Positioning for Reflation

On Wednesday, the Fed announced they will be creating money to purchase $300B of treasury debt, an additional $750B of agency MBS, and another $100B of agency debt. The message is clear: the Fed will fill the government debt funding gap, targeting long interest rates lower. 2 to 10 year notes will be the first victims of interest rate assault.

There are long term worries that when inflation does come, the Fed will be in a difficult position, unable to unwind its asset portfolio, as most of it will be held in agency MBS and other somewhat obscure debt (read: illiquid versus treasuries). An investor looking for protection has an easy choice to make, despite it being a relatively consensus view: buy assets that will hold value as global money supplies skyrocket.

Precious metals are the most obvious choice. Amongst most liquid choices (versus relatively illiquid Rhodium, which is another great opportunity) that possess best relative value is silver, which is nearly 40% off last year's peak price (whereas gold is less than 10% discounted). The monetary quality of gold and silver in particular will attract demand, and should move up merely as expectations of global currency supplies continue to increase, regardless of underlying real global economic activity. Since much of silver production is a byproduct of recently decreased base metal mining, the supply fundamentals are relatively supportive, at least to offset decreased industrial consumption.

There is quite a bit of interest in capturing an expected reflation amongst commodity related bets. Oil and natural gas benefit in the long run as supply destruction accelerates. In addition to ramping up of money supplies, look no further than statistics like decreased drill rig counts pointing to higher prices in the imminent future. Shale gas wells, the source of so much new supply keeping rigs busy, generally experience completely diminished production within 2-5 years. Any rebound in the demand side will amplify price recovery. The caveat to the bullish argument comes with the fact that the drill rates can be ramped up quickly, and inventories are at record highs.

Versus North American natural gas, crude oil price increases are more fundamentally dependent on demand revival. As OPEC has cut several million barrels per day, the market now has faith that overhead supply exists in the ground. Until that recently lost demand strongly trends back, even with increased global money supply, I believe crude is less likely to become an object of speculation.

Base metals such as copper will need genuine recovery of economic activity, just as crude. Correlation between energy and base metals should be very high for the next year or two because of this.

To bet on the most meaningful recovery of banks, we need asset price recovery. Increased credit will eventually help this happen. The more the markets see Fed lending at low rates is here to stay, and not merely a 6 month fix, the more the decreased cost of capital will drive the fundamental multiple of all real estate assets up. Time to let these policies soak in will be curative in itself. But it will lead to a paradox: the minute we see believable recovery in prices, there will be (or perhaps there already is) anticipation that Fed funding stops. This should coincide with mark-ups of bank assets and intuitively more aggressive bank initiated lending as banks no longer need to hoard capital. Excess liquidity of these massive proportions (banks currently hold 603B of excess reserve balances) lent into the economy will drive interest rate spreads down while likely moving price levels up. These falling risk spreads could meaningfully offset the lack of Fed credit lines and money printing in a future healthier economic environment.

Now this last paragraph must be the Fed's goal, otherwise it would not be embarking on these policies. One could postulate their way out might be to simply guide base money growth down to target lower inflation rates for an arbitrary period of time (to simply enable population and productivity increases to catch up with the recent spike in money supply). This would probably guide the softest landing, but could make a for a rocky decade of rapidly increasing prices.

In nominal terms, the results of this policy will be anything but 'slow growth' that is projected by so many analysts that cannot help but impose low multiple mood-driven analysis on views of future recovery. Just as easily as this market fell apart from 1200 S&P, we could melt up just as quickly. Changing expectations will lift multiples rapidly, all while actual nominal GDP will have no place to go but up, just as velocity (economic activity) returns to normal trend growth. This means healthier tax receipts to fund current US government debt growth. A higher price level this time around will see higher wages. It really is a different paradigm from the consensus view.

