The Fed contributed mightily to 2 financial bubbles over the past decade. Now it seems bent on a course that will create another in the world's emerging economies.
By Jim Jubak
Who really 'owns' the Fed?
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world's emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world's emerging economies have started to worry about what will happen if all the hot money flowing into their economies and markets suddenly starts flowing out.
"As long as the world exercises no restraint in issuing global currencies such as the dollar," Xia Bin, an adviser to the People's Bank of China, said, "then the occurrence of another crisis is inevitable."
Mr. Bernanke, call off the helicopters
(For more about reaction to the Fed's latest decision to push money into the economy, see my blog post "Everybody loves Ben's $600 billion -- at least in the short term.")
I think some degree of worry -- less than full panic but more than polite concern -- is appropriate at this stage. And that worry should play a role in shaping your investment strategy as the decade advances. In today's column, I'm going to lay out the "Oops, the Fed's done it again" scenario. Later this week, on MSN Money and my website, I'll tell you what I think you can do about that danger.
Just talking about exuberance
In 2000, I'd say the sin was one of omission. The Fed sat on the sidelines, aware that a stock market bubble was building but doing nothing to head it off.
Remember how then-Fed Chairman Alan Greenspan talked about "irrational exuberance"? Well, it was all just talk. The Fed, which had the power to try to moderate the bubble by tightening credit on Wall Street, believed that trying to manage bubbles was futile. All a central bank could do was watch from the sidelines and then help clean up the wreckage.
And quite a bit of wreckage there was and still is. The Nasdaq Composite Index ($COMPX) peaked at 5,048.62 on March 10, 2000, and bottomed at 1,114.11 on Oct. 9, 2002. That was a loss, top to bottom, of 77%.
Eight years after the October 2002 bottom, the Nasdaq composite is up handsomely -- 131% as of Nov. 5.
But 10 years after the bear market began in March 2000, the Nasdaq has barely recovered half its losses. From a high of 5,048.62, the market had clawed back to 2,578.98 at the close Nov. 5. That means the Nasdaq Composite Index is still down 49%.
Making a mess
I'd put the Federal Reserve's role in the financial and economic crises set off by the U.S. mortgage mess in a different class. The sin here was one of commission. The Fed played an active role in creating this global meltdown and in making it as bad as it was. (Or should that be "is"?)
To clean up the wreckage from 2000, the Federal Reserve lowered short-term interest rates. At the Nasdaq Composite's height in March 2000, the Fed's benchmark rate was 5.73%. The central bank kept rates above 5% for an additional year -- the benchmark rate was at 5.47% on March 7, 2001 -- but then it began to cut, and fast. By March 6, 2002, short-term rates were at 1.74%, and by the end of 2002 they were just 1.23%. By July 2003 the Federal Reserve had cut them to 0.96%.
And there they stayed. For too long, the Fed now concedes. A year later, through most of June, short-term interest rates were just 1.11%. That marked the turn in the cycle. Finally, on June 30, the Federal Reserve began to raise interest rates, though very slowly. By the end of the year they were at 2.27%. By November 2005, they had finally reached 4% again. And by June 2006, short-term rates crossed the 5% barrier.
But by that time, the low interest rates that had been intended to help clean up the wreckage of the bear market of 2000-02 had set off their own bubble, in real estate and lending.
In the fourth quarter of 2002, when short-term interest rates were 1.23%, the real median price of a U.S. house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005, the real median price was up to $262,634. That's a 33% increase in the median price of a house in just three years -- without inflation. That's extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. It was possible to buy and flip for a quick profit. Possible to refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn't ask questions about your income or credit record.
By 2006, this price appreciation had peaked. The median real price of a house that year ranged from $250,000 to $263,000. But by the second quarter of 2007, it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That's a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (And because the house they live in is by far the most valuable asset most families own, and because home ownership rates in the United States are much higher than stock ownership rates, that 36% drop in housing prices was more devastating for most families than a 77% drop in stock prices.)
Trust the Fed again?
That track record suggests that "What, me worry?" isn't a reasonable response to the Federal Reserve's two rounds of quantitative easing, a strategy that pumps money into the economy to try to get it moving more quickly. The first round, which ended only this spring, saw the Fed buy $1.7 trillion in Treasurys and mortgage-backed securities. The new round announced last week would add $600 billion of Treasury buying to the total.
The dangers of these two programs to the U.S. economy are scary enough. The Federal Reserve is buying all these debt instruments on the cuff. The Fed doesn't actually have the money to pay for these purchases.
