International Equities at Year-End

Received from my friend David Kotok.

International Equities at Year-End: The Advanced Markets
December 19, 2013

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, He can be reached at

As the end of 2013 approaches, the global economy is still suffering from the financial crisis of 2008 and subsequent deep recession. Global economic growth slowed from 3.2% last year to an estimated 2.9% for 2013. Growth of the advanced economies is estimated to have been only 1.2%. Recovery in the US economy is broadening and gathering momentum but remains below the path of most past recoveries. The United Kingdom’s economy has also moved onto a solid recovery path, yet it still has a great way to go to make up for the ground that was lost. In contrast, the recovery in continental Europe is still very tentative in a number of economies, aside from Germany and several of its northern neighbors. In Japan, an unprecedented change in economic and financial policies, “Abenomics,” has aroused the world’s third largest economy from over two decades of stagnation and deflation, helped by a 16% depreciation of the currency.

Global equity markets registered much stronger returns than the above-noted modest economic performance might suggest. The MSCI World Index, in US dollars, is up 19% for the year to date (through December 17). Led by Japan (MSCI Japan up 20.8 %), the MSCI EAFE Index for advanced markets outside of North America advanced 13.7%. The MSCI US Total Market Index topped most markets with a 25.14 % advance, while Canada underperformed, with the MSCI Index for Canada essentially unchanged for the year to date (-0.05%). Also noteworthy has been the outperformance of small-cap stocks in the advanced markets. For example, the iShares MSCI EAFE Small Cap Index ETF, SCZ, is up by 20.8 %, while the iShares MSCI EFA Index ETF (large-cap) is up 13%.

The strong performance of the advanced equity markets in the face of weak macroeconomic fundamentals is likely due to several factors. Investors’ concerns about a number of risks that had been depressing markets have eased. The Eurozone appears to be addressing its problems and looks far less likely to break up; the Chinese economy seems to have avoided a sharp slowdown and to be gaining momentum; and the fiscal standoff in Washington has ended – for now. Another important factor is the stimulative monetary policies being pursued by the major central banks, with the prospect of very low interest rates continuing for an extended period. Corporate profits generally have been quite strong despite the modest economic growth. And equity markets typically look forward: investors foresee the global recovery gaining momentum in the coming year.

We, too, are generally optimistic about the advanced equity markets in 2014, although another 20+% gain seems unlikely. Two countries, Japan and the United Kingdom, and a region, Northern Europe, have the most promising prospects. In Japan the Abe government and the Bank of Japan are strongly committed to following through with their efforts to sustain the economic recovery and break deflation definitively by combining very aggressive monetary easing with a balancing act of debt consolidation and fiscal encouragement of the economy, along with far-reaching economic reforms. A test will come in the spring when the consumption tax is to increase. We expect the government to seek to partially offset the effects of this tax with a reduction in the corporate business tax and with new spending. The Bank of Japan will likely step up its monetary stimulus if that appears necessary. We expect further depreciation of the Japanese yen in 2014 and for that reason will continue to favor a Japan ETF that is hedged for changes in the yen/US dollar exchange rate: the WisdomTree Japan Hedged Equity Fund, DXJ. That ETF is up 32.3% year to date, while the unhedged iShares Japan ETF, EWJ, is up 20.31%. The longer-run performance of the Japanese economy will depend on economic reforms promised but still not clearly defined. The ultimate success or failure of “Abenomics” will likely hinge on the extent to which needed structural reforms are initiated and implemented. The jury is still out on that.

In Europe the United Kingdom economy looks now to be on firm footing and should advance at almost three times the 1% average expected for the Eurozone. The negative effects of the financial crisis and a housing overhang are declining; the government has eased off its somewhat overzealous fiscal austerity program; and the Bank of England is maintaining an accommodative policy stance. The MSCI UK Index is up 9.5% this year.

In continental Europe, Germany was one of the very few Eurozone economies to eke out positive GDP growth for the year, estimated at 0.5%. It is both the largest economy in the Eurozone and has the best macroeconomic prospects for the coming year. Positive investor expectations for the German economy and equity market lifted the MSCI Germany Index by 21.7%, considerably bettering the 16.6% advance for the French market, which has recently been losing ground to the German market.

