On August 23, 2011, the price of gold reached $1,913.50. Today the price is $1,450 – a drop of over 25%. What is going on? Why should we care?

In June of 2012, we [this post is co-written with Claude Erb] released a controversial academic study based on a comprehensive historical analysis that claimed that the fair price of gold was $800. This number seemed unfathomable back in June. Ten months later, it is a different story.

So how do you determine the fair price of gold?

Obviously, there is no precise formula. With stocks, we usually look at a value indicator, like the Price-to-Earnings (PE) ratio. A PE ratio of 30 is expensive. A PE ratio of 5 is cheap.

With gold, a natural benchmark is inflation. Our research shows that over the very long term, gold moves with inflation.

Let’s consider a few examples from history.

In 562 B.C., during the reign of the Babylonian king Nebuchadnezzar, an ounce of gold purchased 350 loaves of bread. Given the current price of gold, that works out to about $4 a loaf. Yes, you can get a cheaper loaf of bread – but the bread that many of us buy at a local bakery is that price.

The second example is more powerful because it focuses on wages. We tried to find a job 2000 years ago that we could compare with today. We ended up looking to the military.

In the era of Emperor Augustus (27 B.C. to 14 A.D.), a Roman Centurion was paid 15,000 sestertii. Given that 1 gold aureus=1000 sertertii and given there is 8 grams of gold in an aureus, the pay comes to 38.58 ounces of gold. At current prices, this is about $56,000 per year.

The Centurion who commanded 80 Legionaries is roughly equivalent to a U.S. Army Captain. The current wage for a Captain is $46,000 – which is fairly close.

This implies that gold is a good store of value. Essentially, gold is a good inflation hedge – but our examples are over the very, very, very long term, more than 2,000 years.

Our paper looked at the price of gold over history and noted that when the “real” price (adjusted for inflation) rose above its average, it usually reverted lower.

We calculated that the fair price, based on the level of inflation in 2012, was $800. The market price in 2012 was far higher. We also documented that, in the past, when you purchase gold when the real price is high, the future returns are very low.

Why is this important?

Investors (both individual investors and institutional investors) make the assumption that gold is an inflation hedge. Many institutional investors buy gold to fulfill their mandate to protect against inflation.

However, our paper shows that gold is an awful inflation hedge for investors.

Gold is a good inflation hedge if your investment horizon is measured in centuries – not years.

There is a simple reason. Gold prices are extremely volatile. Inflation is not volatile. As a result, gold is an unreliable hedge for inflation. Our paper shows that even with a 20-year horizon, gold is a terrible inflation hedge.

So where are we?

First, don’t expect an investment in gold to provide an inflation hedge. We are not saying ‘don’t hold any gold’. Our research also shows that a diversified portfolio of commodities (which includes gold) can provide a good inflation hedge over reasonable investment horizons.

Second, beware of buying gold when the inflation-adjusted price is high. Historically, the fair price of gold is closer to $800 than $1,450.

For more detail, read our paper, The Golden Dilemma.

1. why did it take so long? and
2. why only downgrade one notch?

Downgrade history

S&P downgraded France in January of 2012. However, S&P downgrade the U.S. in August of 2011. Until yesterday, Moody’s considered France and the U.S. to be equally risky. It is stupefying that any reasonable person would consider France either equal or less risky than the U.S. [See Moody’s report here.]

Why I would advocate a bigger downgrade for France?

Here are some of the reasons:

• Total debt (government, corporate, private) to GDP greater than Italy or Spain
• 40 consecutive years of government fiscal deficits
• Unemployment rate is now 11% (9.5% last year) and is the highest in 13 years (Germany unemployment is the lowest in 30 years)
• 0% GDP growth over past 18 months
• Banks dangerously levered and many already zombied
• Government spending 56% of GDP (U.S. and Germany in low 40s)
• Uncompetitive labor costs
• Extravagant social programs with retirement in many cases before 60
• Deficit target of 3% of GDP in 2013 is widely consider a “joke”

Hence, the doowngrade should have been multiple notches and the downgrade should have happened long ago. Who are the credit rating agencies trying to fool?

What does this mean for Europe?

