Ramblings of a Portfolio Manager

Bullard vs. Buffett


The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.

Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.

The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.

The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.

So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.