Tuesday, April 15, 2014 - Yellen in the Lions' Den

Yellen in the Lions' Den
by Sinclair Noe

DOW + 89 = 16,262
SPX + 12 = 1842
NAS + 11 = 4034
10 YR YLD - .01 = 2.62%
OIL - .22 = 103.83
GOLD – 24.20 = 1303.40
SILV - .41 = 19.66

Stocks were all over the place today. We started with triple digit gains for the Dow Industrials, dipped to triple digit losses, then back into positive territory for the close with the major indices closing just below their morning highs. This kind of volatility does not engender confidence; it does warrant caution.

The utilities sector gained 1.3% and finished ahead of the other groups, extending its YTD gain to 11.8%; the biotech ETF added 1%, while the broader healthcare sector advanced 1.1%.Tech stocks have been beaten up quite a bit over the past couple of weeks. The Nasdaq 100 Tech Index (NDXT) is down 7% since April 1st. The Nasdaq Composite has exhibited weakness, but not to the point of meeting the definition of a correction; it would take a slide to 3,922 to mark a 10% fall from the March 5 closing high at 4,357; a 10% pullback from the March 6 intraday high of 4,371 would be achieved at 3,934.

The Labor Department’s Consumer Price Index, or CPI, increased 0.2% in March after posting a 0.1% increase in February. Excluding volatile food and energy prices, core prices ticked up 0.2%.Prices rose 1.5% for the 12 months ending in March. That is up from February’s year-over-year reading of 1.1%. Core prices moved up 1.7% over the 12 months, up from 1.6% in February.

A major factor in both headline and core CPI in March was a 0.3% increase in shelter costs. On an annual basis, housing costs were up 2.7%, the fastest pace in six years. The indexes for medical care, used cars and airline fares also increased in March. Apparel prices rose for the first time this year. Household furnishings and recreation prices dipped in the month. Real or inflation-adjusted hourly wages, meanwhile, fell 0.3% in March to $10.31. Real wages have risen 0.5% over the past 12 months. So, we’re not seeing wage-push inflation.

The big difference has been housing; shelter costs account for a full third of the basket of goods and services tracked in the consumer price index. In the past year, consumer prices excluding shelter have risen just 1%, an indication that inflation pressures are subdued outside of housing.

The old rule of thumb was that rents and utilities combined should not take up more than 30% of household income. A new study by Zillow finds 90 cities where the median rent, not including utilities, was more than 30 percent of the median gross income. A study by Harvard finds that nationally, half of all renters are now spending more than 30% of their income on housing, up from 38% of renters in 2000. Part of the reason for the squeeze on renters is simple demand; between 2007 and 2013 the United States added, on net, about 6.2 million tenants, compared with 208,000 homeowners.

For many middle and lower income people, high rents choke spending on other goods and services, impeding the economic recovery. Low-income families that spend more than half their income on housing spend about a third less on food, 50% less on clothing, and 80% less on medical care compared with low-income families with affordable rents.

Federal Reserve Chairwoman Janet Yellen is scheduled to go to the lion’s den tomorrow, making a speech before the Economic Club in New York. Today, Yellen took the show on the road, speaking to a banking conference in Atlanta, she said current rules on how much capital banks must hold to protect against losses don't address all threats. She said the Fed's staff is considering what further measures might be needed, and such measures would likely apply to only the largest and most complex banks. Yellen said the Fed would review the likely effects of imposing stricter rules on banks. That probably plays better in Atlanta than Manhattan.

At some point Yellen must press the case of the Fed as regulator and in control of the banks rather than vice versa. Now, any threat or hint of threat at tighter control is only likely to result in the big banks moving risky behavior into less regulated areas of the financial system. These areas are often called the shadow banking system.

One area of concern for Yellen and her Fed colleagues is the short-term debt markets. So, Yellen would like to see the banks hold more capital; the idea being that it would make them less susceptible to a run. Now, when you hear that the Fed Chair is concerned about a bank run, this is not the old fashioned bank run, with customers lined up at the door of Bedford Savings and Loan and Jimmy Stewart trying to persuade his neighbors that their long-term loans will provide sufficient liquidity to short-term needs.