The Eurozone continues to face substantial challenges, including further deleveraging and generally tight credit conditions as banks seek to strengthen their capital positions. Eurozone banks will face stringent stress tests in the coming months. The ECB may be faced with the threat of deflation and, if so, would likely respond with further easing. While there have been some important advances, establishment of a sustainable monetary union is still incomplete. Eurozone equity market performance in the coming year looks unlikely to match that of 2013, which was 18.9% to date for the region.

Outside the Eurozone, Sweden and Switzerland have strong, well-run economies that have been held back by the weakness of demand in their all-important European markets, as well as by their own strong currencies. The Swedish market, as measured by the MSCI Sweden Index, has gained 12.4% year to date, and the MSCI Switzerland Index is up 18.3%. These economies and markets should do well as Europe slowly recovers.

In the Asia-Pacific advanced markets, Australia, New Zealand, Singapore, and Hong Kong have all underperformed this past year. A continuation of the recent strengthening trend in China should help these markets in 2014, particularly that of Hong Kong.

Bill Witherell, Chief Global Economist

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Crowding-in …Bonds

Sharing this piece from my friend David Kotok.

Crowding In – Bond Interest Rates
December 14, 2013

We are watching bond market volatility as Treasury bonds struggle with questions about what the Fed (Federal Reserve) is going to do. Only the passage of time and improvement of communication from the new Fed leadership will resolve this issue of inadequate clarity and resulting volatility.

At the same time, we are aware that the federal deficit is shrinking. The pressure of new Treasury bond issuance is falling all the time. Markets tend to ignore this trend in the short run. In the longer run and in the past, with the federal government “crowding out” other borrowers, having to sell more bonds put more pressure on markets. The fewer bonds there are to be sold, the less pressure there is on markets. This is called “crowding in” and is a characteristic that market agents have forgotten after the recent and long period of high deficits in the United States.

In 2014, governmental crowding in has arrived in force. Its influence will be felt in markets. Coupled with restrained state and local budgets, we now have a shrinking federal deficit that is now headed under 3% of GDP and trending lower. This is a very powerful force against rising bond yields.

Greg Valliere, an expert observer of Washington, DC, politics and the dynamics of our political system, described the shrinkage of the deficit as follows: “The first two months of the fiscal year look spectacular. Data released yesterday by the Treasury Department show the deficit down by 22% compared to the first two months of last year, with receipts up by 10% to $362 billion. Cynics respond that about $30 billion of that total comes from Fannie and Freddie, which are pumping profits back to the government.” When I asked Greg for more detail about the GSE share, Greg offered this addition about “the enormous one-time tax break of about 20 billion that grossly affected the GSE contribution”: “Both Fannie and Freddie will continue to contribute to the Treasury, but not at the Oct.-Nov. pace.” Many thanks to Greg Valliere for giving us permission to share this insight.

We think Greg is right in his assessment that the falling deficit will persist. We believe it will be a force throughout the rest of the Obama term. It is quite possible that the deficit could decisively dip under 3% of GDP and even approach 2% or 2.5% of GDP. That will be a remarkable event. It will happen at the same time that the pressures on the housing agencies and mortgage finance entities are diminishing. All this coincides with rising house prices and the gradual recovery of our economy. As a nation we find ourselves on the benign recovery side of the pain that convulsed the economy during the financial crisis.

In sum, the new-issuance pressure of bonded indebtedness at all government levels is not intense and not of the nature to drive up interest rates. Instead we have crowding in, not crowding out.

Meanwhile, the issue of inflation is being ignored by bond investors. The headline personal consumption expenditure deflator is falling. Market-based priced Core PCE is falling even more. It is trending under 1%. Core CPI is also falling. Producer Price inflation is trending at about 1%. In fact, the case can be made that the collective indicators of price level changes could all trend under at or near 1% sometime in 2014.

The real interest rate in the bond market (after inflation is removed from the calculation) rises when the anticipated or measured rate of inflation falls. As we know, over time, it is the real interest rate that counts.