Instead, it is creating dollars out of thin air -- printing them, figuratively at least -- and at the same time creating a huge liability on the Fed's own balance sheet. Of course, the Fed may be able to pay off that liability by selling the bonds back to the market someday, but you're entitled to wonder where the buyers for $2.3 trillion in U.S. debt and mortgage-backed debt are going to come from.
If you're the kind of person who worries when you see a big debt and no obvious way to pay it off, then the Federal Reserve's current balance sheet undoubtedly worries you.
But even if you shrug off the Fed's balance sheet, the Fed's current course presents -- what shall we call them? -- challenges for the U.S. economy. That $2.3 trillion in quantitative easing is potentially inflationary: Pumping that much money into the U.S. economy will, eventually, push up the prices of all sorts of things. (Which in the short run is what the Fed wants, as long as the gain in prices is no more than 2% annually. Good luck fine-tuning that one.)
Putting 2.3 trillion new dollars into the world weakens the U.S. dollar, making imports more expensive and driving down the U.S. standard of living. At some point, that $2.3 trillion also drives up U.S. interest rates, because you're got to pay people (mostly overseas people who are already holding a lot of U.S. dollars) more to take all those dollars, and those higher interest rates will reduce the growth rate of the U.S. economy.
Go overseas, young dollars
But those aren't the possibilities that worry me most or that have overseas central bankers screaming in protest. The big problem is what will happen to that $2.3 trillion created by the Fed. The dollars certainly don't all stay in the United States.
Would you, if you were a self-respecting dollar, stay here earning 0.13% (the yield on the three-month Treasury bill) or even 2.58% (the yield on a 10-year Treasury bond) when you could go overseas and earn 10.75% on Brazilian debt, 6.5% in Turkey or 4.75% in Australia? Would you stay home buying real estate in a market that's barely begun to show a quiver of life, or instead plunk yourself down in Hong Kong or Mumbai or Rio? Would you stay loyal to U.S. stocks, knowing that the U.S. economy is growing at 2% a year, or go cavorting off to join the fast company in China or India or Brazil?
Yes, indeedy, the really big asset bubbles that the U.S. Federal Reserve may be creating now aren't at home but overseas -- in the stock markets of Indonesia, in the real-estate markets of India, in commodity prices in Australia. Everywhere the flood of dollars created by the Fed might wash up.
And because many of these asset markets aren't anywhere near as liquid as those in developed economies, $2.3 trillion can create a huge problem. India is thinking of slapping on currency controls, because so far in 2010, the country has seen a record inflow of $25 billion in overseas cash as stock funds buy Indian equities.
Twenty-five billion dollars is a problem? When the Fed is talking about $2.3 trillion?
Part of the reason that overseas central banks are squawking is that it's unclear what they can do about the problem. The flood of dollars is creating dangerous inflation -- India's annual rate was reported at 8.5% in September -- so the Reserve Bank of India raises interest rates to slow the Indian economy? Besides the hardship that visits on the poor of India who need the jobs that faster economic growth provides, raising interest rates just makes that country a more attractive destination for all those dollars looking for a home.
The nightmare, of course, is that those dollars flow out as quickly as they flowed in. That's exactly what happened in the Asian currency crisis of 1997. Most of the world's developing economies are in better shape and less dependent on external cash flows than in 1997, but these economies certainly aren't immune to disruption.
And even if they don't go the way of Thailand in the 1997 crisis, a huge outflow of hot dollars would send asset prices plunging, with who knows what effects on national financial systems and capital markets. Look what the mortgage crisis did to Lehman Brothers. (Remember it?) The mortgage crisis caused what were comparatively liquid and large markets to freeze tight. Financial and nonfinancial companies couldn't raise even overnight operating capital.
No wonder Brazil's finance minister, Guido Mantega, said with resigned anger: "Everybody wants the U.S. economy to recover, but it does no good at all to just throw dollars from a helicopter. You have to combine that with fiscal policy. You have to stimulate consumption."
Fiscal policy? From a U.S. Congress? I wouldn't hold my breath. Congress punted on fiscal policy decades ago. Even the Clinton administration's vaunted (and real) budget surplus was achieved by a deal between the secretary of the Treasury and the chairman of the Federal Reserve. If the politicians in Washington were capable of conducting fiscal policy, the Federal Reserve wouldn't be implementing policies like quantitative easing. Ben Bernanke and company know exactly how dangerous this course is. But what's the choice?
