Lighthouse Investment Management

Letter to Investors

November 2013

Letter to Investors - November, 2013

Page 1

Lighthouse Investment Management

Contents
Conversations with Myself: Does The Fed Print Money? ............................................................................. 3 Figuring Out The Fed ..................................................................................................................................... 8 Anecdotal Evidence: The Back Office.......................................................................................................... 11

Letter to Investors - November, 2013

Page 2

Lighthouse Investment Management

Conversations with Myself: Does The Fed Print Money?
In this imaginary argument, two antagonists (P for "pro" and C for "contra") argue over financial questions. Today's topic: is the Fed printing money? Asked if he was printing money, Bernanke replied "Not literally"1. P: Of course the Fed is printing money! C: It depends. P: What do you mean? C: In the US, coins are produced by the US Mint, and dollar bills by the Bureau of Engraving and Printing. P: But the bills are issued by the Federal Reserve C: The Fed issues currency by shipping it to a bank and charges that bank's account with the Fed. Positive bank balances are a liability for the Fed, and so is currency in circulation. So the Fed merely exchanges one liability for another. P: Okay, but I am talking about the trillions of dollars printed by what they call Quantitative Easing. C: Yes, so what about them? All the Fed does is buying existing bonds from the market. Primary dealers exchange bonds for a credit at the Federal Reserve. They receive a low-yielding asset in exchange for a higher-yielding asset. P: I'll give you an example. On March 28, 2013, the Treasury auctioned off $13bn of fresh 7year bonds2. On April 4, $3bn of that same bond were bought back by the Fed. C: And? P: The Fed is absorbing 100% of net new issuance of government bonds with more than 10 years maturity! And just because the
1 2

Ben Bernanke, semi-annual testimony before the House Committee on Financial Services, July 2013 1.125% US government bonds due March 31, 2020, CUSIP 912828UV0

Letter to Investors - November, 2013

Page 3

Lighthouse Investment Management

Fed lets those bonds enter the secondary market for exactly five business days, you won't call it "printing money"? C: "Monetizing the debt" would only apply if the Fed bought these bonds directly from the Treasury. P: By absorbing 100% of net new issuance and keeping yields artificially low the Fed is enabling the government to run huge deficits with impunity. When the Treasury hands out more money than its revenues, it spends that money into existence. C: Still no printing money. P: This is semantics. Because of five business days! Explain to me: Why does the Fed go through primary dealers, which take their cut, instead of buying directly from the Treasury? C: Credible deniability. That's all. The Fed can deny monetizing the debt, since it is not purchasing bonds directly from the Treasury. The Fed has to be careful, since some politicians want to "end the Fed". P: A complete farce. Five days in order to "pretend" no monetization of debt has taken place. C: What do you prefer? Mass unemployment, civil unrest and no bank open for business? P: That's what [former Treasury secretary] Paulson tried to make us believe in the fall of 2008... Can we agree on the fact that the Fed has helped the government to run higher deficits at lower costs than would otherwise have been possible? C: Temporarily. P: And now the Fed has painted itself into a corner. Look what happened when they started talking about 'tapering' purchases just a tiny bit. The bond market went ballistic. They won't be able to stop. C: The deficit has already declined from 11% to 4% of GDP. The primary deficit [excluding interest payments] is down to -1.7% of GDP. At some point the Fed will be able to reduce bond purchases, and the market will like it. P: But the economy is not improving. The Fed has tried its tricks for six years now, to no avail. Where is the credibility? Credibility is the only asset a central bank has. They have the monopoly over issuance of Letter to Investors - November, 2013 Page 4

Lighthouse Investment Management

money. Nothing but pieces of paper, or digital entries, deriving their value only from the fact of being legal tender, and the implicit promise of not producing infinite amounts. Let me give you an example: let's say your boss gives you a promotion, a title (no monetary value). You go home and proudly tell your wife. She laughs at you, since she learned that every single employee got the same promotion. It has no value. Things are only valuable if there is a certain scarcity. C: What does this have to do with the Fed? P: If the Fed loses credibility, people will doubt its promise to keep from printing infinite amounts of dollars. C: You can still go into any store and buy stuff. They must accept your dollars. P: Yes, but at what price? C: Ah, the hyper-inflation fears. Where is your inflation, if I might ask? The Fed's balance sheet has expanded from $800bn in 2007 to $3.8 trillion. And core inflation is at 1.7%. P: The money created by the Fed is, for now, lying idle. The banks can't lend it. Instead, their excess reserves at the Fed went from zero to $2.2 trillion. But once demand picks up, they will lend. And, with the multiplier effect of fractional reserve banking, this could translate into a $22 trillion demand shock. Don't tell me this won't lead to inflation in a $17 trillion economy. C: Banks are not reserve-constrained. They simultaneously make a loan and credit the customer's account. There is your deposit. They don't need reserves to make loans. P: That's some MMT [Modern Monetary Theory] voodoo. This is not how it works. C: If there was demand for loans, banks would satisfy the demand regardless of the level of excess reserves at the Fed. P: Okay, let me ask you this: if money printing, or however you want to call it, really worked, why haven't we done so since a long time ago, saving millions of unemployed from their misfortunes? C: When private sector demand has a cyclical shortfall, the government should step in and temporarily replace it. P: Ah, the old Keynesian school. But Keynes also demanded that government debt incurred to be reduced in good times. C: Look, the US is at 100% debt-to-GDP ratio. It's elevated, but it's been higher in the past, and we didn't go bankrupt. P: That was in times of war. C: What about the "war on terror"? Isn't that a war, too? Letter to Investors - November, 2013 Page 5

