My how far have we come, in less than six months, a market that was firmly focused on inflation risk has swung sharply as growth has crumbled. Deflation is now more and more openly discussed and with the Fed funds rate approaching zero, talk of liquidity traps, unconventional measures and quantitative easing are all firmly on the agenda. With all this volatility and uncertainty one can’t help but ask, what happens next? The most obvious near-term steps involve both sizable fiscal stimulus and pre-commitments to keep rates at lower levels. Beyond that, more active plans to target longer-term securities are also likely to come into focus. But further action is also likely to be needed to try to reduce the spread of risky debt to risk-free securities. In the current episode, more than in 2002-03, it is less clear that influencing the Treasury curve alone would be enough to bring borrowing rates down sharply or deliver the easing in financial conditions that has so far been missing. For that reason, other measures including Fed purchases of risky assets could also be important. While these options are further away outside the US (and Japan), because there is still relatively more room for policy rates to fall, in principle many of the same options exist for policymakers in the other major economies too. In terms of the markets, these policy shifts have important implications. They make it highly unlikely that the market’s pricing of higher US rates next year will prove correct. Longer-term yields may also fall further, particularly if they become a target of policy, while mortgage spreads could compress from current levels as policy shifts more explicitly towards reducing the spread between risky borrowing and risk-free rates. For FX, the implications are less clear, but the risks are towards USD strength in the near term, but weakness further out. The good news – particularly with a Bernanke Fed – is that policymakers have a heightened awareness of the unusual risks posed by deflation and liquidity traps, and have plenty of tools left in the arsenal. But the biggest problem is likely to be that these policies will look radical and may require significant political capital to find support. Whether talking about the size of fiscal stimulus that could be needed or ‘unconventional’ monetary policy, we are moving towards territory where orthodox responses may not be enough. The key risk now is a lack of boldness on the policy front in the face of extraordinary pressures. Hence the title of this piece, we need radical action by the government before Obama is inaugurated on Jan 20, 2009, simply put, we need President Bush to save Christmas (or other similar winter holidays)!
With riskless short-term interest rates now close to zero, conventional monetary policy is becoming ineffective. So what other measures do US policymakers have up their sleeves? There are three options with a relatively high likelihood of near-term implementation: (1) a large-scale fiscal stimulus program, (2) more proactive use of Fannie Mae and Freddie Mac for purchasing and securitizing mortgages, and (3) a pre-commitment by Fed officials to keep the federal funds rate low for a considerable period (probably following a final 50- basis-point cut at the December 16 FOMC meeting). Options (1) and (2) are likely to be quite effective, while (3) would probably provide a more modest boost. If these policies fail to result in an economic pickup, Fed and Treasury officials would likely reach deeper into the unconventional policy toolkit. In particular, Fed officials might (4) purchase long-term Treasury and Agency securities in a more aggressive bid to lower rates further out on the yield curve, perhaps in order to finance another round of fiscal easing. Finally, the Treasury might (5) decide to purchase risky assets outright, and this could again be financed by Fed money creation. Both of these policies would probably be quite effective, although they are more radical and not imminent.
While it would be nice if the government would take such bold actions, risking any capital on that assumption is sheer lunacy. Now is the time to focus purely on individual securities experiencing aberrational price movements, one fantastic example of this is Citigroup. Over the past week we have seen Citigroup’s market value fall by more than half. This is the largest bank in the U.S. on a deposit basis. Currently the NPV for the investment bank is so negative that it is dragging down the value of the relatively good commercial bank. Although I think Citigroup will raise additional capital, further diluting shareholders, I would be surprised to see it fall any further. The following programs backstop Citigroup’s liabilities: a) its deposits are FDIC insured; b) the company is working out a program to insure some of its debt with the FDIC; c) the Federal Reserve discount window is always open to the company; d) it can sell commercial paper to the Fed; e) it can use the primary dealer debt facility; f) its deposits, which equal $780 billion, are primarily sourced overseas (64%) giving the bank greater diversity in capturing funds; g) it has access to bank protection programs in multiple countries around the world; h) it has $393 billion in long-term debt; i) it has net free cash flows; j) it has paid down $94 billion in long-term debt this year and $42 billion in short-term debt; and k) it is reducing the size of its balance sheet faster than any other company in the banking industry. The company’s estimated Tier One ratio by year end is 10.45%. This is very high relative to the past. Its stockholder equity is estimated to be $150 billion assuming the TARP contribution. Although I don’t technically have a hard line valuation number on the stock, I think its value is well above $4 which it closed under on Friday. At $4 they are valued at .4x tangible book value which is quite ridiculous. Although my investing career is not as long as others I think .4x tangible book value represents an interesting risk/reward trade-off. That being said this is a rather speculative wager, as we have seen in this market fundamentals matter far less than sentiment. I will keep you posted on Citigroup as I research this situation more.