Rising real interest rates have a slowing effect on economic activity. Falling or lower real interest rates spur economic activity. Presently, with inflation rates not widely accepted as accurate by market players but trending lower and bond interest rates not widely accepted as bargains by market players but trending higher, a possible collision course or tension between the two indicators results. That tension could slow the pace of economic growth, and any such slowing could and would lead to a subsequent robust rally in bonds.

What bonds to buy, what bonds to hold, and what bonds to sell? When should they be swapped? These are the conundrums investors face.

Fortunately, there are good answers to be found. We have long said that the tax-free, high-grade bond sector is cheap relative to other bonds. It still is. Sectors of the bond markets that are yielding real tax-free returns of 3% and even 4% are very attractive. One can get those returns without taking a lot of credit risk. We are not talking about Detroit, Puerto Rico, or other credits in the municipal bond space that are questionable, facing bankruptcy, in bankruptcy, or otherwise under pressure. We are talking about the highest-quality credits that are available at bargain real yields and bargain relative nominal yields. Build America Bonds, the taxable cousins in Muniland, also remain cheap.

Lastly, the disposition of investors to run from the bond market continues to intensify. We see evidence week after week of liquidation of mutual fund shares. This has been going on for six months. Credit Suisse recently created an analysis of various fund flows (December 10, 2013). They ask the question, “What’s all the fuss about fund flows about?” They then dissect the various measures of fund flows. The conclusion is fairly clear. The flight from bonds has forced mutual funds to sell. They are selling as a class. That means when Fidelity sells, it has to sell its bonds, and Vanguard is not able to buy because they have to sell bonds as well.

As in an earlier period of intense liquidation, the liquidation of bonds now underway works to create bargains in the bond space as sequential investors capitulate due to fear. They extract money from the bond side and place it elsewhere. Then they wonder and second guess their actions.

Has anyone thought that the bond sell-off might be overdone? The economy and its recovery are not so robust and not so impacted by rising inflation pressures as to cause bond interest rates to spike higher.

Maybe, just maybe, we will have low inflation, lower interest rates, and gradual economic recovery that will persist for quite some time. Maybe, just maybe, the backup in home mortgage interest rates will slow the housing recovery so that it will not be robust. The recovery in the labor market may also persist slowly, as the evidence seems to show.

We are approaching the end of the year in managed bond accounts. That is a big piece of Cumberland’s activity. We resist this notion that the bond market is headed for an absolute debacle in 2014. We particularly favor the tax-free municipal bond. Where appropriate, we recommend tactical hedging as a method of dampening overall bond portfolio volatility.

At Cumberland, we do not view the world as coming to an end in bond land. When a high-grade, long-term tax-free yield of 5% is obtainable in a very low-inflation environment, we think that bond investors who run from bonds and liquidate them will look back, regret the opportunities they missed, and wonder why they did it.

David R. Kotok, Chairman and Chief Investment Officer

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Reducing the uncertainty premium

From my friend David Kotok

The Evolving Policy Landscape
December 13, 2013

The evolving policy landscape in the United States is reducing the uncertainty premium. That is bullish for US financial markets and its economy and outlook.

A troika of Fed (Federal Reserve) officials, including Bank of New York President Bill Dudley, Fed Vice Chair Stanley Fischer, and Fed Chair Janet Yellen, will lead policy in 2014 and 2015. That is the period of time in which the Fed will transition from $85-billion-per-month quantitative easing to a gradual extraction and approach to neutrality. We expect the Fed’s communication strategy to improve, its policy to become more consistent, and the application of same to become more transparent. The Fed’s new leadership lineup represents an excellent evolution.

For the first time in recent years in Washington, DC, lunacy has given way to a baby step back towards sanity. We have a budget deal, albeit a small one. We have a deferral of shutdowns and shocks for at least a year or two. The Speaker of the House of Representatives, John Boehner, is re-emerging with new strength and is in control of his caucus. There is isolation of the extremists on the right, and less so on the left. We have a deficit forecast of less than 3% of GDP and falling.

The rate of inflation in the US is below 2% and falling. By some measures it is 1% and falling. The outlook for inflationary shocks continues to diminish. This is positive for bonds and borrowers and constructive with regard to transparency and the accurate reporting of earnings, profits, and sales. Less inflation means more accurate numbers and fewer distortions.