This said, I'm betting with the Fed, long BAC and XLF, picking on some US Steel (X) (anticipating actual economic recovery), and am bullish precious metals. Long treasuries must be reiterated as a viable position. When Japan embarked on quantitative easing earlier in the decade, long maturity bond markets ramped towards bubbly price levels. Even now, Japanese 30 year bonds are under 2%. With the US 30 year at 3.61% post-announcement, I see no more obvious opportunity. To me, just as before the Fed announcement, the market is a bit in denial. Options and futures expiration may be playing some role in the recent somewhat muted price action. The Fed will keep buying more, expanding these programs outward, and because of this, it is reasonable to target a 1.5-2% 30 year. Just as Pimco has been so aggressively pushing, buy what you know the government is committed to buying.

Comments

[Dave Wrixon:]

The Fed is filling the funding gap, because others have made it clear they won't. If you read between the lines a little this is not all good news. Indeed, it might be an act of desperation that simply allows others a window of opportunity to get their money out.

Mar 22 07:25 AM

[ebschor:]

RIght now banks are borrowing money at close to 0% and lending it out around 5%. It is impossible for them to not be profitable. Banks traditionally do well when the yield curve is upward sloping and rates are low or heading down. Furthermore, the liabilities side of a bank's balance sheet is traditionally short-term (deposits), while the asset side is traditionally long-term (mortgages).

The one thing we can all be certain of, thanks to the helicopter Bernanke Fed policies, is that interest rates will rise (they can't go "much" below zero - remember Japan in 1998). And they will likely need to rise FAST to try to stave off hyperinflation.

Banks traditionally do poorly when rates are rising since the liabilities side adjusts upward much quicker than the assets side. For example, depositors will require higher rates for deposits while mortages are fairly fixed in their rates unless homeowners refinance (why refinance to a higher rate?), or move, or new home buyers enter the market.

It is near impossible to hedge against this interest rate move even if you know it's coming. One way to do it is to have other sources of profit that can help offset the rising interest rate environment (for example, BAC's acquisition of ML - probably why Lewis calls it a long term darling).

The Fed is setting us up for either high inflation, quickly rising interest rates, or both. If you're going to invest in financials, look for banks that have more than just lending going for them. BAC, GE, etc.

Also, precious metals are a great investment with Bernanke in charge. Gold is a great hedge against inflation. Take this example: I borrow $100,000 from my home equity line of credit at around 2.5% - 3%. I use that $100,000 to buy gold. Inflation kicks in. That $100,000 cannot purchase nearly what it purchased when I took out the loan but I still only owe the bank $100,000. The bank does not "adjust" what I owe based on some inflation rate. Gold will have increased in value - probably substantially. Sell off enough gold to pay off the loan. Keep the remaining gold as a "reward" for forecasting the inflation to come.

Mar 22 08:32 AM

[Mad Hedge F...:]

This is where the big money will be made. Traders looking for the Next Big Play are keeping a laser like focus on two key commodities. Chinese stockpiling prompted copper to break out of its recent trading range to the upside to $1.70, taking lead producer Freeport McMoran (FCX) up 30% on the week. Crude rose 15% to a high of $46. These impressive moves happened during a week when global equity markets were in complete freefall. This suggests that the bulk of the world’s growth will be in emerging economies, and that the next round of commodity buying will be even more ferocious than the last. Since I believe that the future is all about the ascent of hard assets over paper ones, this is music to my ears.

Mar 22 10:14 AM

[User 380687:]

Michael,

I would love to get your opinion on something that I believe you eluded to in a previous article.

Background.....All I hear about the past few weeks is how the Fed is "dooming" the United States to an tremendously damaging amount of inflation as soon as we come out of this mess and into some sense of a recovery. This discussion of future inflation is scaring everyone into buying commodities, TIPS and scaring them from many equities.

