The VIX is down, but the market's fears are still huge

I'm showing this chart for the umpteenth time in order to emphasize a point I haven't made in quite awhile. The chart shows how tight the relationship between implied volatility (a proxy for the market's level of fear, uncertainty, and doubt) and equity prices has been over the past year. As fear and uncertainty subside, equity prices rise. It makes perfect sense, especially since the crisis that set in starting in mid-2008 was all about widespread fears of a global financial collapse.

The point I want to make here, however, is that when the yield on cash is basically zero, and the Fed tells you yet again, as they did today, that cash is going to yield zero for quite some time to come, you have to be consumed by fear, uncertainty and doubt to want to hold on to cash. You have to be extremely, extraordinarily worried that the economy is fragile and likely to suffer a setback; that the housing market is on the verge of another collapse; that the Chinese are going to sell all their bonds and send our yields soaring; that the Fed is going to make a huge inflationary mistake and then have to crush the economy; that Obama and the Democrats in Congress are going to take over the healthcare industry and end up spending trillions more than they are claiming it will cost; that the U.S. government will lose its AAA rating and sink under the weight of many tens of trillions of unfunded liabilities; that no one in Washington, nor any group of concerned citizens in the heartland, will be able to stop this runaway federal government spending train, much less turn it around.

If instead you think that there is a glimmer of hope that catastrophe might be averted; that the economy might manage to eke out a moderate recovery with growth rates of 3-4%; that the political winds are now blowing to the center-right instead of the left; that the housing market, after one year of price and construction stability, can manage to avoid another collapse; that the gradual return of confidence will boost consumer spending and lift the animal spirits of businesses just a little bit; that some people out there have enough of a profit motive to figure out how to put at least some of the economy's many idle resources and workers back to work; then you have no reason to hold cash, and every reason to invest in something other than cash. And as investors who currently hold cash gradually come to understand this line of reasoning, the very act of shifting out of cash will add to the economy's upward impetus and become a self-fulfilling prophecy.

There are many wise investors who argue that the equity market is overvalued, that it has risen too far, that it's another bubble waiting to pop. I take issue with those concerns, because I see plenty of evidence that tells me the market is still very conservatively priced. T-bond yields of only 3.65% tell me that the bond market has virtually no hope of the economy returning to trend growth in the foreseeable future. MBS spreads at historically tight levels tell me that the bond market has almost no fear that the economy or inflation will surprise to the upside. Credit spreads are still at levels that in the past have been the precursors to a recession. Corporate profits are well above average compared to GDP, yet equity prices haven't budged for over 10 years and P/E ratios are only average. On the whole, I think the level of yields, spreads, and equity valuation is only consistent with a belief that the economy will be very weak for a long time, and that downside risks still outweigh upside risks.

So if you are even the slightest bit optimistic, it pays to take some risk these days. And to top it off, that's what the Fed thinks as well, and that's what they are trying to encourage people to do.

Fed's MBS purchase program ending with a yawn

The Fed's program to purchase $1.25 trillion of MBS will end in a few weeks, but for all intents and purposes, and as far as the market is concerned, it is over. The big question all along has been how much these purchases, which began about one year ago, were distorting the market, and therefore how disruptive the end of the program might be.

A quick glance at the top chart here would suggest that the Fed's purchases have played a significant role in bringing down mortgage rates and thereby supporting the housing market; fixed rates on jumbo mortgages have fallen 235 bps since the program was announced on Nov. 25, 2008, and conforming rates have fallen about 125 bps.

But since the Fed has only been purchasing conforming MBS, that doesn't explain the outsized decline in jumbo rates, and the huge narrowing of the spread between jumbo and conforming rates. If the Fed were artificially supporting the prices of conforming MBS, then the spread between conforming and jumbos should have widened, not tightened.

Spreads on conforming mortgages have fallen to their lowest levels ever, as shown in the second chart. Could this be all due to Fed purchases? I tend to doubt it. If the Fed were artificially supporting the market, then the proximity of the end of the support should have already caused the market to push spreads wider, but there's no sign of that yet. Yes, spreads have widened just a bit in the past several days, but that's no more than just a random blip.

I've argued in the past that the end of the Fed MBS purchase program could result in a 30-50 bps widening in MBS spreads. That's still possible, but right now it seems less likely. The explanation for why spreads are so tight is therefore this: spreads are tight because the market expects Treasury yields to be relatively low and stable for a long time, and MBS are therefore very attractive since they offer higher yields with virtually no default risk.

Milton Friedman on the fallibility of monetary and fiscal policy

Just a reminder that neither fiscal nor monetary policy is well-suited to fine-tune the economy. Efforts to do so generally cause more harm than good. I can vouch for the wisdom of these words, having observed the interaction of politics and economics for the past 35 years. Milton said this in 1958, and it is still true today, if not more so:

The available evidence…casts grave doubt on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy....and much danger that such a policy may make matters worse rather than better…The basic difficulties and limitations of monetary policy apply with equal force to fiscal policy.

Political pressures to ‘do something’ …are clearly very strong indeed in the existing state of public attitudes.

The main moral to be had from these two preceding points is that yielding to these pressures may frequently do more harm than good. There is a saying that the best is often the enemy of the good, which seems highly relevant. The attempt to do more than we can will itself be a disturbance that may increase rather than reduce instability.

HT: John Taylor