Lastly, gradual improvement in the labor markets is underway. It is slow. There are soft spots. The trend, though, continues to be positive.

We approach 2014 with a rather magical if unexpected combination of positive policy, financial, and economic forces. Next year will start as a very good year. After that, as with anything else, it all remains to be seen.

David R. Kotok, Chairman and Chief Investment Officer

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Zero Hedge

Interview with Zero Hedge
December 2, 2013

Over the weekend we conducted an interview with Chris Whalen. It was released on Zero Hedge this morning. Here is the url:

The text of the interview appears below. We thank Chris Whalen for the invitation to conduct the interview on this very important topic of low interest rates and monetary policy.

Last week, I published two articles, on Zero Hedge and Breitbart, respectively, that highlight the issue of “financial repression” via low interest rates. Below is an exchange with my dear friend and mentor David Kotok, Chairman of Cumberland Advisors. We discuss the question of whether the current policy of the Federal Open Market Committee is feeding deflation via low rate policy. This question has great significance since the stated goal of FOMC policy is to raise inflation to ~2% annually and boost employment. From my perspective working in the housing sector, the combination of current Fed policy and new regulatory strictures such as Dodd-Frank and Basel III are clearly thwarting efforts by the FOMC to reflate the housing sector and the wider US economy. — RCW

Whalen: David, I really appreciate your comments on the ZH article last week, “Default, Deflation and Financial Repression.” In particular, your focus on ultralow interest rates, Federal Deposit Insurance Corporation premiums and the flow of cash from the banks to the Federal Reserve System is very illuminating – and disturbing. As you know, I have long maintained that the FDIC’s fiscal need to fund the deposit insurance scheme is a separate matter from monetary policy, but when we have near-zero interest rates, the average FDIC premium of 7-10bp does become significant. Can you talk first about what is happening in the US money markets from your perspective?

Kotok: You wrote a very important article last week, especially the part about the Fed taking billions out of the economy and away from savers in order to subsidize the banking industry. But there is another and more nuanced part of the puzzle that we need to consider. We have a Fed Funds target of 0-0.25% in place presently. The Fed is also paying 0.25% per annum on excess reserves. This means the reserve rate is higher than the actual Fed Funds rate while the lower bound is maintained at zero. The GSEs, who are large sellers of Fed Funds, cannot legally deposit directly with the Fed. So, they sell Fed Funds, and the banks buy them and redeposit the cash with the Fed. The FDIC levies an asset-based fee on each bank and that includes the reserve deposit assets which are under their FDIC jurisdiction. So the actual Fed Funds rate, inclusive of the FDIC insurance levy, is below the gross (0.25%) reserve deposit rate. Some larger, riskier banks pay even higher FDIC fees than the average and are effectively losing money on this trade. Meanwhile the US subsidiaries of foreign banks, which are not subject to the FDIC levy, have an advantage in the short-term markets.

Whalen: So your basic point is that the fact that rates are so low in absolute terms is distorting the US money markets, in part due to structural costs like the FDIC insurance premium? The nineteenth-century economist Walter Bagehot maintained that in order to prevent bank panics a central bank should provide liquidity to the market at a very high rate of interest. Yet today the neo-Keynesian tendency that controls the FOMC believes that the fact the Fed has the virtually unlimited ability to temporarily expand the money supply refutes Bagehot’s dictum. In today’s terms, Bagehot was warning us against keeping rates too low for too long because real money would flee from financial repression.

Kotok: Antoine Martin of the Federal Reserve Bank of New York, in his important 2005 paper “Reconciling Bagehot with the Fed’s Response to September 11,” argues that Bagehot had in mind a commodity money regime in which the amount of reserves available was limited. Thus, keeping rates high was a way to draw liquidity, that is gold, back into the markets. Bagehot also understood that low interest rates fuel bad asset allocation decisions – what we call “moral hazard.” In the age of fiat money, however, economists have taken the opposite view, namely that an unlimited supply of reserves obviates the need to attract money back into the financial markets. Remember that Martin’s paper was written two years before the start of the subprime crisis.

Whalen: His timing was impeccable.