As you stated in an earlier article, supply and demand drive all elements of economics. The supply of dollars and the quantity of goods drive asset prices. The supply of dollars is driven by the Fed and how they enable banks to create money through lending programs. Traditionally, an easy multiplier has been that banks create 10 times their equity...assuming a 10% equity ratio. Over the past 15 years, this has evolved to be much more aggressive. As banks have become national and international (it wasn't but 20 years ago that banks were all small and state based banks) they have found ways to justify operating at 7% capital and sometimes less. Additionally, with off balance sheet vehicles, they have been able to leverage well above the traditional ratio. Lastly, the "shadow" banking system existed as well to highlight this leverage. We have heard stories and seen evidence of firms operating at 40 times leverage when we all know traditionally this couldn't be healthy.

As a result of this increase in supply of lending, based on the same equity cache, there was more money supply. This of course drove up asset prices, which drove up the desire to make more assets (real estate for example and fake assets like a CDS when one doesn't own the underlying debt it is insuring. That is just the creation of an asset with available cash), which could keep up with the demand and huge growing supply of money so the asset values continued to rise.

Question - So, what I am wondering, and assuming, is that the destruction in money supply by the deleveraging back to the lending ratios known to be safe, secure and reasonable has been tremendous. If the money quickly created in the past year and in the coming year by the Fed is greater than this lossed supply, I can agree with the critics claiming that we will have tremendous future inflation. However, if the amount is less than what was destroyed, isn't it fair to assume that the inflation of the future will not have anything to do with this gov't led creation of money, but the natural growth of the economy. Again, assuming that the money created by the Feds actions is less than the amount taken out of the system through this massive de-leveraging, aren't we going to be just fine on the inflation front?

Why isn't anyone else asking this question or doing the math to see where the destruction of money compares to the creation of it.

Clearly, we have had massive destruction lately which is causing rapid deflation....we want the Fed to hyper inflate right now. I would much rather my house lose 20% in value than 75%!!!!

Does this question make sense?

I need help doing the math as I don't have access to the right info to determine one side or the other.

Mar 22 11:16 AM

[TWOfold:]

Money Supply = Cash + Credit


Cash is being printed by the Fed.
Credit is being destroyed by the Markets.

If cash is printed faster than credit is destroyed, then we get inflation.
If cash is printed slower than credit is destroyed, then we get deflation.

So ask yourself if credit leverage is increasing or decreasing. How about stock market margin credit? Is it higher or lower today at DOW 7000 than when we had DOW 14,000?

Credit card limits higher or lower today than in the past?

Home equity loan credit availability higher or lower today than when homes were worth 25% more last year, or 40% more back in 2006?


And the basic question: which is larger: supply of cash or supply of credit?

Mar 22 11:45 AM

[Michael B. ...:]

Remember the credit-created portion of money supply is not made of available credit, it is used credit. The whole crux of the measurement problem is that the effective credit multiplier has dropped, and conventional metrics can't really tell you how far it has fallen. It is clear if you look at M2 money that the destruction of credit money does not show through these aggregates, otherwise you would see a sharp negative spike down (I believe it is still approximately positive y/y, even if you factor out monetary base growth).

If the Fed's knew how much money had been precisely destroyed, this whole problem could be easily solved by printing and filling in the hole directly (capitalizing the banks). Instead, they are creating programs that are the equivalent of a blind man stumbling around in a china shop. Eventually, they will get it right (and even go past). Since these financial markets have self-reinforcing mechanisms, I imagine that once the trend reverses, it will reverse euphorically, and we will get large one time moves in inflation rates. Those won't be sustainable - we may get 10-20% annual inflation rates for a year or three, but eventually the move will subside. Rate of money creation is just important as actual amount created. If they achieve their goal, they can just subside the rate. The difficulty here is the lag time between all of these behaviors.

Remember, if the Fed achieves an upward revaluation of houses by altering the fundamentals (by changing the long term cost of capital), banks presently insolvent are sitting on a gold mine.

