Economic & Market Update: December 15, 2008

“Week-End At Bernie’s”

Chip Norton, Managing Director of Fixed Income & Economic Analysis

Last Week:

PPI:                                                         Falls 2.2% on energy and price declines

Retail Sales:                                        Down 1.8%

Dow:                                                        8629

S&P 500:                                                879

VIX:                                                        54

3-mo TBill:                                          0.01% 

10-yr                                                       2.55%

3-mo Libor:                                         1.87%

AAA 10-yr Municipal:                     4.43%

Dollar/Euro:                                       1.35 – Significant weakness

Oil:                                                          $49.7

Economics This Week:

Date      Item                                  Est.                     Comment

12/16    FOMC                               50 bps cut          Fed losing options

12/16    CPI                                    -1.5%/0             Inflation is dead for now

12/18    Leading Indicators         -0.5                      Continued downtrend

Just when you thought the carnage in the financial markets can’t get worse you wake up to read about the most amazing ponzi scandal in the history of the markets. What makes this story so fascinating is the fact that Bernie Madoff was able to deceive some of the most sophisticated investors, advisors, institutions and attorneys in the country.  The numbers are obviously staggering with the leveraged loss supposedly ranging someplace near $50 billion on about $18 billion in underlying equity.  I leave the unfolding facts of the story to the Wall Street Journal and others who have done a great job peeling back the skin of this onion.

The question of how he pulled off this scheme without detection by so many folks doing high levels of due diligence is beyond explanation, but the bottom line of the story seems to be that his charm and associations provided the credibility and access ultimate to money looking for a low volatility, high return home.  Madoff’s house of cards has fallen and many investors will most likely lose millions, but the ramifications go far beyond Madoff.  In this observer’s opinion, this case may put a nail in the coffin on any hedge fund investment that doesn’t have, at minimum, 100% transparency.

One could go further to say that this will sour investments in most alternative funds for some time and that the pendulum will now swing rapidly back to more traditional investment choices. Indeed, there’s little need for a manager to invest in esoteric private investments with long lock ups and sophisticated structures to achieve high potential returns. A quick look at simple corporate bonds at 850 bps over Treasuries, or even high yield corporates at nearly 2000 bps over Treasuries, show “traditional” opportunity. And that’s not even considering the value in traditional equity investments. 

The movie “Week-End at Bernie’s” is centered around the morbid tale of a guy named Bernie that’s dead, yet the characters pull off a huge party propping him up as those he’s still alive.  The story ends when the game just can’t go on anymore and they have to admit he’s dead. This may now be the case for the wild world of secretive hedge funds. Even greats like Paul Tudor Jones and Ken Griffin (Citadel) say that they are heading back to more traditional investments.  Yet another reason why 2008 will be seen in history as a vintage year of change.

Fed Time- Ho Ho Hum & QE

In the next few days, the FOMC is again expected to pull the monetary level on interest rates. The current expectation from the fed fund futures is for a 50% probability of a 75 bps cut to just 25 bps.  The second high probability at about 38% is for a 50 bps cut in rates.  As mentioned in last week’s report, the Fed is quickly winding down its ability to move monetary policy via the funds rate. What we will quickly hear is a new term called “quantitative easing.”   Quantitative easing is just a fancy term for providing large amounts of liquidity to the market in many forms other than simply reducing the fed funds rate.

In Bernanke’s recent comments he says, “Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.”

Bernanke has described several means by which the Fed could influence financial conditions through the use of its balance sheet, including purchasing longer-term Treasury or agency securities on the open market in substantial quantities – something they already do in the open market operations. The Fed can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market, asset backed and money markets. These actions are almost identical to those steps taken by Japan in the 1990s. 

In Japan’s case things haven’t worked out so well.  According to the Financial Times, Japan saw its public sector debt burden soar from 65% to 175% of GDP between 1990 and 2005. Lending rates did not fall quickly enough, and Japan became embedded in a cycle of debt deflation.  The Fed will move down this path in a very careful and deliberate manner. They have thought this through carefully and understand the risks. Indeed, Chairman Bernanke is a brilliant student of history and understands well the liquidity traps during the Great Depression as well as Japan’s economic mistakes. Let’s hope he has learned enough from history not to repeat it.

Source: Cleveland Fed

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