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Jubak's Journal
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Big growth saves the Fed's bacon
With billions wagered on continued low interest rates, the spectacular rise in GDP does what Alan Greenspan could not: Raise the specter of higher rates.
By Jim Jubak
Did the huge 7.2% advance estimate of third-quarter GDP growth just save the U.S. Federal Reserve and the rest of us from the fixed-income speculators?
Its highly likely. The extraordinarily strong economic growth, announced last week, is just the right kind of off-the-charts number to take air out of the bubble in financial assets. It puts some risk back into those big leveraged bets in the markets for bonds and other fixed-income products. And if the traders who have made those big bets start to feel so worried that they begin to unwind those positions piece by piece now, thats all to the good. It reduces the danger that the bond and stock markets could be thrown into chaos if everybody rushes for the door at the same time once interest rates actually start to rise.
And thats got to make at least some of the folks at Fed breathe easier, because its the central banks policies that have helped inflate that bubble. And we all remember how the last bubble in financial assets worked out.
Why the Fed really needs to be saved
It may come as a surprise to investors that the Fed needs saving. After all, many of us have spent the last two years wondering if Alan Greenspan and Co. would be able to save the U.S. economy from, first, recession, and, second, from a long period of agonizingly slow growth.
But the Fed does need to be rescued from the worst consequences of its own monetary policies. And the central bank is so trapped between an economic rock and a monetary hard place that it has very little power to save itself without the help of some good economic luck.
Which is exactly what the third-quarter gross domestic product delivered last week.
Heres the problem the Fed faced when its Federal Open Market Committee met to vote on the direction of short-term interest rates on Oct. 28. It was just a few days before the GDP report was released. (The Fed undoubtedly knew what the numbers would say when they were announced; indeed many economists had predicted growth for the quarter would be at least 6% on an annualized basis.)
All the data until Oct. 28 indicated the economy was recovering, but the recovery was still fragile. CEOs were not upping their budgets for plants and equipment, nor were companies hiring rafts of new workers. Indeed, the economy had finally started to produce some new jobs -- but not in large enough numbers even to keep up with growth in the U.S. workforce. Consumers had to keep the economy going with their spending, but some of the numbers from August and September were weak enough to raise fears that consumer enthusiasm to spend might be starting to falter, at least a bit.
It wasnt that the Fed hadnt tried to get economic growth back on a steady path again. The Fed had cut interest rates a now-famous 13 times from 2001 to 2003. The cuts took the short-term interest rates set by the Fed to 1% from 6.5%. That made it cheaper for consumers and corporations to borrow. So, it certainly wasnt the Feds fault that companies didnt want to invest even when money was so cheap. The rate cuts created the tremendous boom in mortgage refinancing that turned out to be so critical in keeping the economy afloat as the corporate sector worked to unwind the capital spending excesses of the 1990s.
That isnt all the Fed did to stimulate growth. The U.S. central bank also kept pumping new money into the economy. In the last 12 months, for example, M-3, the money supply measure that uses the broadest definition of money, grew by 8%. Putting more money into the system guaranteed that banks and other financial intermediaries would have plenty of funds to lend, and the money growth also helped keep interest rates low.
Add in the economic stimulus from the Bush administrations tax cuts, and the economy had a massive package of monetary and fiscal stimulus working in its favor.
Trying to prevent an economic relapse
The package helped increase growth in GDP from 1.4% in the first quarter of the year to 3.3% in the second quarter. And it helped to point many leading economic indicators toward even better growth for the third quarter. But it hadnt been enough to make the Fed feel that the economy still couldnt have a relapse.
The Fed was determined to do all it could to prevent that relapse and the greatest danger -- and the one that the bank had the most power to avert -- was from a premature rise in interest rates. Higher rates could choke off growth before it had a chance to become self-sustaining. And it didnt matter if the rate climb came in response to the Feds own policy or as a result of bond traders and investors belief that an economic recovery was just around the corner. Its arrival would push interest rates higher.
So in the public announcement following the August meeting of the Open Market Committee, Fed Chairman Greenspan emphasized that the bank had no intention of raising interest rates for a considerable period. By making a long-term commitment to not raising rates, the Fed hoped that it could stop the upward draft in long-term interest rates that had begun in the early summer. (If youre a bond investor, you wont forget July, the worst month for bonds ever.)
A commitment to lower rates wasnt universally popular inside the Fed. Although most members of the Open Market Committee agreed that it was important not to choke off any economic recovery by raising rates now, some committee members worried about the wisdom of telling bond traders that they didnt need to fear a hike in rates by the Fed for a considerable period.
By taking the risk of a Fed rate hike out of the picture, the Fed would be giving an all clear to speculation in the fixed-income markets. (I dont use speculation and speculator in a pejorative sense, but simply to distinguish individuals who put short-term, leveraged bets on the direction of markets from investors with their longer time horizons.) A bond trader could borrow at the short end of the yield curve at something near 1% and invest that money at the long end of the curve, say 4.3% for the 10-year Treasury note. To turn that for a lucrative play on the difference between 1% and 4.3%, a bond speculator only needed to increase the amount of borrowed money, called leverage. If playing the spread on $100,000 of notes yielded a profit of $1,000, then borrowing $100 million would result in a profit of $1 million. And the biggest speculative positions involved sums much larger than that.