All I can say is this: imagine the credit multiplier is not 10x right now, but 5x. Simultaneously the money base doubled (and will soon have tripled). At the moment, the short run (1 year), we're barely keeping our head above water preventing deflation. In the long run (2 years out), as the supply of liquidated homes clears, we are left with the same monetary base and the fed unable to mop a majority of that liquidity up (since it primarily made up of long term MBS, treasuries, and CDOs traded for treasuries in early Fed programs). The new money base will be 3-4T while the multiplier will recover from 5x to 10x, lets say. Suddenly real aggregate money supply has the means to double once credit starts moving. By the time the recovery starts, it will probably be a lot more difficult to position.

Mar 22 01:51 PM

[Northstar10000:]

The Fed just cut a deal with China so they can gracefully exit our bonds via limited future purchases and mild liquidation. Sorry if you think they did it to keep rates low for us the poor americans.
Fooled again partner.

Mar 22 02:38 PM

[Rob Viglione:]

Let's caveat your statement by noting this "graceful exit" is anything but benevolent. It is born of necessity as the Chinese will not continue the historic pace of Treasury purchases, and the Japanese are about to have their own current account turn negative. Both our #1 and #2 creditors will be cutting our line of credit in the near future.

The timing of the cut in the line of credit could not be worse, with the President's budget projected to be $9.3 trillion in deficit over the next decade.


On Mar 22 02:38 PM northstar10000 wrote:

> The Fed just cut a deal with China so they can gracefully exit our
> bonds via limited future purchases and mild liquidation. Sorry if
> you think they did it to keep rates low for us the poor americans.
>
> Fooled again partner.

Mar 22 03:06 PM

[User 380687:]

Michael,

I agree with your numbers and statements. The question I want to explore a bit more is how much contraction we have had in the supply of money on the street chasing assets. If we had hedge funds with 3% capital and 97% leverage, and the model shifts back to a more traditional 20% capital and 80% leverage, assuming no destruction of capital, this is a reduction of 6.66 times in liquidity if my numbers are correct. This of course represents a 32 to 1 ratio of leverage. What I don't know is what was the average that our world was away in before this crisis.

This would lead me to believe that the increase in cash supply by the Fed of 2 or 3 times still could be offset by the destruction of previous leverage.

I understand your point that it is quite murky knowing what in fact has been removed from the global economy as so much was off the books, so to speak. But, everything I read makes me believe that the market liquidity could have averaged 7% capital for 93% borrowings. Moving back to a 20% capital requirement for every dollar borrowed would be a drop of a factor of 3 in money supply.

Assuming this is accurate, the Fed could inflate the supply of money by a factor of 3 to even the supply and demand back.

Mar 22 07:03 PM

[Jim Bob Jones:]

If it has to be inflation so be it! We're supposedly waiting for private capital to show up to the party but guess what? No ones coming to the party yet. If Private capital (the rich)is on the sidelines and the poor and middle class are bankrupt it seems to reason that the gov has to pump money in just to keep us going. Maybe what we need is a socialistic country with a few dictators that run the Walmart kids out of town. Last I read they were raking in about 20 billion a piece per year while beating the hell out of their suppliers and workers.

Mar 22 07:51 PM

[Gedankonomist:]

Did Hosea prophesy about the FED and it's efforts at "monentizing the deflation?"

"8:7 For they have sown the wind, and they shall reap the whirlwind"

Mar 22 07:53 PM

[mcnoodles:]

I agree, I would like to see some figures on how much 'money' has been destroyed. Also with rampant inflation now anticipated I don't see how real estate (regardless of current value) can be a bad bet.

Also we assume that this inflation is unprecedented and that the thought of $50000 gold or $100 cokes is ridiculous. It already has happened. My Grandmother told me the other day that her first yearly salary would not be enough to take the family out to eat these days. So is it inconcievable that one day a slap up meal for 2 will cost $50,000. No...its happened and I guess we might just get there quicker than the 60 years my Granny had to wait....

So long as you can keep your job, a jumbo mortgage has never seemed so appealing....