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Jim Jubak has been writing Jubak's Journal and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of the 2008 book "The Jubak Picks" and the writer of the Jubak Picks blog. He's also the senior markets editor at MoneyShow.com.
http://articles.moneycentral.msn.com/Investing/JubaksJournal/oops-has-the-fed-done-it-again.aspx
By DAVE KANSAS
But the swift rise of the market -- the Dow is up about 10% from its Aug. 31 close -- comes against a backdrop of somewhat unsettling news. The jobless rate remains stuck just below 10% with little respite in sight. The housing market is still very weak, and is enduring further shocks as lenders' foreclosure problems keep getting worse. The political situation seems a bit chaotic. And the global recovery is uneven enough that the Federal Reserve is thinking of yet more extraordinary measures to get things rolling.
Even with those headwinds, the mood among stock investors as we near the end of October is surprisingly upbeat. Third-quarter earnings are coming in better than expected and optimism about the Fed's latest extraordinary plan -- quantitative easing part two, or QE2 -- is rampant in the stock market. We entered the dreaded September-October period in fear; we are leaving it with bliss breaking out.
Such sudden shifts in sentiment, especially with uncertainty on the rise, makes me a little queasy. Given the widespread gains, it might make sense to examine your portfolio now with an eye toward rebalancing, rather than wait for the end of the year. In so doing, you may want to pare back some of the bigger winners and salt away the gains for the coming year.
Here's where things get interesting. The big winners this year have come from several corners, and not just in the stock market. In the U.S., small-cap stocks have outperformed bigger stocks, with various small-cap indexes up 10% to 14% year-to-date. Outside the U.S., emerging markets, especially in Asia, have recorded robust gains. In other words, riskier stock investments seem to have done better than the safer, blue-chip shares.
Away from stocks, other assets also have had decent years. The Barclays Capital U.S. Government Bond index is up 9.4% year-to-date. The Barclays Capital U.S. Aggregate Bond Index is up 8.6% this year. Gold is up about 30%; oil has gained 10%; and food commodities have done well. The Dow Jones-UBS Commodity Index is at a 52-week high. The dollar had a great start to the year, but it has retreated and is down sharply against the yen and up a smidge against the euro.
The one asset class that hasn't done very well this year is cash. Interest rates for cash deposits are extremely low, reflecting the Fed's policy of record-low short-term interest rates. So, in the spirit of rebalancing, where we take from winners and add to the laggards, any portfolio trimming should get parked in cash. It feels terrible to park money in cash at these rates, but there's always something comforting about capital preservation.
In analyzing which winners to winnow, bonds have had a strong run for several years. Some believe that the bond market could be facing bubble-like trouble. Earlier this month, Mexico sold a 100-year bond with a yield of 6%, a highly unusual move that fed talk of a bubble. And corporations have gotten rock-bottom yields, too, with International Business Machines recently selling three-year bonds with a yield of 1%. All of these unusually low yields in the bond market have amplified the bubble chatter. If you've got an outsized bond position, trimming some winnings before year-end makes sense.
In the stock market, blue-chip stocks have underperformed. High-dividend-paying blue chips have grown in popularity recently, but these stocks have still trailed riskier sectors such as small caps, real-estate, transportation and Internet shares. Winnings here should be trimmed probably in the small-cap and real-estate areas first, with an eye toward maintaining (or even adding to) blue-chip positions.
Commodities, which should be less than 10% of your total portfolio, have had yet another good year. I've written critically about gold from $1,000 an ounce to $1,300 an ounce. Nothing like being wrong. Despite the gains, it's hard to see gold going lower when the euro, dollar and yen all want to be weaker.
If commodities have risen above 10% of your total portfolio, you should consider reducing the biggest gainers, which probably would include gold. But given the strong year for stocks and bonds, your commodity position may not require any slimming.
The main reason to rebalance is to keep your overall long-term strategy in place. Usually this means something simple, such as selling highflying bonds and adding to underperforming stocks. But so far this year, a lot of asset classes have done well, making the rebalancing exercise somewhat thornier.
But we live in somewhat thornier times. The Fed is preparing for QE2, which means it will essentially print more money, and central bankers are talking about a desire for more inflation. These are two things that would've been very difficult to imagine just three or four years ago. And they also are a bit contradictory.
Given the still extraordinary nature of our times, banking some winners might make the holiday season that much more enjoyable.
http://online.wsj.com/article/SB10001424052702304898004575556753777592096.html