economy is at last positive, as reported the National Association of Purchasing Managers (now called ISM). But manufacturing employment continued to fall.
ISM's Backlog of Orders Index indicates that order backlogs grew for the first time after 21 months of decline. ISM's Supplier Deliveries Index reflects slower deliveries for the second consecutive month. Manufacturing employment continued to decline in February as the index fell below the breakeven point (an index of 50 percent) for the 17th consecutive month. ISM's Prices Index remained below 50 percent as manufacturers experienced lower prices for the 12th consecutive month. . . .
ISM's PMI is 54.7 percent in February, an increase of 4.8 percentage points from the 49.9 percent reported in January. ISM's New Orders Index rose from 55.3 percent in January to 62.8 percent in February. ISM's Production Index rose 9.2 percentage points from 52 percent in January to 61.2 percent in February. The ISM Employment Index is at 43.8 percent for February, an increase of 1.2 percentage points when compared to the 42.6 percent reported in January. . . .
"The overall picture shows growth in manufacturing activity during the month of February," added Ore. "The PMI hasn't been above the 50 mark since July 2000, so this is certainly welcome news. Manufacturing has struggled and hopefully this signals the beginning of a strong recovery. . . ."
INTEREST RATES AND CORPORATE DEBT
By injecting new reserves into the economy by purchasing U.S. government debt — mostly short-term T-bills — the FED has lowered short-term interest rates. This has killed the return for bank passbook savings account holders and money-market fund savers. In the following chart, you can see the dramatic fall in the commercial paper rate, which parallels the T-bill rate. Compare this to the highest-rated Aaa corporate bond rate. A year ago January, when the FED began to lower the short-term rate, the corporate bond rate was a hair above 7%. It stayed in the range until early December, when it fell to 6.5%, where it has stayed.
Corporations borrow short-term money to finance inventories and to keep their doors open. They finish projects that were begun prior to the recession. CD-rates are emergency money rates and day-to-day operations rates. The FED's expansion of money since last January has stimulated this kind of business activity.
What matters most for businesses, long-term, is the long-term corporate bond rate. The lower this is, the cheaper it is to borrow long-term money for financing land acquisitions, buildings, equipment, and other longer-term productive assets. The FED's stimulus package has had very little effect here. It has not succeeded in driving down corporate bond rates low enough to persuade managers to begin loading up on long-term corporate debt.
What about the response of business to cheaper short-term and mid-term money? It has sagged remarkably. Commercial paper (CD's) has fallen from over $325 billion to about $200 billion.
These are short-term loans. What we are seeing is remarkable. The law of economics is this: "At a lower price, more will be demanded (other things being equal)." But the short-term money rate has fallen from 6% to under 2%, yet the amount CD money demanded has plummeted. The decline in demand has been even more dramatic with commercial and industrial loans from banks, which are longer-term loans. They have fallen from about $1.1 trillion to $520 trillion — a drop of over 50%.
Conclusion: other things have not remained equal. Despite falling short-term and commercial loan rates, businesses have left the debt markets in droves. This means that they have stopped expanding. They are operating on the basis od retained earnings.
This is rational in a market that is not expected to produce profits in the near future. If your business is not producing profits, or is even producing losses, you don't want to increase your debt load unless you think that a turnaround in your firm's profit picture is imminent. What the fall in commercial loan demand indicates is that American business decision-makers do not expect a turnaround anytime soon.
The St. Louis FED also surveys rates of investment in several areas of the economy. On one page, it lists six areas of the economy.
Hard hit in 2000 were real private fixed investment and real nonresidential fixed investment. The biggest hit was in nondefense capital goods orders: down to a negative 25% at the bottom: the end of third quarter. It rebounded to a negative 18% in the fourth quarter. But equipment and software investment continued downward into the negative 10% range.
Only one area of the economy stayed positive: housing starts/home sales. Here is the heaviest debt load for consumers. Housing is basically a long-term consumer good, heavily funded by mortgages. So, consumers have remained optimistic, long-term, but their employers have grown pessimistic at least with respect to the short term.
Consumers believe that the housing market will always rise. They think, "buy now, pay later." They think, "I can lock in low-interest fixed mortgage money today, and I'll pay it off with depreciated dollars." This strategy has worked ever since 1946.
The credit markets are supplying this money to borrowers. The mortgage market is presumed to be secured by the U.S. government, so Fannie Mae and Freddie Mac keeps making available mortgage money to borrowers. These enterprises are called GSE's or Government Sponsored Enterprises.
If mortgage holders think they can win at the expense of mortgage-issuers, why do people continue to put their money into pools of long-term mortgages? Because they think these pools of capital are government-guaranteed. They are looking for high returns short-term. They figure they can sell off their holdings later if rates climb. They think they can protect themselves against both default (because of a supposed government guarantee) and interest-rate risk (by selling to new buyers if rates go up). They assume that their investment will be liquid forever.
There is a Web site devoted to warning the public about the risk to taxpayers from these GSE's: FM Watch. It has warned against the massive increase in derivatives in the mortgage-based GSE's. It has also warned against recent equity losses. The looming risk is gigantic: "the GSEs now guarantee more debt and mortgage-backed securities ("MBS") than all comparable U.S. Treasury debt."
Since September 11, the nation has learned that risks once deemed improbable can quickly become possible. With the nation in a recession, all financial institutions risk being adversely affected but none more than Fannie Mae and Freddie Mac, two Government Sponsored Enterprises ("GSEs"). For years, the GSEs have been permitted to operate on thin capital cushions built for best-of-times assumptions. The last few months have underscored the riskiness of GSE excesses o and permitted GSE abuses arising out of September 11. Recent developments are dramatic:
In the third quarter of 2001, the value of Fannie Mae's shareholder equity fell by $10.6 billion, a result of risky hedging in the derivatives market. Fannie Mae's debt/equity ratio is now 53:1, five times more than the average for commercial banks. If Fannie Mae were regulated like a commercial bank, it would face serious risk of closure.
