Bill Gross Predicts a 3.5% Fed Funds Rate

Bill Gross' November market commentary is up on the PIMCO website. In it he pokes fun at Citigroup CEO Chuck Prince for his colorful commentary back in July regarding potential exposure to bad private equity-related debt: "As long as the music is playing you've got to get up and dance. We're still dancing." Turns out Prince probably should have stopped dancing, or at least kept his mouth shut. Investors probably won't look to kindly upon Prince dancing his way to a $6.5 billion writedown.

More important than Chuck Prince however is Gross' outlook on the US economy going forward and particularly his outlook on what Bernanke must do to bail us out:

So both old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s “Super SIV.” Whether Paulson’s “Committee to Save the World – Part II” will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the “shadows.” Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.

Ben Bernanke has no such luxury. While he does have the backstop of a global economy powering on at a 4-5% annual clip, today’s U.S. IPOs were more a creation of leverage and the shadow banking system’s ability to create productivity gains through finance, as opposed to technological innovation. With banks and their shadows in retreat and modern day “world saving committees” relatively impotent, Bernanke must do some heavy lifting as opposed to the light housework required of Alan Greenspan in 1998. An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s.

So here at the beginning of another Fed week we should look for another 50 basis point cut in the Fed Funds rate as Bernanke seeks to preempt further weakness. This would still leave another full percent for Bernanke to cut before approaching the 3.25% that Gross is predicting. While the smart money is on a 25 basis point cut, I'm going to break from the mold and predict a larger move. Look for this cut to further weaken the dollar and lead to another commodity rally. It is now within the realm of possibility that oil could reach $100 before a cyclical slowdown in the winter. While $100 a barrel oil seems amazing, this isn't the first time we have seen it before. Below is a graph courtesy of James Hamilton at Econbrowser:

Dollar price per barrel of West Texas Intermediate divided by ratio of CPI for the indicated month to the present value.

The other thing to look for is for a major announcement from a foreign central bank that they are officially removing their dollar peg. There is already a great degree of consensus among Gulf executives that removing the dollar peg would help their economies. Of the six major economies in the Gulf region, five -- Saudi Arabia, Oman, Qatar, Bahrain and UAE -- maintain a dollar peg. The sixth, Kuwait, removed their peg in May. All are dealing with serious inflation issues, and are unable to fight against the inflation because of the devaluing dollar.

The Fall of the Dollar (and Rise of the Amero?)

Harvard professor Larry Summers frames the issue of the weak US dollar simply enough:

The falling dollar generates anxiety almost everywhere. Americans and those dependent on American growth worry about the proverbial “hard landing” as inflation and interest rates rise with a weakening dollar, causing asset prices and output to fall. Europeans and others with currencies that float freely against the dollar worry that their currencies will bear a disproportionate share of the dollar’s decline and appreciate too far, leading to competitiveness problems. The falling dollar risks rising inflation, asset bubbles and the loss of macroeconomic control in countries that have tied their currencies to the dollar’s sagging mast.

The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.

He then points out some inadequacies in the current manner of exchange rate management (or lack thereof):

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

Finally he advocates for change:

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yolked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

I think a new currency strategy is a must, but I am definitely concerned about what the "next administration" might come up with. If you hear me advocating for the status quo it is likely from a position of concern about the new policy rather than an expression of satisfaction with the existing policy. (Out of left field: Does Larry remind anyone else of Nouriel Roubini in saying the global economy is the most vulnerable since 1998?)

US policymakers aren't the only ones concerned about the weak dollar being financed by China. I read that OPEC is likely to review pricing oil using a basket of currencies rather than just using the dollar. I also wouldn't be surprised to hear about Middle Eastern countries dropping their dollar pegs. Our firm is actually going through a similar evaluation of our firm's currency overlay policy to determine if we should hedge our currency exposure to a basket currencies rather than arbitrarily using the US dollar as our home currency.

