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Tuesday, October 12, 2010

Do As I Say Not As I Do....

Over the Columbus day weekend I had time to reflect and as it does so often my mind turns to the markets and trying to figure out what is going on behind the scenes.

As a parent we have all fallen into the trap of "do as I say not as I do"; whether it is not coming to a complete stop at a stop sign or failing to plan ahead. Our children look to us for guidance and emulate the things that we do regardless of what we say. The same is true of the Federal Reserve and their governors and open market committee, which I like to call the open mouth committee.

The FED is a huge believer in MOPE(Management of Perspective Economics) which they accomplish either by actual policies , intervention or plain old jawboning(floating trial balloons).  Using MOPE they either talk about the economy and other things the FED can affect to achieve a desired outcome. The FED uses MOPE just as a parent does to get their kids to act a certain way except the FED is influencing the public(there are plenty that would argue that kids and the public are the same thing). For example, when the FED feels the economy is flying too high there will be speeches hinting at rising rates and cooling things off prior to any action.  MOPE can be implemented in both blatant and subtle ways; think back to Chairman Greenspan pontificating that people should go out and get a variable rate mortgage.  One can question why a FED Chairman would be recommending a reckless course of action when mortgage rates were very low, given that it is perceived that the FED is looking out for the economy and thereby Americans. Greenspan must have known that at some point that rates would rise and many people would get hurt. Instead he was looking to push the economy ahead and he knew full well that the increased level of borrowing would pump the economy, and dam the consequences.

There are many examples of MOPE, two that come to mind right now are, the bank stress tests, and changing the FASB mark to market rules. Both of these items were highly touted and had an impact on the economy, however, neither truly revealed anything nor corrected the underlying problems. The bank stress tests were too simplistic and did not take into account true worst case realistic scenarios. The results of the bank stress tests to no one’s surprise showed the banks in good shape, was shouted from the rooftops, just to inspire confidence in the system. FASB the group charged with setting the standards for accounting in this country used to inspire confidence and trust. FASB is one of the reasons that the US markets have developed to the highly sophisticated level of today, because there was a sense of trust that companies’ feet were held to the fire by the standards of accounting set. In the wake of the 2008-09 financial meltdown the venerable FASB reduced its credibility by changing the “mark to market” rules for valuing the banks “toxic” securities, which gives a true reflection of the value to “mark to model” or as some appropriately call it “mark to fantasy”. The mark to model method essentially gave the banks a free pass to make up values for their toxic balance sheets making the banks look much more solid and solvent then they truly are. The perception in the market could now be managed that the banks were on better footing since they were not required to write down their stupid and miscalculated bets seeming stemming the giant write downs. The mark to model regulation gave rise to the market rally and the FED and government successfully used MOPE to create the “extend and pretend” economy as it has been deemed.

Flash forward to the present and we have the FED actively using MOPE. The FED chairman and multiple people at all levels of the FED have been touting the QE2(quantitative easing) and targeting higher inflation for a couple weeks now as the economy had been seen hitting the skids. As a result the markets took off particularly in the resource sector. The QE2 talk coupled with the US putting pressure on the Chinese to revaule the Yuan sparked a run in the market. The markets have run up stocks and resources because QE2, which is a fancy name for money printing, implies inflation through currency debasement. The current MOPE policy is working so well that the FED fears that the markets will run away from them creating too much inflation.

Now the FED is using MOPE to reign in the rally as evidenced by Janet Yellin speaking out on Monday during a sleepy market due to Columbus Day. "It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking," Yellen said. The FED and Yellen know that the markets will take this a sobering note and will cool down at least for the short term. The reason Bernake and company were speaking out about QE2 and low rates as far as the eye can see is because they wanted to juice the markets in hopes of a spillover effect to the real economy. The market was “expecting” QE2 so it was pricing it in and Yelllen was used to slow down or deflate the balloon so to speak. You see dear reader the way MOPE works is that stating or threatening an action can have a desired effect. The FED will do its  QE2 magic but they wanted to buy time hence all the speeches about how the inflation rate is too low. The FED knew the market would interpret this as QE2 is imminent and begin to price it in, then having Yellen throw a little cold water on the party does three things for them: 1) it gives them time until the FED meets in November without the economy starting a tailspin, 2) it also gives cover for the FED to act in November thereby at least giving the perception of not acting and influencing the mid term elections and 3) when QE2 is announced the markets will have priced in part to all of it so they will remain buoyant but not become irrational.

The result of MOPE is similar to the concept of “buy the rumor sell the news” in stocks. For example with gold if you want it to rise you can print money and it will accommodate. If you want a rocket launch in gold just threaten to print money and it will go up twice as fast. The FED will execute its QE2 policy, but they are trying to control the situation so that it doesn’t runaway in to a blow off top. In the short term they will be successful using this course of action until the markets sniff out that things are out of control. Once things get completely beyond the FED’s ability to implement their MOPE strategies we will have real problems. The irony here is that Yellen’s statement “excessively easy monetary policy, involving ultra-low interest rates and an expansion in the Fed's balance sheet, could create big problems down the line” is very true if not prophetic.  I believe that Yellen and the rest of the FED know that it is unavoidable as the imbalances from the 30+ yeas of boom and credit expansion have not been corrected. When the FED loses control of MOPE is the tipping point, it could be a day, week, year or 2 years there is no way to know but we do know it is coming. Then we will all be MOPEing unless you have taken steps to protect yourself as best as possible.

Also as a quick follow up to further bolster my case from a prior post "Municipal Jenga" comes the following two articles out today:

The first is "US Cities Face Half A Trillion Dollars of Pension Deficits" which comes to us courtesy of the Financial Times via CNBC.com. At a state and municipal level, governments are increasingly finding themselves between a rock and a hard place and they can't print money like the FEDs nor are they going to be able to tax the populous in to oblivion.

The second article also brought to us via CNBC.com is "California to Sell 24 Government Buildings for $2.3 Billion". The state of California is desperate to plug the budget problems and this is the latest in their efforts.  I would be leery of getting involved in California in particular. Even with the 7th largest economy in the world, if it were a country, California's expense and revenue structure is so out of whack that no good can come out of this situation. There are just plain better places for your hard earned capital than California

These are just two of the latest examples of why I wrote the blog post warning about the dangers of investing in the Municipal Bond space at this point in time. While Municipal Bonds provided a safe haven in the Great Depression, this time around investors may find themselves on rough seas instead of a safe port. Almost every state faces these types of problems and for the time being the risk level in Municipals is way to high for my comfort level. As always do your own due diligence.

10 comments:

Ben And Timmy’s Not So Excellent Adventure…. | Moneta Advisors, LLC. said...

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