Kotok: Bagehot’s classic text advocated a penalty interest rate secured by good collateral. He was envisioning a form of discount window mechanism similar to what central banks used in the pre-QE era. That mechanism has been mostly replaced with QE, which is a policy that we are still in the early stages of learning about. More recent Fed papers have delved into the impact of QE on otherwise neutral interest rates. It certainly lowers them for a while and in the early stages of QE. Other researchers have noted how the central bank’s remittances to the Treasury alter the fiscal authority budget balance. And others have focused on the potential methods for terminating QE and getting to a neutral position. Still others are trying to solve the mystery of how to reduce the impact of QE and restore a more neutral policy. Lastly there are the inflation hawks, who forecast an inflationary outcome of QE. They may eventually be right, but after five years the evidence suggests that excess reserves are not by themselves very inflationary. It takes an acceleration of growth to turn post-crisis disinflation force around,. That means rising demand is needed to obtain rising price pressures. So far, we haven’t seen much of either in the course of our grand experiment with QE. My colleagues and I have written about these various research papers, and the links can be found on our website,

Whalen: Well, the 2001-2007 period certainly suggests that Bagehot’s concerns about low interest rates fueling moral hazard have not been refuted. The FOMC’s aggressive easing of interest rates, combined with deregulation of the financial markets and the FDIC’s safe harbor with respect to bank asset sales between 2000 and 2010, fueled a speculative binge that nearly destroyed the western world. When Lehman Brothers failed, we had created some $60 trillion in toxic assets that were not supported by the $13 trillion asset US banking system. Now almost seven years since the bust, a large portion of that pile of crap has yet to be remediated.

Kotok: Very true, but the past is past. We must focus on the future. Whether or not you believe that a flexible reserve system like the Fed’s addresses Bagehot’s concern about attracting liquidity back into the markets, the fact is that very low interest rates do distort money flows. That is why your point about the Fed taking $100 billion per quarter out of the hands of savers is so important. But what do the banks do with that money? They deposit it with the Fed. And what does the Fed do with that money? They pay the banks 0.25% and then invest in US Treasury debt and mortgage-backed securities (MBS) at a higher rate, and thereby generate what they call a “profit.”

Whalen: So your point is that the $100 billion per year that the Fed is taking from the hands of consumers, meaning savers, is actually passing through the banking system and going to the Treasury via remittances from the Fed?

Kotok: Precisely. The practice of the Fed calling the spread they earn on their nearly $3 trillion portfolio of securities “profits” is a monstrous distortion of the word. What they are doing is feeding deflation in the real economy by reducing savers’ income while pushing down the federal budget deficit. Between budget sequestration and the spread arbitrage created by the low interest rate paid on excess bank reserves, US government policy is clearly operating with a deflationary bias. As you and I have discussed for several years with respect to the higher FDIC deposit insurance premiums, we need to take a holistic view of government policy. The whole playing field gets level if the Fed’s excess-reserve deposit rate is set higher and thus eliminates the false profit they now recognize via remittances to the Treasury.

Whalen: Well, you are assuming that the banks would actually lend out the additional profit that they earned in higher rates on excess reserves. Wouldn’t we need to also raise the target for Fed Funds to say 0-1% from the current 0-0.25% in order to give some of the benefit back to savers of all stripes?

Kotok: As we wrote last week in our Market Comment, in the Fed there are those who argue that the rate should be lowered or maybe go to zero. It is currently 0.25%. Others argue that the rate should be raised or that the amount of required reserves should be changed, thereby changing the excess reserves composition. All sides of this debate are passionately argued by skilled agents in monetary economics. But the real question the FOMC needs to ask is, what are we going to do if inflation continues to fall? That is, if we find ourselves in a deflationary trap. Many commentators argue that we are in one or near one. I am worried about it.

Whalen: It is perhaps not surprising that commercial bankers are against lowering the rate paid on the $2.3 trillion plus in excess reserves sitting on deposit at the Fed. That is 20% of the assets of the entire US banking sector, again another sign of deflation. Given the sharp drop in net interest margins in the US banking industry, the Fed may need to boost interest paid on reserves just to keep the industry from imploding. Just as in the 1930s the Fed fueled deflation by not making credit available, today the opposite seems to be the case – low rates are fueling deflation and impeding the creation of credit to support the economy. Where are you on the issue of when FOMC policy is likely to change?

