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August 01, 2005

"Real" Nervous Indigestion

Hey Fella With The Million Smackers, And Nervous Indigestion. Rich Fella Eatin' Milk And Crackers, I'll Ask You One Question...As was completely expected, fully discounted and widely anticipated by the markets, we now have Fed Funds rate increase number nine under our belts for this cycle. Don't you worry, number ten is just days away at this point. And as of now, the Fed Funds futures market is "telling" us there's a near 100% probability of another hike to come on September 20. Mark your calendars! Very quickly, we thought we'd provide a bit of broader perspective on just how monetarily "tight" the Fed really is at this point. As we've discussed many a time lately, we need to remember that credit being created outside of the US banking system, over which the Fed has little to no control, is still very substantial, regardless of what happens with the Funds rate at any point in time. In fact, this is really one of the first Fed tightening cycles where the credit markets have completely overridden Fed actions by voting and acting to keep long rates low, fueling the housing bubble. It's absolutely a clear sign that the Fed is much less in control of the broader credit markets than may be widely believed.

And in our minds what's really important when looking at just how "tight" the Fed is at any point in time is to home in on real interest rates, not the nominal illusion of the stated Fed Funds rate. Let's take a two second trip down memory lane, shall we? In the following chart we're looking at the history of the Fed Funds rate in addition to the year over year change in the CPI over close to the last half-century. By and large, the Fed Funds rate has been kept above the moving growth rate of inflation over time with the exception of a very few instances.

What will help put the picture above into a bit more perspective are the numbers. In the table below we've broken this data down into average experience by decade and then a cumulative average for the 40 year period 1960-1999. By decade, the data varies. And for some very good reasons.

As you can see, the 1960's and the 1990's look quite similar. On average, the Fed Funds rate has been held at approximately 210 basis points above the ongoing rate of CPI inflation. Always trying to catch up until Volcker took the reigns. The 1970's is a special case in that the Fed was chasing inflation. And chasing hard as the decade drew to a close. The Fed was not being accommodative on purpose in the 70's by showing on average an equivalency between the Funds rate and the rate of change in CPI. It was chasing an inflation acceleration experience of a generation. An inflation bulge the magnitude and speed of which it had not dealt with before in its entire history as an institution. In the 1980's, the opposite was true. Shot with a pretty darn good dose of inflationary pressure paranoia, the Fed was sincerely tight throughout most of the 1980's, keeping the Funds rate well above the CPI. Let's face it, and as you can see in the long term graph of the CPI and the Funds rate, under the Volcker regime, inflationary pressures were put into a strangle hold by the Funds rate.

But as we try to look at what might be considered "normal" for the level of a Funds rate over the rate of CPI reported inflation, we believe the 2.1% number is very justifiable. Not only was it virtually the exact experience of the 1960's and 1990's, but it just happened to be the on the money average for the total forty year period 1960-1999. Where are we today? With a Fed Funds rate at 3.25% (soon to be 3.5%) and an implied forward inflation rate of 3% (as measured using the average TIPS yield YTD), we have a spread of 0.25-.5%. C'mon, if that isn't theoretical zero, then what is it? And today, the Fed is not chasing runaway inflation, at least not as measured by the headline CPI. Bottom line? On a real basis, the Fed is still wildly accommodative. Wildly. Money is still free, so to speak. What the Fed has essentially done over the last 13+ months is bring the Funds rate from negative territory to near zero on a CPI inflation adjusted basis. Is that the new age definition of neutrality? Add to this the significant non-bank credit creation of the moment we have been yakking about for some time now and we still find ourselves in an environment very much conducive to speculation, excessive risk taking, etc. Not that this is bad, per se. It simply is what it is and we need to incorporate it into our thinking appropriately.

One of the arguments being put forth today suggesting that the Fed has perhaps already tightened too much is the fact that certain domestic money supply measures have been slowing rather dramatically on a rate of change basis over the recent past. Although historically this has been a pretty darn good indicator that perhaps the Fed has pushed it a bit too far, we need to remember that our present circumstances are quite different than past experience. And maybe dramatically so. The M's (the measures of money supply) absolutely pick up what is happening in the banking system. No question about it. But if you've been watching closely, you already know that the banks are under pressure in terms of C&I lending. The flattening of the yield curve is kicking sand in the faces of their net interest margins. Perhaps you'll remember from our prior discussions little tidbits like the fact that the asset backed securities markets have been the leading provider of domestic mortgage credit over the past 18 months. This bypasses the banking system virtually entirely. So although the money supply numbers are certainly useful, we suggest that in a changing world, we need to adjust our thinking and blind reliance on prior cycle guideposts. Lastly, when it comes to watching the rate of change in money supply, we also need to remember what we are currently comping against, and that's phenomenal prior growth in the monetary aggregates. So we have a mushroom cloud in monetary growth over the last three, four, five years, and now the growth in money aggregates slows relative to the mushroom cloud days. That doesn't mean the money is gone, and in no way has it contracted in absolute terms. As always, the proper question should be, "compared to what"?