Here are some quick thoughts:

• The first shoe to fly in the disintegration of Euro is France
• France will have no choice but to cut government spending
• There are more pensioners than farmers and farm subsidies/benefits will be cut
• As in past, farmers will disrupt the economy, blocking highways, airports
  and eventually send France into economic death spiral
• There is no Euro without France

France will raise taxes on rich to finance its deficit

I have no problem with people paying their fair share of the tax burden. However, beware and learn some lessons from overseas.

• France counting on €20 billion in extra tax revenue from taxing rich
• I doubt they will get a quarter of that. People are moving to Belgium and to London
• These measures are a back door stimulus for neighboring countries and will hurt France in long run.

• The Fiscal Cliff, Government Spending and Growth
• The Fed’s Dual Mandate
• The QE3 Mistake
• QE and Future Inflation

The Fed made a mistake today in launching QE3. This is not just my opinion. It is the overwhelming opinion of America’s CFOs.

In the Duke University-CFO Magazine Global Business Outlook Survey released September 10, 2012, we asked a key question. If your borrowing costs were reduced by 50bp [an optimist assessment of QE3], would you accelerate or increase your capital investment? 647 of 667 or 97% of CFOs said "No".

We also asked them why? Here I quote them directly (I did not correct spelling or grammar). An extraordinary 343 CFOs took the time to respond. Here is an excerpt of some of their comments.

CFOs: We need increased growth not lower rates

• "Forecasted sales will determine the justfication for increased investment plans
  much more than interest rates, which we feel will continue to be low for quite
  some time."
• "We have been getting good rates so far but I need revenue to stay consistent to
  want to invest in projects – we need the sales"
• "We need to see reliable growth before we are willing to invest any further."
• "The main driver of investment decisions for us is consumer demand and/or new
  products/new market entries. Borrowing costs in an important factor, but at
  current levels not a determinant one."
• "We are currently in a holding pattern on capital investments regardless of rates
  until the overall economy recovers more."
• "The investment plans are not tied to the interest rate, but rather to sales and profit"

CFOs: Rates already low so even lower irrelevant

• "Currently financing capital additions in the 3% range. The desired yields on a
  project just won’t be effected by couple points of interest cost one way or the
  other."
• "Rates are already so historically low that there is not room to lower them enough
  to make a significant difference."
• "The interest rate will not fluctuate that great to influence our decisions in this area.
  We already have exceptionally low financing available to us. Our weighted average interest rate on debt is currently the lowest in our history."
• "We have a stated strategy and borrowing costs would likely not cause us to
  accelerate our plan."
• "Rates already extremely low – further reductions can only be minimual and will
  not drive investment decisions."
• "Borrowing costs are already very low. Overall economy is weak not warranting
  any need for additional investment."
• "Interests rates are low enough for investments to be made. However, near and
  mid term economic conditions do not allow for these decisions to be executed at
  this time."

CFOs: Uncertainty and regulatory climate hurts investment

• "We need a better economic and regulatory climate. A decrease in interest rates is
  not what we need."
• "Interest rates already at historic lows. It’s not high interest rates that are holding
  us back, but uncertainty about federal policies and loss of financial wealth of our
  customers."
• "Too much economic uncertainty – want to be able to respond should the fiscal
  cliff scenario occur in the US."
• "It is not interest rates but ROI and uncertainty."

Summary

It is amazing to me that all of the focus is on interest rates – when these rates are at a 50-year low.

In order to make substantial progress on job creation, we need economic growth. The key to economic growth is capital investment. In a separate part of the survey, CFOs indicate a level of capital investment over the next 12 months that is insufficient to make a dent on the unemployment rate.

Even if QE3 is successful in lower rates, it will fail to spur capital investment. While the Fed will spend $85 billion a month, the CFOs say they will have nothing to show for it.

We asked CFOs a number of questions to determine the sensitivity of capital spending to changes in interest rates. In usual circumstances, there is a negative relation between interest rates and capital investment (lower interest rates means higher investment). However, our current economic environment is not ‘the usual’ or reflective of a historical average.

One key advantage of our survey is that we can get information about intentions given the current circumstances.

Our results suggest that planned capital investment is insensitive to rate changes.

Will Interest Rate Decreases Trigger Investment

In the survey (released today), we ask about the possible stimulative effect of interest rate decreases.