On Mar 22 11:16 AM User 380687 wrote:

> Michael,

> Why isn't anyone else asking this question or doing the math to see
> where the destruction of money compares to the creation of it.<br/>
>
> Clearly, we have had massive destruction lately which is causing
> rapid deflation....we want the Fed to hyper inflate right now. I
> would much rather my house lose 20% in value than 75%!!!!
>
> Does this question make sense?
>
> I need help doing the math as I don't have access to the right info
> to determine one side or the other.

Mar 23 12:17 AM

[Fighting Yoda:]

Michael:
I would disagree with your reasoning; available credit is quite different from used credit. Both are rapidly decreasing. Nobody wants to borrow – buy house or a car, nothing but deep discounted stuff. There are too few credit worthy borrowers who the banks would lend to. The demand and availability of credit will continue to decrease with job losses and recession.

Fed has been trying to inflate for more than one and half years – unprecedented availability of liquidity – but nonetheless – deflation. The reason there is no demand. Almost all these tactics were used during the great depression, to no avail.

If quantitative easing (money printing), zero interest rates, stimulus (govt. spending) etc could prevent deflation Japan would not have the lost decade. Japan did all of the above to no avail. They could not spur demand for credit. Japan was in much better shape – the world economy was booming (unlike now), Japan had a trade surplus, and Japanese households were not under debt (had lot of spending power).

US consumer would continue to retrench – from 72% of GDP to the average of 65% - that is a loss of $ 1 Trillion on GDP.
It would be deflation all the way.



On Mar 22 01:51 PM Michael B. Krause wrote:

> Remember the credit-created portion of money supply is not made of
> available credit, it is used credit. The whole crux of the measurement
> problem is that the effective credit multiplier has dropped, and
> conventional metrics can't really tell you how far it has fallen.
> It is clear if you look at M2 money that the destruction of credit
> money does not show through these aggregates, otherwise you would
> see a sharp negative spike down (I believe it is still approximately
> positive y/y, even if you factor out monetary base growth).
>

Mar 23 01:05 AM

[norom:]

The velocity of money is lower than its ever been relative to quanitity. could this be the result of reduced spending or something more sinister like...say...a less even distribution of dollars.

If rich people have all the money there will be a lower velocity, as one rich person may spend less frequently than 100 poorer people with the same basic needs.

The one thing all these articles seem to miss is the present situation amongst consumers. We are busy comparing numbers to last year and years prior and crying wolf. Something has fundamentaly changed and no one has seemed to have nailed it down, at least based on what I've read so far.

Mar 23 08:11 AM

[alexmi:]

Why is rhodium great opportunity? I got 1oz when ask was around $2000/oz and someone said that production cost is around $4600/oz. Now it is around $1000 and not very liquid. When will the demand for rhodium pick up? Jewelery demand is down and car demand is down.

Mar 23 08:34 AM

[Harbert24:]

Good comments re: deleveraging and the money supply. I am surprised that there isn't commentary re: the velocity of money. One would assume that it, as with deleveraging, significantly impacts the situation and further dampens economic activity. Comments?

Mar 23 08:42 AM

[Steve in Gr...:]

You might go out to Kitco.com and look at the history of rhodium in relation to gold. If you look at 2004-2008, rhodium/gold is roughly 6, and the ratio trended up over that period. In 6/08, it was roughly 10. In 12/08-1/09, it was roughly 1. All the non-gold noble metals (silver, platinum, palladium) went down in relation to gold during the 2H08 contraction, but none quite as much as rhodium. When industry begins to recover and PPI begins to reflate, why wouldn't the ratio go back to 10? Of course, I'm assuming gold will go up too, so this might be quite the move.


On Mar 23 08:34 AM alexmi wrote:

>
> Why is rhodium great opportunity? I got 1oz when ask was around $2000/oz
> and someone said that production cost is around $4600/oz. Now it
> is around $1000 and not very liquid. When will the demand for rhodium
> pick up? Jewelery demand is down and car demand is down.

Mar 23 10:31 AM