In all of this I think that one fact is abundantly clear; any policy change is better than a move towards the North American Union (NAU) and the Amero. The NAU is a President Bush supported idea to combine Canada, Mexico and the US into a Union to rival the rise of the European Union. The Amero would be the combined currency of the three countries. When I first heard it I thought it was definitely just a crackpot conspiracy theory, but then I saw this clip from Lou Dobbs (not that Lou Dobbs is the official arbiter of what is conspiracy and what is mainstream):



I think this interviewer was completely blindsided by the Amero discussion:


Here is a picture of the Amero. Looks harmless enough, eh? (I'm just getting used to being a part of Canada)
Hat Tip: Brad Setser

Images for the week

Maybe I'm just lazy and didn't want to write full posts, but this past week I've come across quite a few great self-explanatory images. I've included a few below:







Hat Tips: Barry Ritholtz, Greg Mankiw, Calculated Risk, Bespoke, WSJ

Fire Time Lapse Video

Microsoft Buys $240 Million Stake in Facebook

It was a two horse race between Google and Microsoft to determine who would buy a stake in Facebook and get the rights to broker Facebook's international ads. Today Microsoft won that race, purchasing a 1.6% stake in Facebook for $240 million. This is another move in Microsoft's strategy of regaining relevancy in the online advertising world after getting blindsided by Google in recent years. While this deal pales in comparison to the company's $6 billion purchase of aQuantive/Avenue A Razorfish it does signal that Microsoft is still willing to spend some of its $21 billion dollars of cash on key internet advertising assets.

This deal is also interesting because it gives us a real value for Facebook: $15 billion. Mark Zuckerberg probably has a big smile on his face right about now as he thinks back to the $1 billion offer he received from Yahoo about a year ago. Many thought Mark should have taken that offer, but obviously he's going to get the last laugh on this one. At $15 billion Facebook is bigger than the market capitalizations of Bear Stearns, H.J. Heinz and Baidu.com and is about the same size as Sempra Energy, Ameriprise Financial and Xerox.

To put all of this in perspective Sempra Energy has about $11.6 billion of revenue and roughly $1.1 billion of net income compared to Facebook's $150 million of revenue and $30 million of net income. Okay, okay I know comparing a technology company with a gas utilities company is comparing apples and oranges, but you must admit it is a sobering perspective. Before this deal I find it hard to imagine that Facebook had much more than $20-30 million of cash and Sempra has about $1.3 billion, but I digress . . .

The 100x multiple on trailing earnings may seem a little rich, but Facebook is also making huge gains on MySpace its chief competitor in the social networking space. It is also experiencing dramatic revenue growth, particularly from Canada and Asia. Even from a quick glance at Alexa the ground Facebook has made up is stunning. You may have to click the graph to really see it, but you can see how Facebook's daily reach as measured by Alexa has risen dramatically over the past year, gaining on Myspace all the while:
During September Facebook attracted 30.6 million US visitors to Myspace's 68.4 million. So although it is growing faster it still has some ground to make up. But, Facebook's control over the US market is not what excites investors. He's a blurb from a Wall Street Journal article that describes it well:

Facebook, a service that lets people set up their personal Web pages, is seen as the next big venue for placing online display ads. The company has nearly 50 million users, many of them the young audience that advertisers covet. In addition to selling ads on its own, the company over the past year has started placing ads through a deal it signed last year with Microsoft, under which Microsoft brokers banner ads on Facebook's U.S. site until 2011.

The deal signed today is an expansion of that agreement and focuses on international versions of the Facebook service, which Facebook is now starting to open. A deal with Microsoft would allow Facebook to shift some of the burden of selling international display ads to its larger partner. Microsoft in recent years has built up a large online advertising sales force and has invested in technologies to broker advertising over the Web.

By the end of this year, Asia will account for 35% of the world's social networking users, with 28% of users in Europe, the Middle East and Africa, 25% in North America, and 12% in the Caribbean and Latin America, according to research firm Datamonitor Plc.

It is that strong international growth, particularly in Asia that has investors giddy. I think if we have learned one thing at this point it is to not underestimate Mark Zuckerberg or Facebook. I think it is not beyond the realm of possibility to expect a Facebook IPO sometime in 2009.

Foreclosure Wave is Not Over Yet

I think this IMF chart is self explanatory:

Hat Tip: Calculated Risk

San Diego Fires

San Diego is experiencing some horrible fires today. In fact you can actually see the huge smoke plumes from satellite images (right). Hundreds of homes have burned already in a firestorm that has reminded many of the devastating Cedar fire in San Diego 3 years ago. The difference this time is that there are actually between 6 and 8 fires across the county and the high winds and Santa Ana conditions that provoked these fires are due to stick around for a few more days. The bottom line is that there are simply not enough firefighters to fight these fires. The vast majority of the firefighters are spending their time helping the 250,000 evacuees flee their homes.

Please keep San Diego in your prayers over the next few days.

What is this Super SIV thing?