• "By how much would your borrowing costs have to decrease to cause you to initiate, accelerate or increase investment projects in the next year?"

667 CFOs responded to the question. For a 50bp reduction in borrowing costs, only 3.0% would initiate, accelerate or increase investment. For a 100bp decrease in costs (which would be an extraordinarily optimist QE), and additional 5.7% would increase investment. In the current environment, investment is insensitive to interest rate decreases.

We asked a mirror question about interest rate increases impacting delay or cancelation. For a 50 bp increase in rates, only 5.4% would delay or cancel their investments. For a 100bp increase in rates an additional 8.6% consider delay or cancellation. Both of these questions suggest that investment is not responsive to modest to substantial changes in interest rates.

We were somewhat concerned that some of the respondents had no investment plans. We asked a separate question to isolate only those who planned to invest. We then recalculated the above sensitivities. For those that will be investing, a decrease of 50bp would lead only 2% to initiate, accelerate or increase investment. For those that will be investing, an increase in rates of 50bp would cause only 5.3% to delay or abandon the investments.

In the Words of the CFOs

Here is what the CFOs state (we also asked them to explain their responses):

• "Rates are already at historic lows, so lower rates would not impact our decision."
• "Rates are too low now to create a stimulus with lower rates"
• "We need to see reliable growth before we are willing to invest any further."
• "The interest rate will not fluctuate that great to influence our decisions in this area.
  We already have exceptionally low financing available to us. Our weighted
  average interest rate on debt is currently the lowest in our history."
• "Borrowing costs don’t drive our investment decisions unless they rise
  dramatically."
• "Interest rates already at historic lows. It’s not high interest rates that are holding
  us back, but uncertainty about federal policies and loss of financial wealth of our
  customers."

Implications for QE

Today’s capital investment is remarkably insensitive to both increases and decreases in interest rates. The reason for this is that the effective hurdle rates are very high – and builds in a buffer. In other words, before pursuing a project, the CFO already takes into account a +/- 100bp change in the borrowing cost environment.

The bottom line is grim for the prospects of additional QE being successful. Rates are already at 50-year historical lows. Many have noticed the diminished impacts of each non-conventional intervention since the original QE. Our survey shows that even an optimistic impact of 50bp reduction in rates would have little measurable impact on capital spending.

Indeed, it is possible that the speculation about QE3 or QE4 generates additional uncertainty – over and above the heighted uncertainty that already exists in the current economic environment. Uncertainty has a negative impact on capital investment.

Economists are split as to whether there would be any real benefit to a third round of QE.

I will present new evidence from a recent survey of 450 U.S. Chief Financial Officers that suggests a new wave of QE will have little or no effect.

The Drivers of Growth

Everyone agrees that we need growth. Growth puts people back to work and growth reduces the fiscal deficit. The real issue is how to get the growth. Some advocate a Keynesian-style stimulus which others think this will have a negative effect in the longer term.

Private investment is critically important for growth. Yes, it is true that consumer expenditures represent two thirds of GDP. However, consumer expenditures are smooth. For example, in the terrible first quarter of 2009, real consumer expenditures dropped by 1.6% (annualized). In contrast, gross private domestic investment (which includes residential and non-residential investment) plunged by 43.0% (annualized).

Current non-residential investment is weak. In last month, Duke-CFO survey of 400 executives, nominal CAPEX was expected to grow by only 4.9% over the next year. While this is much better than the negative numbers of 2009, it is not enough to drive meaningful growth. In addition, residential investment (housing) has been lying fallow.

Of course, there are other growth drivers. However, it is naive to think that exports can lead growth given the recessions in Europe and Japan and the slowdown in China. Government is a negative contributor to growth as both the federal and state governments reduce their expenditures in the face of revenue shortfalls. In addition, consumers continue to deleverage and are an unlikely engine of growth.

In contrast, corporate America is sitting on a vast cash hoard — some onshore and some offshore.

So what can the Fed do?

Fed Options

The Fed has a dual mandate: price stability and growth. Prices are already stable.

Interest rates are the usual focus of the Fed. The short-term rate is already essentially zero. It is unlikely that the Fed would push the short-term rates below zero.

