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Saturday, October 31, 2009

Doug Noland lays out the likely course of unwinding and reflation

The consensus view holds that the unprecedented – and ongoing – intervention is fundamental to crisis resolution and sustainable recovery.  Noland counters here that such massive market intrusions always create the backdrop for excesses and the next crisis.  The Fed is fighting the last war.  Instability still looms, as well as orthodox myopia.
Mortgage Madness:
by Doug Noland
Prudent Bear
October 24

October 22 – MarketNews International (Steven K. Beckner):  “Federal Reserve Vice Chairman Donald Kohn said Thursday that prices of mortgage-backed securities are likely to fall when the Fed eventually begins selling MBS from its portfolio.  He gave no indication when that might be. But Kohn, echoing earlier comments by New York Federal Reserve Bank President William Dudley, said the Fed may well avoid any losses on its asset holdings, as well as on its liquidity facilities.  ‘These programs may be unwound without loss,’ Kohn said, commenting from the audience at a Boston Federal Reserve Bank conference. He said the Fed entered the market ‘when prices were depressed by high premiums’ and so ‘the Fed could finance without risk.’ That in turn will mean they can be ‘unwound without loss.’”

Federal Reserve holdings of mortgage-backed securities (MBS) this week exceeded those of Treasuries for the first time ($777bn vs. $774bn).  The Fed is now well past half way through its program to purchase $1.25 TN of MBS – which is slated to be completed in March.  Federal Reserve Credit jumped to $2.172 TN, up from less than $900bn to begin September 2008.

Mr. Kohn is too optimistic.  My view is that the Fed is paying too dearly for these mortgage securities and large losses are inevitable.  And while Fed-induced price distortions are not having a big impact on U.S. housing, they exert enormous influence on finance and markets globally. I don’t expect the Federal Reserve’s MBS portfolio to be unwound anytime soon.  Instead, the Fed will live with this exposure for years to come – and will likely expand the scope of mortgage exposure in future crisis periods.  And I expect Washington’s conglomeration of mortgage risk will at some point make or break the dollar.

In the five years preceding the Lehman collapse, benchmark Fannie Mae MBS yields averaged 5.60%.  A very strong case can be made that Fannie, Freddie and the entire mortgage Bubble pushed mortgage borrowing costs artificially low.  Over the past year, as the Fed has been building its Trillion dollar MBS holding, benchmark yields averaged 4.30%.  Fed officials have been talking confidently of their success in unwinding various liquidity facilities that were implemented during the crisis.  Yet the most meaningful government intervention runs unabated throughout the mortgage marketplace.  Between the Fed, Fannie, Freddie, Ginnie Mae, and the FHA – it’s full speed ahead into the uncharted waters of mortgage market nationalization.  It is not easy to envisage a viable exit strategy.  Few contemplate the costs.

The consensus view holds that this unprecedented – and ongoing – intervention is fundamental to crisis resolution and sustainable recovery.  I counter that such massive market intrusions always create the backdrop for excesses and the next crisis.  Most believe inflation does not these days pose a risk and that loose monetary policies no longer foster financial leveraging and other dangerous excess.  Indeed, most see this as an atypical backdrop with little risk to fiscal and monetary looseness.  Many argue that sticking with unprecedented policy responses for an extended period is the appropriate course to combat deflation.  I contend that each government-induced reflationary period comes with its own set of inflationary biases, market responses, excesses, and risks.  But they’re not going to jump up and down and make themselves obvious.

Yet some aspects of policy risk are becoming more apparent.  This week, China reported 8.9% third quarter GDP growth.  The Chinese economy has bounced back convincingly, and Bubble dynamics have returned in full force.  Increasingly, there is a case for a surprisingly strong recovery throughout Asia and the emerging markets.  Crude oil this week traded to $82.  The Goldman Sachs Commodities index jumped 2.2%, increasing y-t-d gains to 48.8%.  Global reflation has attained a head of steam - and the Bernanke Fed is falling only further behind the curve.

Of course, the counter-argument is that U.S. unemployment is 9.7% and the recovery is fragile.  The Fed’s dual mandate – price stability and full employment – certainly provides good cover for sticking with ultra-loose monetary policy. Besides, few see meaningful risk inherent with Fed policymaking anyway.  Nonetheless, the bottom line remains that U.S. monetary policy and the weak dollar are the dominant forces powering inflationary forces globally.  

It is a fundamental tenet to my thesis that the unfolding reflation will be altogether different than previous reflations.  The old were primarily driven by Fed-induced expansions of U.S. mortgage finance and Wall Street Credit.  Our mortgage industry, housing and securitization markets, and Bubble economy were at the epicenter of global reflationary dynamics.  The new reflation is fueled by synchronized fiscal and monetary stimulus across the globe.  China, Asia and the emerging markets/economies have supplanted the U.S. at the epicenter.  U.S. housing is completely out of the mix.  

Those fixated on old reflationary dynamics look today at tepid U.S. housing markets, mortgage loan growth, consumer spending, and employment trends and see ongoing deflationary pressures.  The Fed is wedded to the old and is positioned poorly to respond to new reflationary dynamics.  A stable dollar used to work to restrain global finance – hence global inflationary forces.  The breakdown in the dollar’s stabilizing role has unleashed altered inflationary dynamics – forces that the Federal Reserve disregards.

Two open questions come to mind.  First, when will the new global reflationary dynamics meaningfully impact the U.S. inflation outlook?  Second, what impact will the prospect of foreign central bank tightenings have on U.S. market yields?

U.S. market yields are not priced for a global reflationary backdrop.  Notions of a “new normal” and a central bank content with an extended hiatus tug U.S. and global yields artificially down.  Fragile U.S. underpinnings have global markets convinced both that the Fed will err on the side of ultra-loose monetary policy and that dollar weakness will constrain global policy tightening.  The brunt of global reflationary forces may have shifted overseas, but the U.S. remains firmly at the epicenter of market distortions.

And nowhere do price distortions have more impact than in the mortgage arena.  While Washington and the media focus on Wall Street compensation and regulatory reform, an incredible amount of mortgage risk quietly shifts to the American taxpayer.  Beyond the Fed’s $1.25 TN of MBS, Fannie’s and Freddie’s “books of business” continue to expand, while the FHA and Ginnie Mae balloon their exposure to risky mortgages.  In the short-run, this process reduces systemic stress and boosts market liquidity.  The markets remain quite happy with this dynamic – for now.

The secular bear thesis and the next round of financial crisis don’t require a wild imagination:  The U.S. economy underperforms in the new global reflationary backdrop.  The Fed stays ultra-loose for too long – along with timid Chinese and other central bankers around the globe.  The U.S. fixed income marketplace – especially MBS – becomes too predisposed to artificially low Fed funds and market yields.  Historically low U.S. yields – in the face of booming Asia/emerging markets – continue to weigh on the dollar.  Dollar devaluation and global dynamics set the stage for an inflationary surprise.  And any jump in inflation fears would find U.S. bond and mortgage markets especially poorly positioned, with the U.S. economy extraordinarily vulnerable to any spike in yields.  A crisis in a rising rate environment would be especially problematic for a Fed and Treasury confronting Trillions in mortgage Credit and interest-rate risk.  Foreign holders of our mortgage paper could lose big if market prices and the dollar move against them simultaneously.  And it’s safe to say that the Federal Reserve wouldn’t be profitably unwinding its MBS portfolio.

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