Over the weekend several readers asked me questions about the video clip I posted last week. They wanted more background on Structured Investment Vehicles (SIVs) and the Master Liquidity Enhancement Conduit (MLEC) that has been in the news this week (I foreshadowed the potential for such a fund back on September 5th). Then today the Wall Street Journal had a nice little article about what SIVS are, how they work and how they are related to the subprime situation:

Structured Investment Vehicles (SIVs) and similar instruments called conduits are entities that issue short-term, low-yielding notes called commercial paper. SIVs use the proceeds from selling such paper to buy longer-term, higher-yielding instruments such as credit-card debt and mortgage-backed securities. SIVs differ from conduits in that they can also issue longer-dated notes and use leverage. Though banks typically keep SIVs off their balance sheets, they usually assure that some or all of the vehicles' IOUs will be repaid.
The Pros: SIVs are a source for investors of commercial paper, typically considered a safe-haven investment. They can be profitable for affiliated banks, while generally keeping the risks associated with their higher-yielding debt off their sponsor banks' balance sheets.
The Cons: If the vehicles either can't sell commercial paper or suffer losses in the assets they hold, their affiliated banks could wind up having to help by lending funds to keep the vehicles operating or taking some losses back onto their balance sheets, potentially resulting in a massive hit to profits.
The Context: The popularity of SIVs has boomed since the strategy was invented by two Citigroup bankers in the late 1980s. But they became a source of worry for bankers and policy makers when a credit crunch that began this summer sapped demand for both commercial paper and risky asset-backed securities -- a double-whammy for SIVs. The Treasury Department recently brokered the creation of a $100 billion fund to buy assets from SIVs in hopes of kick-starting the moribund commercial paper market. Some critics call the fund a bailout of Citigroup, the largest sponsor of SIVs. The fear is that trouble for SIVs could compound problems in the credit market, hurting the broader economy, while also slamming the balance sheets and reputations of major U.S. banks.

Citigroup is the bank at the center of the storm. They have the most exposure -- some $80 billion -- to off-balance sheet entities like SIVs and conduits and as such are taking the lead on structuring the "super fund" that will take on the assets of the struggling entities. As you might expect there are a quite a few skeptics out there. Nouriel Roubini calls the whole thing a "Super Bailout Shell Game." Clearly those aren't words of confidence. It seems Roubini has more questions than answers:

What should we make of the SIV rescue plan, the so called Master Liquidity Enhancement Conduit (MLEC), also informally referred to as the Super-Conduit? Does it make financial and economic sense? Is it all a smoke and mirrors con game or a serious attempt to deal with the liquidity crunch in the SIV/ABCP market? Is it another case of moral hazard – with the US Treasury playing a critical role – or is Treasury only solving the collective action problem of coordinating the actions of many players? And is this just another musical chairs game or “don’t ask, don’t sell” game – reshuffling SIVs assets and liabilities with nice fees for the participating dealers – with no financial effect on the underlying illiquid assets or a way to defrost such illiquid assets? And how similar is this rescue plan similar or different to that of LTCM? Is this effectively a scheme to bail out Citigroup that is the most SIVs-exposed US bank? And are the implicit claims of Treasury and the Fed that this is not a bailout where there is no public money at risk credible?

Roubini has had his finger on the pulse of this credit issue since earlier in the year. He has been saying all along that this isn't just a liquidity issue, that this is an insolvency issue. No amount of financial engineering or wizardry is going to keep subprime borrowers seeing 30-50% jumps in their mortgage payments from defaulting on their mortgages. If that truly is the case and the issue here is that most of these SIVs hold low quality assets linked to risky borrowers then this whole scheme would seem to only delay the inevitable.

Alan Greenspan also has his concerns. (Is anyone surprised that Alan has an opinion on this matter? This guy can't stay out of the news these days)

I for one am not all that confident that this is the solution. I think that there are a lot of big banks and hedge funds who are realizing that when they finally find a market for some of the assets on their books the mark downs they will take could be devastating. There just hasn't been a lot of good news in the ABS markets. For those of you who have been following the ABX indices you may have noticed that after finding stable footing for a while in late August the BBB-rated indices are in a dramatic free fall once again. After starting the year over 90, the ABX HE-BBB-07 index is now trading just over 20. The ABX index itself probably won't last too much longer. There are far fewer than 20 eligible subprime securitizations this year, not enough to establish a liquid index according to Markit's rules. The index itself is not even two years old, but without subprime originations the liquidity in the existing index might begin to dry up putting further downward pressure on the index. I don't care how you slice it, which fund you put it in, what fancy name you put on it, or who helps organize it, the underlying "Super-SIV" assets are toxic waste and for every dollar market participants put in only pennies are likely to come out.