While the Fed essentially controls short-term rates, it only influences long-term rates. The famous Greenspan "conundrum" refers to a situation where the Fed was trying to influence long-term rates and failed.

At the last FOMC meeting, the Fed extended the so-called Operation Twist. The Fed agreed to spend $267 billion to buy long-term bonds and finance it by selling shorter-term bills. The idea is that buying the longer-term bonds bids prices up thereby reducing yields. The predicted effect would be to lower long-term interest rates.

Yes, there are other options which might include lowering the 0.25% interest rate it pays on reserves to zero to spur banks to lend money rather than park it with the Fed. It is possible to purchase other assets (in an indirect way) which might lower interest rates on corporate bonds. They might even copy the Bank of England’s scheme to subsidize bank lending.

The common theme is reducing the cost of borrowing.

The Mistake

However, the Fed is missing something very basic. The cost of borrowing is already very low. The yield on Moody’s Baa rated bonds is only 4.8%. The highest grade bonds, the Aaa, yield is only 3.3%. These rates are rock bottom– and we haven’t seen levels like this in 50 years.

Lowering the interest rate a little more will not have any measurable effect.

Let’s consider the reasons why.

New Evidence from the Corporate Investment Process

Corporate investment works the following way. Someone within a firm makes a proposal to fund an investment. The expected return on the investment (based on forecasted cash flows from the investment) is compared to the cost of financing the investment. There is an adjustment for risk. If the benefits (cash flow returns) outweigh the costs after adjusting for risk, then the investment is pursued.

In the recent Duke-CFO survey, we dig deep into this investment process.

1. The Firm’s Cost of Capital

The firm’s cost of capital is a blended average of the after-tax cost of debt and the cost of equity (what shareholder’s expect to get in buying the company’s stock in the longer-term). We asked our audience what their weighted average cost of capital is.

• The answer is 9.3%.

This number surprised us because it was higher than we expected. In a different part of the survey, we ask about expected returns on equity and the same CFOs pegged a 6.2% total annualized return over the next 10-years. We know the cost of reasonably risky corporate debt (Baa) is 4.8%. The after tax cost is, say, 4%. How do you average 6.2% and 4.0% to get 9.0%!?

It is fair to say that this cost of capital includes some ‘other’ risk contingencies.

However, the story does not stop here.

2. The Hurdle Rate

Most firms do not approve every project that exceeds their cost of capital. They are looking for a target return above the cost of capital to maximize the returns to their shareholders. We asked the same firms for their hurdle rate.

• The answer is 13.5%

Essentially, firms are adding a cushion for contingencies. The cushion is large. The gap from 9.3 to 13.5% is 4.2%. Considering that their true cost of capital is more likely to be 5-6%, the gap is more like 8%!

But there is even more to this story.

3. What Projects are Pursued?

Next we posed the following question to see how likely it is, in the current environment, that a firm pursues a project that exceeds its hurdle rate. Among projects that exceed the hurdle rate, that CFOs could fund if they wanted to, and that they have the management time and expertise to implement, what proportion are pursued?

• The answer is 33.2%.

So even if the project is offering a return of 8% above the cost of capital, there is only a one third chance that the project is approved.

The Fed-Corporate America Disconnect

The Fed’s version of ‘stimulus’ is to lower interest rates. The logic is that lower rates reduce the cost of investment and makes it more likely that firms invest. Here is where there is a disconnect.

This fine tuning does not work. Given the investment cost is so low, a small further reduction in costs will have little or no effect. Indeed, we asked corporate executives about this, very directly. We asked the following contra question: suppose that the firm just approved an investment project that exceeded the hurdle rate, but unexpectedly, the economy wide interest rates increased by 1% (think of the Baa yield going from 4.8% to 5.8%). What is the chance that you would abandon or delay that approved project?

• The answer is 3.4%.

A full one percent increase in rates would have a negligible effect on investment. Any sort of further QE action would be extremely unlikely to have a one percent effect. Hence, the impact on investment is nil.

The disconnect is that the Fed thinks that making small changes in interest rates will drive growth. Corporate America operates differently. They build in large contingencies before they make investments.

Of course, there is a similar logic for mortgage rates. The current 30-year fixed rate is only 3.35%. In addition, mortgage interest is tax deductible. The rates are at historical lows yet the housing market is still sick. It is unlikely that a Fed influenced reduction in an already low mortgage rate would have the desired effect.