The problem goes to an area of regulation overlooked, or perhaps neglected by Congress and the various regulators; specifically derivatives; and after the collapse in 2008 what the regulators did was to concentrate the risk of the derivatives among four major Wall Street banks; the big banks just got bigger.

If you’ve ever stood in a teller’s line at the bank, you may have noticed the FDIC sticker, which reads, “Backed by the full faith and credit of the United States Government.” Effectively, that means, if the assessments the FDIC charges the banks to meet the needs of the Deposit Insurance Fund run short, the taxpayer must prop up the fund to make insured depositors whole. On top of that promise, the National Depositor Preference statute came into being in the US in 1993, making all deposit liabilities at insured depository banks preferred over the claims of other creditors.

The serious wrinkle in the plan is that if one of the four largest banks in terms of derivative exposure was put into receivership by the FDIC, its derivative counterparties have the legal right to assert a super-priority claim on the liquid assets of the bank, jumping in front of depositors. Typically, the counterparties start grabbing their collateral before the public is even aware of the problem.

The Deposit Insurance Fund probably has about $40 billion in assets. With the Dodd-Frank prohibition against further taxpayer bailouts of banks, where would the FDIC turn to stem a run on one of the largest banks?

Under the Federal Deposit Insurance Act, the FDIC, acting as a conservator or receiver for an insured depository institution, has the right to “disaffirm or repudiate any contract or lease.” But here again, Wall Street has the FDIC between a rock and a hard place. Let’s say there was a reenactment of 2008 and Citigroup was sliding toward insolvency. If the FDIC repudiated Citigroup’s derivative contracts, it would set off a panic and contagion at the other three largest banks holding trillions in derivatives, creating an even larger financial tab for the Deposit Insurance Fund to meet. Banks taking deposits of public funds are required to pledge collateral against any funds exceeding the deposit insurance limit of $250,000. But derivative claims are also secured with collateral, and they have super-priority over all other claimants, including other secured creditors. The money is gone before you get to the teller’s window.

But before you lose any sleep over the prospects of another, potentially far worse global financial meltdown, take solace that the economy is recovering. There are a few more jobs, and consumers are spending, and the housing market is improving, and the Fed has been pumping money into the economy to foster this growth of credit. Right?

Well, one of the lessons we’ve learned in the recovery is that there is a difference between credit growth and economic growth. And absent real and sustainable economic growth a gap eventually forms as credit growth expands. The more one spends on a place of shelter the less one has to spend on other things, and overall demand is reduced. Bank lending finances the purchase of existing assets, particularly with reference to real estate. Such existing asset finance does not directly stimulate investment or consumption, but it drives up asset prices, and that leads lenders and borrowers to believe that even more credit is both safe and desirable. The expansion is like a rubber band that can only stretch so far.

So, it seems the greatest danger to the current economy are the very mechanisms that are still used to “fix” the last financial crisis: money-printing and asset-purchases by major central banks around the world that unleashed a global flood of liquidity for over five years. Most of this massively huge pile of cash has landed in the laps of banks, institutional investors, hedge funds, private equity firms, and other speculators has not been used to boost lending to the private, and thus has not contributed to the recovery of the real economy. Instead, it has been poured into financial assets and has artificially goosed their valuations.

This money sloshing through the system and the persistence of zero-interest-rate policies have driven desperate investors ever further out into “all risky asset classes,” including emerging assets, junk-rated corporate credit, Eurozone peripheral debt, and equities. That buying pressure has inflated their valuations even further. And in the emerging markets, it led to an appreciation of exchange rates.

And when the rubber band breaks, there will be a derivatives bet on it. When the derivatives default, the counterparties, operating in an unregulated shadow banking world of their own design, do not have sufficient capital to pay off the derivatives bet, and so the first thing they’ll do is raid the bank vaults, and when that dries up, the short-term credit markets freeze, because none of the counterparties have faith that the other party has any more in capital reserves than they have.