Not that everyone has to agree with us by any means, but if one is accepting of the fact that the Fed is far from even having begun real monetary tightening, and that meaningful banking system and especially non-banking system credit creation is still the order of the day, then we suggest that it becomes especially important to question and analyze any type of macro economic slowing that is either present or may be to come in what remains a very accommodative environment. If the economy slows into the second half of the year, which we have been expecting, it will be happening within an ongoing environment of monetary accommodation well above what has been seen on average over the last four decades+. Not exactly a rosy scenario for the current economy relative to inflation adjusted monetary policy. And just what would it say about the character of the current economy? As you know by sheer simple math, IF the Fed Funds rate today were 2.1% above the CPI stated rate of inflation, we'd be looking at something near or just above the 4.5-5% level. The Fed is implicitly telling us that the economy could not handle this type of a real or nominal Funds rate by their actions, despite all of their talk about a growing economy in public communications. As always, when it comes to the Fed, actions speak much louder than words.

So what else does this type of loose "real" monetary policy of the moment also accomplish in the current environment? It keeps a lot of money chasing whatever asset or asset class happens to be inflating out of desperation for what investors in that asset class perceive to be "investment" return. And, of course, this very act of chasing the inflating asset simply reinforces the ongoing inflation experience of the asset class itself...for a time. You'll remember one of our old tried and true market truisms - money always chases the inflating asset, until it stops inflating, of course. That was true of stocks late in the prior decade. So will it also be true with residential real estate at some point? Of course. It's the "when" that's the important and unknown variable. For all we know, it may already be starting.

One last table that we consider absolutely striking, if nothing else. Below, we're looking at the difference between the Fed Funds rate less the year over year change in CPI at the conclusion of every Fed rate peak for cycles of the last four and one half decades. It's marked at the month the peak in the effective Fed Funds rate was first realized at or near each tightening cycle end. To be honest, when we went back over history to develop the data in the table, it left us shocked relative to where we stand at the current time.

Remember, with a Fed Funds rate currently at 3.25% and an implied inflation outlook of approximately 3%, we're looking at a like differential of 0.25% (to become .5% w/ the 8/9 rate increase). Relative to what you see above in terms of past experience, how can anyone even be suggesting that the Fed is done or near done for this cycle? How can that even be an issue, let alone a ballpark analogy by a Fed head from Dallas? Let's put it this way, if the Fed is even close to done in terms of tightening rates at the current time, it will be one of the most accommodative monetary policy stance relative to CPI at the end of a Fed tightening cycle ever seen in the last half century at the very least, if not ever. In other words, "what tightening cycle?" in real, or inflation adjusted terms. There hasn't been any!!!!!!

Very quickly, as you can see in the table above, we also included a column of numbers that is the Fed Funds rate less the "core" CPI rate of change at each interval. We did it just for perspective given the fact that so many commentators of the moment focus on the core (less food and energy prices) inflation rate. Cutting right to the bottom line, it really delivers the same basic message as the Fed Funds rate less headline CPI. Our current experience up to this point is quite unlike anything seen in prior cycles, assuming we're approaching some type of end point. And, as you know, we haven't made a peep in this discussion about how the headline CPI may be meaningfully understating the true character of inflation in the US economy.

As we have been suggesting for some time now, we need to keep a very sharp eye on the rate of change in credit creation ahead. In the "non-real" interest rate tightening cycle we have been living through, it's borrowing that has supported the economy plain and simple. It absolutely has to continue and accelerate for the economy to push forward if the Fed never intends to really tighten at all, as they have not done over the last 13+ months. Through this supposed tightening cycle to date, the Fed has allowed the asset-inflation dependent economy to continue to flourish. At this point, and with talk of the Fed potentially calling it quits sure to heighten ahead, we're left with a situation where borrowing and asset inflation (the two twin sisters) has to be kept alive and growing. We humbly suggest that it's in the rate of change of the rate of change in household and broader systemic credit acceleration as to where we are going to find our answers as to just where the macro economy is headed. You can count on the fact that we'll be watching closely.

You Silly So And So, With Your Pile Of Dough, Are You Havin' Any Fun? If Other People Do So Can You, Have A Little Fun...One area that definitely deserves observation is mortgage refi's. We won't go into what they have meant for the consumer economy stateside over the past half decade. We've been through all that before. But in the spirit of learning to watch for signals of change in the credit acceleration environment, here's what we believe to be one important anecdote.

As you may have seen recently, refi and new mortgage apps have not taken off to the moon as they did in the past when mortgage rates dipped as we have recently experienced. Here's a question for you in terms of refi's, anyway. Is that all there is? Have a good look at the chart below. The recent dip of the ten year Treasury (as the reference rate for conventional mortgage financing) below 4% helped drag conventional mortgage rates to below 5.5%. As is clear, there has been only a momentary blip in refi activity as of this point. For an economy dependent on asset inflation (housing) and monetization of that asset inflation, this isn't going to do the trick in terms of helping to move consumption (and by default GDP) forward. Remember - watch the rate of change in credit acceleration. We think it's the KEY to what lies ahead.