Uncertainty Impedes Growth

There is an extraordinary amount of uncertainty due to a number of known unknowns: a slow moving train wreck in Europe, stubbornly high unemployment in the U.S., four years of trillion dollar fiscal deficits, Iran and other Mid East hotspots, the stalling of the Chinese engine of world growth, and the U.S. November election.

We asked the CFOs why projects that exceed the hurdle rate are not pursued. The answers fall into two categories.

The first is best summarized by a CFO who wrote us, we want "to maintain a strong cash position in the current economy." Essentially, given the risk, corporate America is playing wait and see. This applies to investment as well as employment decisions.

The second is summarized by another CFO who wrote us complaining about “insufficient capital”. That is, even though the firm might have a great project, it can’t get funding from the bank.

So there are ‘haves’ and ‘have nots’. The ‘haves’ are the cash hoarders who will not pull the trigger on good projects because they are worried about the future and want to conserve cash. The ‘have nots’ are firms that lack cash and can’t get bank loans to finance good projects because the banks want to conserve cash.

The survey evidence suggests that some small tweak of the interest rate will not drive growth. It would be far more effective for our policy makers to pursue an agenda with the goal of reducing policy uncertainty. The patient will best return to health in a stable environment.

Testifying before Congress back in 1993, when interest rates were 7.5%, I advocated shifting some of the Federal debt to floating rate debt. If the Treasury had shifted half of the debt to floating rate at that time, they would have saved $2 trillion to date.

Today, however, interest rates are at or near historic lows. It is the wrong time to issue floating rate debt. This type of debt introduces unneeded funding risk.

Treasury Announcement

Traditional Treasury bonds have a fixed maturity, say 10 years, and a fixed coupon rate, say 2%. When you issue such a bond, you exactly know what the cash flow liabilities are: 1% every six months until maturity. Floating rate notes (FRNs) have a fixed maturity but variable coupon. An example bond might have 10 years to maturity but with a coupon that resets every 6 months to reflect the rate on a short-term Treasury bill. When FRNs are issued, the liability is uncertain – because the future path of interest rates is not known.

Many expected the Treasury to push forward with floating rate notes (FRNs) today (May 2, 2012). They were originally proposed in February 2012. See the original report. While the Treasury still sees benefits in the issuance of floating-rate notes, a decision appears to have been deferred because of “a significant amount of feedback”. See the Policy Statement.

The initiative appears to be coming from an industry group called the Treasury Borrowing Advisory Committee (TBAC). They stated:

“The Committee reiterated that its main goals in unanimously supporting FRNs were continued diversification of the investor base and average maturity extension through issuing floaters in lieu of shorter dated issuance. Furthermore, FRNs should lead to a reduction of term premium expense over time. While initial issuance should have final maturities of one to two years, eventually the Committee anticipates FRNs of longer final maturities.” Read the TBAC Report.

This committee is populated with representives from JP Morgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, etc.

The Case Against Floaters

When I made my testimony to the House Ways and Means Committee in 1993, floating rate issuance made a lot of sense. Interest rates were relatively high (7.5%). See Testimony. Indeed, if the Treasury had funded half of its needs with FRNs, $1.9 trillion would have been saved ($2.3 trillion taking the time value of money into account).

Today is different for two reasons.

• Interest rates are at historic lows with the 10-year rate at about 2%. FRNs make sense if you think interest rates are heading down. It seems very unlikely that rates will stay at 2% for the next ten years.
• The U.S. government leverage is significantly higher today than in 1993. The Federal debt is $15.4 trillion and our GDP is $15.5 trillion. When you have high leverage, you do not want to take extra risk on funding (the risk being interest rates going up). We have seen this movie played multiple times already — in Europe.

The Case for Floaters

The TBAC minutes of May 1, 2012 state:

“The Committee again unanimously recommended that Treasury pursue an FRN program, citing the merits of expanding the investor base and providing a cost effective means of extending the average maturity.” Read the Minutes.

There are three issues: bring in new investors, cost effectiveness, and extending maturity. Let me tackle each one.