Lighthouse Investment Management

P: After the Second World War, overall debt, including households and the banking sector, was by far lower than today. C: The US cannot go bankrupt. It has the privilege of having the world's reserve currency. We can always print more money.

P: Wait until the first auction of Treasury bonds fails. Foreigners are buying Treasury bonds since they don't know what else to do with all their dollars. We are one failed auction away from bankruptcy. C: That's not true. The Primary Dealers (an international group of financial institutions3) are required to bid in every auction4. P: So the banks would get filled with stuff nobody wants to buy, and you expect this to work? C: Worst case, Primary Dealers can access the "Primary Dealer Credit Facility" at the Fed. From 2008 to 2010, $9 trillion loans were made. P: The US has already defaulted on its debt three times in the past 80 years. C: How so? P: The US defaulted on its external obligations in 1790. In 1933, Roosevelt ended the gold clause (holders of US government bonds had the option to demand repayment in gold). In 1971, Nixon closed the 'gold window' for foreign Central Banks. In 1979, the US Treasury couldn't pay maturing Treasury Bills on time, twice. Over the past 100 years, the dollar has lost 98% of its purchasing power.

Bank of Nova Scotia, BMO, BNP, Barclays, Cantor, Citi, Credit Suisse, Daiwa, Deutsche, Goldman, HSBC, Jeffries, JP Morgan, Merrill, Mizuho, Morgan Stanley, Nomura, RBC, RBS, SG, UBS 4 "Administration of Relationships with Primary Dealers", Federal Reserve Bank of NY, January 2010

Letter to Investors - November, 2013

Page 6

Lighthouse Investment Management

C: That's called inflation. P: Inflation is simply 'default by another name'. C: Well, what do you prefer, a little bit of annual inflation or a severe deflation with collapse of the banking system and 25% unemployment, like in the Great Depression? P: Don't you remember the 1980's? Inflation jumped above 14%, and Paul Volker had to hike rates to 19% in order to break the vicious cycle. People were struggling to pay their mortgages, and pensioners saw the purchasing power of their pensions erode. C: That was the oil price shock. Oil went from $3.50 per barrel to $39.50 within seven years. P: The oil producing countries hiked prices because they realized they got paid in quickly devaluing dollars. It was a dollar crisis. C: So which one was first, the chicken or the egg? P: Let's leave it at this. We'll continue next time.

Letter to Investors - November, 2013

Page 7

Lighthouse Investment Management

Figuring Out The Fed
Since 2008, the Federal Reserve has been trying one program after the other in order to kick-start the US economy. It culminated in currently buying around $1 trillion of bonds a year. But economic growth remains weak. Why does the Fed continue its ultra-lax monetary policy despite evidence it doesn't help much? The people at the Fed are not stupid, so there must be a rational explanation. This is an attempt to figure out their 'game plan'. In a debt-based economy (like ours), GDP grows only if the overall pile of debt is growing. As long debt doesn't grow faster than GDP, the system is stable. You may grow debt faster than GDP for a while (depending on your starting point), but eventually you reach a point where the whole thing becomes unstable. There is no magic number, but anything north of 100% debt-to-GDP probably makes you prone to mayhem. The US is at 100%. Here's how debt and GDP have been growing over past periods (see chart). From 1950-2000, GDP grew slightly faster than debt, so smooth sailing. In the 13 years since the millennium, debt grew more than twice as fast than nominal GDP. And over the past six years, the fork opened even wider. It doesn't take a genius to see the problem with the current situation. Two elements make up nominal GDP growth: real growth (volume, green bars) and inflation (price, red bars). For debt purposes it doesn't matter how the growth is achieved. If real growth is insufficient, you could, theoretically, make up the difference via inflation. We would currently 'need' around 10% inflation. Of course, in that case, yields on 10-year bonds wouldn't remain at under 3%. Unless the Fed declares a 'yield cap'. It could, for example, promise to buy any bonds yielding more than 3% (they have done so in the past). But that would imply a negative real return of 7% for holders of those bonds, and the Chinese and Japanese probably wouldn't keep their trillions of bonds in that case. The Fed would simply have to purchase all outstanding Treasury bonds. So this plan would probably not work. On the fiscal side, there is some hope. The federal budget deficit has been reduced sharply from 11% to 4.4% of GDP (thanks to spending cuts by sequestration, tax increases and a slowly growing GDP). Let's be optimistic and say that the US will be able to get by with a 4% budget deficit. That means nominal Letter to Investors - November, 2013 Page 8