In the week following September 11, the Federal Reserve extended credit of $81 billion to ensure adequate liquidity in the markets. On September 14, Freddie Mac moved in an entirely opposite — and counterproductive — direction, issuing $5 billion in two-year notes that took cash out of the market. No other debt issuer did so because the markets were loathe to buy private company debt during considerable market instability. But Freddie Mac exploited its implied government guarantee to raise cheap money from frightened investors at a time of national emergency. . . .
In recent years, the dramatic growth in GSE debt has significantly increased the risk to U.S. taxpayers. Fannie Mae and Freddie Mac have increased their debt six-fold since 1992, from $196 billion to $1.26 trillion in the third quarter of 2001. In a decade when Treasury borrowing dropped dramatically, uncontrolled GSE debt was moving in the opposite direction. Almost unbelievably, the GSEs now guarantee more debt and mortgage-backed securities ("MBS") than all comparable U.S. Treasury debt.
This debt has been issued chiefly to fund a lucrative investment portfolio, which was undertaken solely to grow profits for GSE shareholders. Here's how it works: the GSEs borrow funds cheaply because of their implicit government guarantee, then invest them. The above-market returns are highly profitable — but do nothing to increase American homeownership. In 2000, both GSEs reported that this arbitrage investing accounted for approximately 60 percent of their net income. That's like a local government issuing a revenue bond to build a schoolhouse, then using part of the money to play the stock market. If the GSEs bet right, their shareholders profit. If they bet wrong, the U.S. taxpayer loses.
Compounding this debt growth, the GSEs are also leveraged far beyond what would be permitted for other financial institutions. At year-end 2000, the GSEs' debt-to-equity leverage for on-balance sheet liabilities was 30:1 versus 11:1 for commercial banks. If the GSEs were to meet the standards imposed on commercial banks, they would need to hold $82 billion in capital — or double their current amount. In their current condition, the Federal Reserve would deem them "significantly under-capitalized" — and they would face serious risk of closure. These institutions simply are woefully undercapitalized — a situation that becomes more perilous during a recession.
The GSEs attempt to mitigate the risk associated with their debt through extensive reliance on derivatives. From 1995 to 2000, the GSEs' derivatives exposure increased over 400%. At the end of last year, the GSEs had $749 billion in such exposure. This is a massive amount of derivatives exposure.
As stated above, recent events underscore the riskiness of a derivatives strategy. In the third quarter of 2001, Fannie Mae reported a startling write-down of $10.6 billion in shareholder equity, reducing its equity by 29 percent from where it stood just three months earlier. Fannie Mae took a big position in the derivatives market and bet wrong. As a result, Fannie Mae's debt/equity ratio shot up to 53:1. This approaches a doubling of the GSEs' year-end 2000 leverage ratio of 30:1.
IF THE HOUSING MARKET FALTERS. . . .
I don't think that Greenspan is worrying much about the stock market. If there is one area of the economy that must get his attention, it is the mortgage market. The housing market kept the economy from falling into even greater recession in 2001. This is because of the existence of what is perceived as both safety and liquidity in the mortgage industry's GSE's. Huge pools of capital have been formed to keep home buyers happy. I receive a bulk e-mail (spam) offer for cheap mortgage money every day. This has been going on for at least a year. Investors perceive these markets as low-risk yet paying an above-market rate of return. Borrowers perceive the debt as profitable: use the home now, see it appreciate, and pay off the mortgage with cheaper dollars.
It is perceived as a win-win deal because of the presence of an assumed government guarantee. If this guarantee if ever perceived by investors as an illusion that Congress cannot back up with money, then the breakdown of the housing markets will be far worse than the S&L crisis of the mid-1980's. Liquidity will disappear.
I think the FED is providing liquidity mainly to keep this market solvent. The problem is, the constant increase in credit money continues to distort the capital markets. Eventually, monetary inflation will produce price inflation. Long-term interest rates will then rise to compensate lenders for the expected decline in the dollar's future purchasing power. Equity in mortgages already held by investors will fall. There will be a derivatives-based, Enron-type event, on a scale vastly larger than Enron.
Congress worries about another Enron, yet its own policies are creating the biggest potential Enron-type event in history.
Housing got through the recession of 2001 unscathed. Any time an investment market is perceived as low-risk, capital flows into it. On the one hand, consumers are willing to borrow. On the other hand, lenders are willing to lend long-term. Liquidity looks permanent. The win-win nature of the arrangement is still widely perceived as low-risk. This is the classic mark of a bubble.
My friend John Schaub, who has spent his career in real estate investing, is convinced that we are close to a housing market peak. If he is right, then the biggest bubble of all is looking not just toppy buy poppy.
We are still in a repressed depression. The Federal Reserve System is still in inflationary mode. The war against a free-market-based readjustment of capital values according to supply and demand with monetary stability is still being conducted by the FED. No one in power wants to know what the conditions of supply and demand would be in a world without monetary inflation. So, the inflation-produced distortions in the capital markets are continuing, as usual. The dollar is still depreciating. The annual increase in the median consumer price index jumped from 2% in December to 3.7% in January.
The war against the dollar's purchasing power will continue. When it comes to attaining a world governed by free market pricing instead of monetary manipulation by a handful of central bank bureaucrats, everybody wants to go to heaven, but nobody wants to die.
March 5 , 2002
© 2002 LewRockwell.com