New Investors

In my opinion, this is a weak argument. Essentially, the FRNs pay a coupon that reflects the Treasury bill rate. So why not just invest in Treasury bills? Treasury bills have been around a long time. The only difference is that you need to roll over the Treasury bills, say every 90 days. However, this is routine and institutionalized. To be clear, there is no economic difference between the cash flows of investing in Treasury bills and investing in FRNs.

In addition, FRNs are not new. It is easy to create a FRN by buying a fixed rate Treasury and entering into a swap agreement (you pay the coupon to an investment bank and they pay you a floating rate). There is a very minor amount of counterparty risk. It is minor because you hold the bond. If there was a problem with the counterparty (which seems unlikely given the history of bailouts), your principal (the bond) is not at risk.

Cost Effectiveness

It is true that the short-term costs are less for FRNs than for fixed rate bonds. The Treasury bill yield is a fraction of one percent — whereas the Treasury bond yield is 2%. So, you save money immediately. However, it is not clear you save money in the end. Consider the choice between a 10-year FRN and a 10-year fixed rate Treasury bond. With the fixed rate bond, you are locked into to 2% for 10 years. With the FRN, the rate fluctuates. Maybe it is 1% but maybe is grows to 8% -it depends on future interest rates and inflation. Who knows? This is exactly what I mean by funding risk.

Let’s take a hypothetical example to get a perspective. Suppose the Treasury decided to fund half the Federal Debt with floaters. Currently, the average interest rate on the Federal debt is 2.8%. This would lead to some immediate savings. However, what happens if rates jump – which is not unreasonable given the Federal Reserve’s balance sheet of $2.8 trillion or 19% of GDP. The savings would be wiped out if rates rose to 2.8 (which by the way, is roughly today’s inflation rate). If rates go to 4%, then the government has to come up with an extra $1 trillion to pay the extra interest they precommitted to. Do you think 4% rates are out of the question? I certainly don’t.

The uncertainty about future interest service is what I call funding risk. The amount of cash needed is unpredictable. If interest rates rise, then extra interest service must come from: 1) higher taxes; 2) spending reductions; 3) more borrowing; or 4) printing money. Note that (4) usually causes rates to increase even more, leading to even higher service costs. (3) can have a similar effect.

Extending Maturity

Yes, FRNs extend maturity – if they are replacing securities that have a shorter maturity. Suppose they replace Treasury bills. In this case, the interest rate risk is identical (both pay the Treasury bill rate). Suppose they replace fixed rate coupons. In this case, the interest rate risk changes. As rates go up, the FRNs become more expensive to service.

The Treasury’s February 2012 document is a good read. They make the case that there could be some cost savings in minimizing the rollover risk. That is, instead of going to market every three months for Treasury bills, you commit for a longer period, say two or five years. They also argue there is a modest term premium that could be captured.

If the FRNs are just 2 years to maturity, then not much additional risk is created. This is especially true today when the Federal Reserve is on record saying that rates will remain low through 2014. However, what makes me nervous is the “eventually the Committee anticipates FRNs of longer final maturities.”

I am in favor of extending maturities. The Treasury has extended the average maturity of the Federal Debt to about 63 months over the last three years. However, this weighted average maturity is no different than the average maturity in the 1990s – when interest rates were much higher. It is best to extend maturity with fixed rate bonds – not floating rate bonds.

Bottom Line

To me, the potential benefits to issuing FRNs are minor. However, the costs could be severe. In a different time, when the Federal Debt was a much smaller fraction of GDP, one could make the case to experiment with FRNs. However, today we face much greater risks.

You don’t need to look far to see the risks created by relying on short-term funding. One of the major reasons that so many financial institutions needed to be bailed out during the crisis was that they were using short term funding. They faced rollover risk as well as very high interest service cost. The same thing happened in peripheral countries in Europe. If they had locked in long term funding at fixed rates a few years ago, the crisis would have been mitigated. Instead, we are facing a €1.5 trillion rollover in 2012 at uncertain costs.

For the Treasury’s plan, there is no roll over risk. However, there is interest service risk. Overall, the costs outweigh the benefits.