Lighthouse Investment Management

debt will increase by that amount every year. In order to keep the debt-to-GDP ratio stable, you'd need 4% nominal GDP growth. There are two ways to achieve 4% nominal GDP growth. The best case is 3% real growth plus 1% inflation (scenario A, see table). If you can only get to 1% real growth, you need 3% inflation in order to get to 4% nominal growth (scenario B). However, if you have deflation, the same 1% real growth gets translated into a nominal GDP decline of 2% (scenario C). This is the horror-scenario for governments and central bankers. Because it makes debtto-GDP grow even if you manage to have a balanced budget (which is highly unlikely, since deflation will make banks go bankrupt, requiring government bail-outs). Also, there is no way for the government to tax deflation (you can tax salary increases, but not real income gains during deflation). Local governments also suffer from falling home prices as taxes are based on home values. The US must achieve 4% nominal GDP growth. However, real growth is only around 1-2%. That leaves scenario "B". The Fed must engineer 3% inflation. The Fed tries and tries. It might seem as if it ran out of tricks, but there are a few cards up the sleeve (dark orange in table):

Importing inflation: If you can't get 'home-grown' inflation (due to stagnant real incomes), then importing is the only option. A 20% decline in the US dollar would probably boost inflation by 2%-points. That might work, unless other central banks fought back (which they are). Letter to Investors - November, 2013 Page 9

Lighthouse Investment Management

Yield cap: The Federal Government currently spends $438bn in interest payments on $16.7trn of debt, yielding a 2.6% average interest rate. If interest rates soared to 10%, interest payments would quadruple to $1.7trn (for comparison: the current annual run rate of the primary deficit s only $289bn). In order to keep interest payments from exploding, the Fed would have to declare a 'yield cap'. It wouldn't allow yields to rise above, say, 3%, by promising to purchase any bonds yielding above. This would create negative real yields, which is a big incentive to borrow and/or spend. Dept repudiation: The Fed currently holds $2.1 trillion in Treasury securities. After paying some dividends ($1.6bn in 2012), the Fed remits its annual profit to the Treasury ($88bn). So most of the interest earned on Treasury bonds goes back to the government (reducing the budget deficit). It's as if the debt didn't exist. The Fed is a private organization, but was created through an act of congress. Some argue that one part of the government (Treasury) owes debt to another part of government (Fed). So the Fed could simply 'cancel' those 2 trillion in Treasury securities, and nobody would 'get hurt'5. A different option: Trying to manipulate the velocity of money (all money printing has been neutralized by a decline in velocity). The Fed would have to change people's behavior with psychological tricks. It would have to deliver an inflation shock by promising 2% inflation (which it does), but delivering 3% or 4% inflation. This might motivate people to increase their borrowing and

Fed Chairmen/woman Volker, Greenspan, Bernanke, Yellen: Shrinking size, growing aggressiveness in terms of monetary policy spending.

CONCLUSION: The Fed's main objective, perversely, is to push inflation up to 3% (unless real economic growth picks up considerably). The remaining tools include dollar devaluation, yield cap and debt repudiation.Given its recent failure to 'taper' the pace of bond purchases it is unlikely the Fed will be able to do so in the near future.
5

An admittedly provocative statement, the discussion of which must be postponed for future letters.

Letter to Investors - November, 2013

Page 10

Lighthouse Investment Management

Anecdotal Evidence: The Back Office

True story. I was working on the trading floor of an unnamed bank. Here was the action. A lot of shouting, millions moved. On a different floor, the back office. Those poor souls had to sort out the mess created by traders, dealing with multiple settlement systems, failed trades and booking errors. In a laudable attempt to improve mutual understanding, every trader had to spend a few days in the back office. Many traders had inflated egos and treated those colleagues with little respect. I decided to be especially nice to compensate. So I pass by the desk of a senior back office worker, let's call her Heidi. She was in despair over a problem. I asked what the matter was. She explained that when balancing out currency positions, she ended up with a negative number instead of a positive. Glancing at her screen I could see she was using what looked like a home-made excel spreadsheet to manage the bank's currency positions. Jokingly, I recommended multiplying the result by "minus one", and moved along. Later, passing again by her desk, she was exhilarated and thanked me for my 'solution': "It worked!" I didn't have the courage to shatter her belief in my capabilities.

Letter to Investors - November, 2013

Page 11

Lighthouse Investment Management

Any questions or feedback welcome. Alex.Gloy@LighthouseInvestmentManagement.com

Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that accounts managed by Lighthouse Investment Management or the author may have financial interests in any instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and we might not necessarily disclose updated information should we discover a fault with our analysis. The author has no obligation to update any information posted here. We reserve the right to make investment decisions inconsistent with the views expressed here. We can't make any representations or warranties as to the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions, misinterpretation or misuse of any information posted is excluded. +++++++++++++++++++++++++++++++++++++++ All clients have their own individual accounts held at an independent, well-known brokerage company (US) or bank (Europe). This institution executes trades, sends confirms and statements. Lighthouse Investment Management does not take custody of any client assets.

Letter to Investors - November, 2013

Page 12