Kotok: At Cumberland we believe the short-term interest rate will be kept low for a long period of time, which we measure in years, not months. We do not expect the Fed to deliberately shock the economy by any action that would cause another recession. The June press conference has served to chasten members of the FOMC. Some members of the Fed are already worrying about the possibility of recession. There is evidence of deflationary and/or disinflationary forces at work now. That evidence has raised the eyebrows of some policymakers and commentators. We are among those who worry about this issue. We do not think Japanese-style deflation will happen, but we worry that it could happen. We keep watching commodity prices and oil prices. Oil is especially important because it flows through so many sectors of the economy. And changes in the oil price quickly translate to gasoline prices, and that means a consumption tax increase or decrease. At an annual rate, a 1-cent change in the gasoline price adds up to about $1.4 billion in raised or lowered consumer expenditures.

Whalen: That is a big change. Let’s get back to the deflation issue. For the past year and more I have been writing about the deflationary impact of Dodd-Frank and Basel III, which are effectively offsetting the low rate policy of the FOMC in terms of consumers and households. Companies and leverage investors benefit from low rates, but the sharp drop in mortgage loan origination volumes is a huge red flag regarding deflation in my book. Imagine what the debt and equity markets will do when we see a negative print on the monthly Case-Shiller Index? Our friend Michelle Meyer at Bank America Merrill Lynch says that Q2 2013 was the peak in home price appreciation in this cycle. I agree and think a big part of the reason that housing is now slowing are the excessive regulatory constraints on lending.

Kotok: You are right to worry about housing and the banks, as usual. Many observers look only at the price level, and they miss the fact that it is the rate of change that counts at the margin. That said, the key piece of the puzzle we need to make people understand is the deflationary effect of low rates. If the FOMC increased the target for Fed Funds gradually, say a quarter point per quarter to 1%, and likewise raised the deposit rate for excess reserves, I think that move would go a long way toward curtailing the deflationary threat we now see building. The Fed could do this by widening the band from 0.0% bottom and 0.25% top to 0.0% bottom and 1.00% top. Then raise the reserve deposit rate to 0.50%. That would allow the markets to clear after the distortion of the FDIC fee. It would also allow a slightly positive numerical interest rate to be attached to REPO and to large deposits. Right now, the very large depositors are actually paying a negative rate cost to have their money in the bank. Your point about low-rate policy hurting consumers is right on target, but look at the short-term funds markets for these large institutional folks. Very low rates and structural impediments such as the FDIC insurance premium are preventing the markets from clearing and functioning in a normal fashion. We cannot rebuild the short-term funds markets until the FOMC allows rates to rise. And the longer we wait, the more painful and dangerous the adjustment process will be. And we haven’t discussed added cost such as those coming from the FDIC’s Orderly Liquidation Authority. I believe that public release is due soon.

Whalen: Well, if you had a 1% overnight Fed Funds rate, the 7-10bp FDIC insurance premium would be irrelevant. If we translate the fundamental concerns of Bagehot into today’s terms, he probably would agree with your view that low rates are preventing the efficient flow of capital in the markets. But our friends at the Fed just don’t seem to understand their own limits and how policy decisions create future crises. The members of the FOMC led by Janet Yellen believe that they can manipulate interest rates and the economy to a satisfactory income, but in fact the current policy mix may be leading us to another crisis – just as the FOMC did between 2001 and 2007.

Kotok: I’m not as harsh on the FOMC members. Janet Yellen knows the difficulties, and she will use her skills and experience to try to manage the transition from QE at $85 billion a month to something less and eventually to zero. A target for Fed Funds is of no significance in terms of monetary policy when we are at a zero boundary. You can make the target 0-1.00 instead of 0-0.25, and I would do that at once if I were in the decision chair. But it makes no difference until the FOMC neutralizes its balance sheet by raising the rate paid on excess reserves and by reaching a neutral position on QE. Remember that they may also have to term out the reserves to show the markets that they can manage the eventual decline in balance sheet size. Market agents are very skeptical about that. Sometimes I wonder if our colleagues at the Fed don’t really listen to comments from outside of the temple – from the markets and from private economists and market pundits. The FOMC missed a very valuable opportunity in September to slowly begin to change policy and to start the process of adjusting market expectations. The Fed believes they can eventually manage a gradual transition from the current, extreme policy stance to something more moderate and stable. The market reaction to the unwise June 19th press conference by Chairman Ben Bernanke suggests otherwise. In September, the markets had adjusted to an expectation for some tapering. The Fed had a free shot to do something. They failed to take it.