Media Coverage

• April 30, 2012 Bloomberg, Father of Treasury Floaters Says Now Worst Time for Sales, by Liz Capo McCormick and Meera Louis. Bloomberg version.
• May 1, 2012 Washington Post, U.S. considers issuing floating-rate debt,
  by Zachary A. Goldfarb. Washington Post version.
• May 2, 2012 Wall Street Journal, Treasury’s Delayed Decision On Floating Rates Raises Questions, by Cynthia Lin. Wall Street Journal Version version.

I am doing a live Webinar on April 11, 2012 at 11:00am ET. It is called Confronting Global Risks.

There is a preparatory video that is available here.

The live session will take your questions. The basic topics are:

I will talk about managing global risks such as:

• a complete breakdown in the Eurozone
• a preemptive strike on Iran’s nuclear installations
• a U.S. debt-to-GDP ratio that is drifting into European territory
• the fact that 4 of 19 banks failed the recent stress test — but the bar was only set at 5% Tier 1 capital (roughly 20x leverage); at 6%, 11 of 19 fail; at 9%, 16 of 19 fail.

Here is the key page. It contains the prep video and on Wednesday April 11, there will be a live stream from this page. You are welcome to register. While this event was designed for Duke alumni, anyone is welcome to register and ask questions. If you can’t make it on the 11th, we will post a video of the event later.

This helicopter drop does not solve the Eurozone’s problems: it merely delays them. The ECB is treating the symptoms not the disease.

LTRO is Long Term Refinancing Operations. LTRO was launched in December 2011 by the ECB. The ECB offers unlimited loans to European banks for a three-year term – at an interest rate of only 1%. The loans are unconditional – banks can do what they want with the funding.

1% is a remarkably low rate – given that most of these banks are insolvent. They would have no hope of getting terms like this in the open market.

In December, not surprisingly, 523 European banks wanted a piece of the action. LTRO1 amounted to €489B of bargain loans. Importantly, about €300B was rollover. That is, banks had loans that were due and they rolled them into new loans at the 1% interest rate. The amount of "new" liquidity was less than €200B.

How massive is massive?

Today, €530B was taken up by 800 banks. The size of LTRO2 was larger than expected and the number of banks participating was a far larger than expected. See my forecast made yesterday.

Before LTRO2, the ECB’s balance sheet stood at €2.7 trillion – far exceeding the size of the Fed’s balance sheet in the depths of the financial crisis.See ECB’s Balance Sheet.

What is unclear, is how much of the LTRO2 is new liquidity. LTRO1 had about €190B of new liquidity. My estimate is that LTRO2 has about €400B of new liquidity. Note this is all in one shot too. It is not a gradual program like the Fed’s QE.

So the ECB’s balance sheet has exploded to approximately €3.1 trillion. Currently, the Fed balance sheet is only(!!) €2.2 trillion. In the November 2008 (QE1), the Fed balance sheet was €1.5 trillion. So, the ECB’s injection is massive.

One further note. It is widely quoted that the rate on the LTROs is 1%. The ECB says that "The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation." Hence, if the ECB’s short-term interest rate benchmark (known as the MRO rate) increases from its current rate of 1%, this would increase the interest rate charged to banks on the LTRO. I think it is unlikely that the MRO will substantially increase over the next three years. Even if it does, it might raise the total rate to 1.25-1.5% which is still incredibly cheap compared to the rates banks would be charged in the open market.

What is the difference between QE and LTRO?

In November 2008, the Federal Reserve embarked on a Quantitative Easing (QE) program. The idea of the program was to purchase both Mortgage Backed Securities as well as U.S. Treasuries. This action bid prices of these bonds up and reduced interest rates. The increased prices helped bank balance sheets. The lower rates helped banks reduce the cost of their lending. The lower rates trickled down to the average borrower, whether a small business or an individual.

LTRO is different. LTRO is specifically directed at European banks. The loans are made to these banks but there are no strings attached. That is, the banks can do whatever they want with the money.

Here are the possibilities:

• 1) Banks could borrow money from the ECB at 1% and invest in sovereign debt which might yield 7% (the so-called Carry Trade);
• 2) Banks could borrow money from ECB at 1% and then provide loans to consumers and corporations;
• 3) Banks could borrow at 1%, issue bonds and then use the LTRO to buy them, i.e. buy your own bonds and hopefully reduce the cost of borrowing in the future; and
• 4) park the money at the ECB and collect 25bp (the so-called Reverse Carry Trade).

