Ramblings of a Portfolio Manager 1-19-2010

Hey Lloyd, will you autograph the dashboard of my Chrysler Sebring?

Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.