One could lose ones shirt
The only problem with a play on the spread between short and long-term rates was the danger that the price of the notes purchased with borrowed cash would fall. If that happened, a speculator would face a margin call that required immediate repayment and result in an immediate, and very large, loss.
With the Fed committed to holding the line on raising rates, which would have the effect of driving down bond prices, the risk in leveraged speculative bets in the bond market went way down.
Could the Fed do anything to put more risk in the speculative equation? Sure. The bankers could threaten to raise interest rates relatively soon. That would deter leveraged speculators.
Of course, it also would put the economic recovery in danger. Not an easy choice for the Federal Reserve.
Doing nothing wasnt an especially attractive alternative, however. The longer the Fed kept its commitment in effect, the larger the leveraged positions that speculators would build. As those positions expanded, there were greater risks that financial markets would plunge into chaos when the Fed did finally eliminate its commitment and reverse its stance and forced speculators to unwind their leveraged positions.
This was a particularly pressing issue for the Fed because the bankers were worried about where all that liquidity theyd been pumping into the economy had been going. It certainly wasnt going into business investment that they knew. From their study of financial history, they feared that much of that increase in the money supply was going into financial assets. That instead of being invested in machines and capital equipment, it was being invested in stocks and bonds and other financial instruments. After an earlier flood of liquidity from the Fed had fueled the bubble that burst in March 2000, the Fed was doing it again, albeit on the smaller scale, in 2003.
GDP to the rescue
And this is where the 7.2% GDP number rides to the rescue.
Just by itself, without a bit of a change in the Feds positions or official commitment, an estimate of that kind of high-octane economic growth puts a big dollop of risk back into the fixed income markets. Growth at 7.2% a year by itself will very quickly take interest rates higher, no matter what the Feds policies are; companies will compete to raise money to use to expand to meet rapidly rising demand.
If the economy is going to grow at 7.2%, leveraged speculators run the risk that rising rates and falling prices will ravage their positions. That lowers the attractiveness of this particular trade, and some speculators will now begin to unwind their positions.
Of course, no one knows if this 7.2% number will be followed by fourth-quarter growth of 4% a year or 6%. But 7.2% growth in the third quarter certainly puts the numbers on the higher end of projections into play. And, by itself, this will raise the consensus for greater economic growth in the last quarter of 2003 and the first quarter of 2004. That, too, will give pause to anyone with leveraged bets that depend on steady or falling interest rates.
My best guess is that the 7.2% number will usher in a period of more volatility in the stock markets as investors debate the possibility of 6% growth for the next three quarters versus 4% growth. Each new bit of economic data will drive the debate first one way and then the other. In and of itself, that greater volatility will raise the risk in leveraged speculation and result in losses large enough and random enough to make some speculators close their positions.
So without doing anything, the Fed will be the beneficiary of a gift of risk in the financial markets. (Of course, the Fed isnt actually doing nothing at the moment. Recent numbers show that, despite its commitment not to raise interest rates, the Fed has slowed the growth of the money supply to almost nothing.)
This gift of risk will have its biggest effect in the fixed-income markets, but the stock markets also will feel the effect as volatility increases in those markets as well as investors vacillate between more widely differing estimates for economic and earnings growth.
This may not have any net effect on stock prices, but the greater volatility should start to increase the levels of fear (and the prices that investors will pay for options to insured against that fear) in the market as measured by such indicators as the Chicago Board Options Exchange volatility index ($VIX.X)
Sometimes its better to be lucky than good. Even at the Federal Reserve.
New developments on past columns
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Shares of GameStop (GME, news, msgs) took a hit on Nov. 3 after competitor Electronics Boutique Holdings (ELBO, news, msgs) announced that its fiscal third-quarter earnings would come in at 5 cents to 6 cents a share. Thats, well, just a tad shy of the 14 cents to 18 cents that Wall Street had forecast. But GameStop was able to contain the damage by quickly reaffirming the high end of its own fiscal third quarter, which ended in October, and for the full fiscal year. GameStop is now forecasting third quarter earnings of 16 cents to 18 cents a share and $1.02 to $1.06 a share for the full fiscal year. The current consensus estimate is 17 cents for the quarter and $1.04 for the year. The company said comparable-store sales remained on track for a third-quarter decline of about 1.5% to 2.5%. GameStop will report earnings Nov. 17. In the longer term, despite the damage to GameStops share price, it looks like the company is picking up market share versus competitors such as Electronics Boutique. As of Nov. 4, Im keeping my December target price of $18 a share. (Full disclosure: I own shares of GameStop.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: GameStop. He does not own short positions in any stock mentioned in this column.
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