Option 1 is what the ECB wants. The ECB is prevented from outright buying of distressed sovereigns (they are allowed to buy on the secondary market). They can achieve the same objective indirectly. They give money to the banks (well, 1% is almost giving) and the banks to the dirty work for them.

For example, Intesa Sanpaolo said today that his bank would take €24B in LTRO and invest in Italian Treasuries with maturities of three years or less.

This Carry Trade is also very profitable to the banks – as long as the system is intact (i.e. there is no meltdown of the Euro area). It is hoped that the increased profit will make these banks healthier.

As I have pointed out in previous entries, the European banks need the help. Most are insolvent.

An alternative strategy would be to massively consolidate the European banks – shuttering the ones that are the most insolvent and allocating quality assets to the relatively strong ones.

However, that is not the strategy that is being followed. Taking a page from the U.S. playbook, no one is allowed to fail. LTRO is available to any bank that can post eligible collateral.

So, in the end, this is printing money. The ECB balance sheet has exploded. It is far greater than the size of the Fed’s balance sheet at the worst time during the financial crisis. Importantly, the quality of the ECB’s balance sheet is far lower. Remember in QE, the Fed was buying high quality mortgages and Treasuries. In QE2, the Fed was buying Treasuries. The ECB has a pile of peripheral debt plus and they have lent to zombie European banks.

Let’s take a step back and consider the following question. Given that we know that European banks are already too highly levered, does it make sense for them to borrow more money and then invest the borrowed money in risky sovereign debt?

From an economic point of view, the answer is no. However, from the banks’ point of view, the answer is an obvious yes. There is no downside for the banks. They will be bailed out if the situation in Europe deteriorates.

Where does the money go?

It is well understood that the most effective remedy to Europe’s malaise is economic growth. However, little of the LTRO is going in that direction. Data released on Monday by the ECB details positive loan growth – but you need to look beyond the top line numbers. There was negative consumer loan growth. There was negative non-financial corporation loan growth. The growth was being driven by financial companies.

Dependence on the ECB

LTRO is a sweet poison. Why should a bank go to the open market and borrow money when you can go to the trough and borrow at 1%? The LTRO creates a dependency on the ECB. The European banks have been effectively knocked out of non-European markets for funding – because foreigners realize that these banks are largely insolvent. However, how long can the ECB provide back up? How long can the ECB ignore that many of the banks are zombie? Is the next page in the playbook, the BOJ strategy of the 1990s?

Avoiding tough decisions

I continue to believe that Europe is not dealing with its problem head on.

The bailout of Greece is a fool’s errand. The €130B and the "selectively defaulted" Greek debt does not solve the problem. Indeed, it is unbelievably naïve to think that the Greek debt to GDP will by 120.5% in 2012. It is a classic case of throwing good money at bad. What Greece needs is a massive devaluation – and that is impossible given that they are shackled to the Euro. Even a 100% repudiation of their sovereign debt would not solve the problem. They are still running massive fiscal and trade deficits and the debt would just be racked up again.

The same is true for the banks. I vote for consolidation – elimination of the weak banks and the strengthening the strong.

How risky is the ECB?

There are a number of risks. However, it is key to understand that the main lever the ECB has is the printing press. Unlike a regular corporation, if the ECB gets into trouble (their capital depleted by sovereign defaults), they could always print their way out.

First, we have already mentioned that the ECB’s holdings are far lower quality than the Fed’s holdings (for example, they are holding Greek sovereigns at par when others took a haircut). That presents a risk.

Second, another risk is the system holding together. If a number of countries exit the Euro (and they could be good countries or bad countries), that would create risk.

Third, and by far the most important, is the risk of monetization. Yes, the ECB could print their way out of a problem. However, that could manifest itself in significant inflation in the future. It is true that we don’t see it today because monetary velocity has plunged. However, at some point, velocity will recover and Euroland will be hit with a huge inflation tax. People don’t put weight on this right now because inflation is so low. But it is naïve to think that cranking the press like they are doing has no future repercussions. Inflation can be avoided only if the money is taken back and we all know that taking back is painful and hugely unpopular in the face of high unemployment.

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