Is it really all doom and gloom? No, but what stands out like a sore thumb is that households in general have really not improved their balance sheet lot as it applies to household real estate over the last decade of phenomenal gains in prices. In other words, the asset inflation in real estate has been monetized to a great extent. We've prepared a table below that looks at the percentage of equity in household holdings of residential real estate over the last ten years. Alongside is the year over year change in residential real estate prices from the OFHEO (government agency regulatory body) data. As you can see, over the whole US since 1996, prices of homes have doubled on a compounded rate of return basis. Now clearly this is aggregate data. We know that many areas have probably tripled. But over the ten year period where nationwide prices have doubled in aggregate, the average US household today still has roughly 56% real estate equity relative to market value. There has been no improvement in this measurement at all over the last ten years.

Is this necessarily a terrible thing? Of course not. But what it does embody is a bit of a dichotomy. Certainly there are a number of folks who have never borrowed another nickel of mortgage debt over the last 10 years that probably have equity of 60,70,80%+ or more in their homes based on current market values. And, in like manner, there are plenty of folks who probably have equity ratios of 10% or less, even at this point. It's all a blend. If homes in aggregate were worth $1 in 1996, the numbers tell us that today they are worth $2. Debt in 1996 was 43.4 cents and equity 56.6 cents. At today's $2 value and 56.3% equity ratio, debt is now 87.4 cents and equity is $1.126. Dollars and cents equity and debt have both doubled over this period. Simple. In aggregate, no one is worse off or better off in terms of percentages of debt and equity in household real estate. So just where is the "wealth effect", so to speak? Yes, absolute dollar equity has doubled. That's great. But so has absolute dollar debt relative to market values. These numbers also suggest it was the debt acceleration that fueled price acceleration. They literally went hand in hand in percentage growth terms. As you know, the debt is now chiseled in marble. But the equity portion of the equation will either benefit or be beheaded by always moving market values ahead. It's simply the nature and character of any balance sheet interplay.

Prices are always a guess. And we won't even attempt to hazard one looking into the future. As always, our role is to provide perspective. And perspective lies below. You'll remember charts we have shown you in the past regarding the total market value of the stock market relative to the benchmark that is GDP. Well here's a little peek at the current market value (as of 1Q 2005) of household real estate values at market relative to GDP over a very considerable period of time.

Although it's extremely clear to us that the Fed is nowhere even near being tight in real terms when it comes to current monetary policy, there are a few good reasons as to why. First, energy cost increases over the last few years act a bit like monetary tightening itself. By crowding out what would otherwise be consumption dollars, they detract from economic growth potential in what is primarily a consumption driven US economy. Secondly, there is no question that the Fed has had to compensate for lack of job and wage growth during the current cycle. Without wage acceleration, just how far can the Fed push the limit in terms of hamstringing the consumer by truly tightening monetary policy with "real" rate increases? But unfortunately the loose real monetary policy has simply fed debt acceleration as being the compensation factor for lack of greater wage gains. How does this relationship apply to real estate? Just have a look.

Clearly, you and we have heard it said a million times that nominal debt levels in the current environment can naturally be higher than what we have experienced in the past given the low nominal interest rate environment we experience. It sounds good on face value, but to be honest, that argument just doesn't hold water at all when looking at the real world. Directly from the Fed is the household debt service ratio updated through 1Q 2005. At a new record high, just where's the big benefit of low nominal interest rates? As is absolutely clear, during the current cycle, and completely unlike prior cycle experience, households have done absolutely nothing to reconcile either their balance sheets or income statements. In our eyes, it's simply one of the fallout consequences of a wildly stimulative monetary and credit culture environment fostered by none other than the Fed themselves. During and after every recession, except the most recent, of the last quarter century at least, households have acted to reduce their aggregate debt service obligations. Our present experience has been to uncharacteristically crank these ongoing obligations up a notch and to achieve all time new highs in the household debt service ratio.

So, where to from here? We'll give you a quick hint, if it's not higher, that wouldn't be a good thing for the consumption and housing driven US economy. In the 2Q GDP report last Friday, quarter over quarter real GDP grew $92.7 billion. Of that, consumption increased $63.4 billion and fixed residential investment (housing) increased $13.8 billion, collectively accounting for 83% of the net quarter over quarter increase in real GDP. Moreover, fixed residential investment as a percentage of GDP rose to 6%. For you history buffs, that's a new fifty year high. How about one last historical marker before we part company? Along with the GDP report last week came the Employment Cost Index for 2Q. The year over year change in wages and salaries recorded it's lowest level EVER. Let's see, new lows on wage growth and new highs in housing as a percentage of GDP. Now do you know why we're so hung up on monitoring the rate of change in household credit acceleration? Just as long as we're clear on what's really driving the US economy at the margin.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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