Tuesday, July 14, 2009

Market expects a very weak recovery

This chart shows the historical rate for 3-mo. Libor (green) and the market's expectation of the rate going forward (blue). Since Libor typically tracks the Fed funds rate rather closely, the blue line is a good proxy (if you subtract 30-35 bps) for where the market expects the funds rate to be. A funds rate of 1% only makes sense to me if the economy is struggling and at risk of further recession or deflation. By that standard (admittedly subjective), the market expects the economy to be in pretty bad shape for the next year. It's not until later next year that the market expects the Fed will be able to lift the funds rate above 1.5%, and even then, 1.5% is historically very low, so the market really doesn't see any significant improvement in the economy for at least a year or two. By the end of 2011 the market expects the funds rate to be about 3%; compare that to the average funds rate of 4.25% over the past 20 years, and you see how gloomy the market is.

There are plenty of good reasons for the market's lack of optimism, as I've detailed in numerous posts concerning the abysmal state of fiscal affairs and the almost total lack of truly stimulative policy. I've thought for some time now that bad fiscal policy was a key source of the market's pessimism and the economy's failure to recover earlier this year, since bad fiscal policy (e.g., higher taxes, wasteful spending projects, tax rebates) can certainly slow the economy's recovery. In short, pessimism is justified, and the market appears to have priced in some pretty pessimistic assumptions about the economy's future prospects.

One key to investing is to decide whether one's own views differ significantly from the views that are incorporated in current pricing. It's also important to avoid the mistake of projecting recent trends too far into the future. Lots of things can and probably will change in the next few years. Fiscal policy currently looks like a slow-motion train wreck: spending is going to be climbing for years, tax rates are going to soar, and the deficit could be measured in the trillions of dollars for as far as the eye can see. But is all that really going to happen, or might there be some important changes for the better? Fiscal policy this year has turned out to be far worse than almost anyone (including me) expected last year; might fiscal policy be better next year than it is today?

I'm an optimist, and I am encouraged by the growing signs that Obama's policies are not sitting well with the public. It doesn't take a high IQ to realize that raising taxes is a bad idea when the economy is weak. It shouldn't be too hard for people to realize that you don't fix our healthcare problem by turning the whole thing over to the government. The support for the new global warming religion is waning, and the number of dissenters is increasing daily. Blue Dog Democrats are feeling very uncomfortable with the healthcare and cap and trade bills.

I also think that despite all the bad news, this economy has been grappling with problems for two years now, and it wouldn't surprise me to see more news such as Goldman Sach's spectacular earnings announcement today. People and companies adjust given time. The profit motive is powerful. Big changes produce big opportunities. Virtually nobody is sitting still.

I see plenty of healthy fundamentals that confirm that positive changes are underway: swap and credit spreads have contracted significantly; commodity prices are up across the board; implied volatility is way down; global trade has restarted; retail sales have increased this year; equity markets are up strongly from their lows; weekly unemployment claims are down; manufacturing activity has improved; corporate layoffs are way down; deflation risk has all but disappeared; M2 velocity has stopped declining; housing is bottoming; confidence is rising.

In short, I think being optimistic can pay off.


Public Library said...

Goldman Sachs is what is truly wrong with this country so it saddens me to see your unabashed enthusiasm for their supposed "prowess".

Without a bailout by the government (direct/indirect), Goldman Sachs does not exist so there should be nothing celabratory in their ability to steal from the people post this reality.

Public Library said...

And not everyone is bearish. Plenty forecasting 3-4% growth including your President...

"Our forecast for the second half of this year and all of next year is that real (inflation-adjusted) economic growth is going to average more than 4% at an annual rate, well above the consensus, which expects below-trend growth of about 2%."


Chad said...

Public Library,

"Without a bailout by the government (direct/indirect), Goldman Sachs does not exist so there should be nothing celabratory in their ability to steal from the people post this reality."

As I recall, GS and other viable banks were forced to take TARP money to run cover for the weak (i.e. Citi).

GS already paying back the TARP money - WITH interest AND less than a year after everyone thought the entire financial system was going to collapse - tells me they didn't need any sort of bailout and would've existed just fine without one.

Public Library said...


Do your research or just read below. GS would have evaporated with AIG had it not been for taxpayers...

"Last fall, in the wake of the failure of Lehman Bros., Goldman transformed itself from an unregulated investment bank into a bank holding company so it could accept deposits. Like other banks, Goldman participated in the TARP program. On Oct. 28, Goldman sold $10 billion in preferred stock to the government, which bears an interest rate of 5 percent through 2013 (after which the rate bumps up to 9 percent). Like other TARP recipients, Goldman received capital on pretty easy terms. Just a month earlier, when Goldman raised $5 billion from investor Warren Buffett, it sold preferred shares that carried a 10 percent interest rate. (At the same time, Goldman also raised $10 billion in a public offering of stock.) The difference between borrowing $10 billion at 5 percent and borrowing $10 billion at 10 percent-in other words, the value of the government subsidy-is $500 million per year. David Viniar, the chief financial officer of Goldman, has made noises about paying back the TARP funds soon. But the firm hasn't made any moves to do so yet.

But wait-there's more! Last fall, concerned that financial firms could raise funds only by issuing expensive debt to the likes of Buffett, the Federal Deposit Insurance Corp. established a program to guarantee new unsecured debt sold by banks. Many banks felt they didn't need to participate. (Here's a list of those that have opted out.) While the FDIC discloses the amount of debt that has been issued under the program (about $250 billion by the end of January), it doesn't disclose which firms have tapped into this program. In November, Goldman was the first company to tap the program, issuing $5 billion in three-year notes at a 3.367 percent rate. On March 12, it sold another $5 billion. In all, the company says it has sold $21 billion in such bonds. Thanks to the government guarantee, and accounting for fees, Goldman is saving several hundred million dollars per year in interest.

And there's still more! A good chunk of the money taxpayers gave to AIG as part of the bailout found its way to financial institutions-including Goldman Sachs. Here's the full list of AIG counterparties, which documents payments made by different entities. AIG's securities lending unit paid Goldman $4.8 billion, Maiden Lane III (the entity created to unwind credit default swaps) paid Goldman $5.6 billion, and AIG has posted another $2.5 billion in collateral to Goldman. Goldman, and many other firms, made the mistake of a) buying insurance from a company that, it turned out, couldn't make good on its insurance contracts, and b) borrowing securities from, and lending securities to, a company that essentially went bankrupt. In normal bankruptcies, firms in these in situations have to get in line with other creditors and ultimately settle for a fraction of the amounts they're owed. As Eliot Spitzer pointed out, because the government didn't let AIG formally file for bankruptcy, Goldman, and so many others, have instead been made whole."

Scott Grannis said...

GS benefited most because its competition evaporated.

Public Library said...

Again, because the Government led by ex Goldman execs cherry picked how this would shake out.