Whalen: Look at the carnage that the Bernanke press conference caused in the mortgage market. Many banks, non-banks got slaughtered in the TBA market for mortgage financing. PennyMac Mortgage Investment Trust (PMT) missed their hedging for mortgage funding by 16% and lost half of their gain-on-sale margin. The Q3 2013 FDIC data also suggests huge hedging losses by commercial banks. The reference securities in the housing market moved 2-3x vs. the 10-year bond. As you noted earlier, only about 1% of the audience actually understands the utterances of central bankers. Obviously this does not include bond traders or most economists, who were caught flat-footed in June and then wrongly predicted tapering of Fed securities purchases in September. So David, if you were on the FOMC, what would you recommend to your colleagues?

Kotok: First, I would strongly reject the idea that lowering the interest paid on excess reserves is a viable option. Fed remittances to the Treasury are $100 billion per year and rising. If the FOMC takes interest paid on excess reserves to zero, remittances to Treasury will rise unless tapering of bond and MBS purchases resolves and ends completely and abruptly. That would shock markets and weaken the economic recovery, which is still fragile. The FOMC must be very careful here. Even if they could simply stop quantitative easing, remittances will rise since the Fed will not sell and must run off the portfolio over a number of years. The Fed could raise the reserve rate paid to 50bp for a start. That clears the FDIC fee hurdle and allows banks to earn small arbitrage on GSE cash. It also allows markets to clear above zero by a small amount, and that restores repo to neutrality. My guess is that bond yields would fall if the bond market saw this action by the Fed. Market agents would accept that the Fed’s QE would peak in 2014, and the process of discounting a return to a more normal neutral Fed could therefore commence.

Whalen: Agreed. A more enlightened FOMC would be issuing bonds to individual savers with the old 6% coupons of Series E bonds to help blunt the impact of financial repression instead of handing the supposed profit to the Treasury. Issue the bonds in $1,000 increments, with a $100,000 limit and make them non-transferable. So we both agree that the folks clamoring to reduce the rate on excess reserves don’t get it?

Kotok: I do not expect any quick return to 6%. Not even close. I guess the US Treasury could issue a small saver bond with a limit but I doubt it will happen. Chris, we are at a zero boundary for the cost of funds in the US markets, so the only way to go is up. We are also at the near-zero bound in most of the rest of the developed world. That means the global clearing system of interest rates is distorted. Forcing an imposed negative policy under these conditions is very dangerous. Positive incentives are usually a better policy prescription than are negative rules. If we raise excess reserve rates and get the financial system to clear, we start to relieve financial repression. Savers gain; hence, consumers gain. Some banks and non-banks start to rebuild earning assets. Poorly managed banks fail or are merged by regulators. You and I both know some of these banker players. They bear shame for launching new banks a decade ago and then watching the erosion of their investors’ capital by as much as 90%. The managements and boards of these banks own some of this outcome. They point fingers at the regulators or the Fed. Meanwhile they haven’t been fired, and they haven’t paid a penalty, and few have been jailed for fraud.

Whalen: No argument here.

Kotok: Chris, your focus in your writings over the past year on falling net interest margins for banks is crucially important here. Now, if you had a counterparty as a prosecutor and if the board-management policing mechanism didn’t protect the embedded imbeciles who ran their institutions into the ground, you would really have a team approach to addressing these issues. If I were czar, excess reserve rates would be higher and terming out. The zero boundary for rates makes the US economy dysfunctional. And the longer we are in it, the worse it becomes. Japan is the proof. And lastly, I would use Singapore law to regulate our politicians and our financial services.

Whalen: Thanks David

David R. Kotok, Chairman and Chief Investment Officer

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