Archive for the ‘money’ Category

Forgive me; it has been six months since my last confession…oops I mean posting.

Since April all major investment markets have rallied. This is true of both stock and bond markets. Much of the rally is due to the coordinated policies of central bankers, especially the US Federal Reserve. Toxic assets (TARP, TALF) were purchased from commercial banks and insurance companies dramatically reducing risks, visible and hidden, of commercial bank asset bases. The twin policies of de-risking and improving disclosure provided the needed incentive for those investors looking for a reason to buy.  A return to risks assumed has been re-established across the globe. Few would argue with the assessment that these efforts have resulted in the desired policy outcome of bringing order and stability to a global financial system that was unable to function in the last half of 2008.

The mandate of the Federal Reserve Bank is to use monetary policy to promote “maximum employment, stable prices and moderate long term interest rates.” Money supply is the major lever the Federal Reserve has to control the negative effects of inflation. This past year saw a unique policy response by the Fed. The unorthodox monetary policy that ensued presents many challenges today and especially in the future timing of unwinding the current position. The question remains: Will high levels of inflation result from the measures implemented by the Federal Reserve in 2008-09?

Money is created by the Fed in two ways: directly and indirectly. In the direct route, the government can print it or mint it. This is sometimes referred to as central bank money and includes net money assets of the government. This money is backed by market confidence in the ability of the issuer to meet its obligation through future tax revenues.

The indirect method is creating money through a fractional reserves system. The Federal Reserve controls the reserve of capital commercial banks are required to maintain in their operation. Today, Commercial Banks must deposit 10% of their assets in a reserve account with the Fed. From the perspective of the commercial lender, they can lend up to 10 times their asset base. This leverage creates money in the economy. This is commercial bank money also known as check book money.

Money supply has several definitions. For our purposes I will define Money supply as MB or monetary base which includes currency in circulation and demand deposits, minimum reserves and excess reserves held by the central bank.

The Fed enters into open market operations buying and selling t-bills, notes and bonds to principal dealers. The effect of a sale of bills or notes is to reduce the money supply by retiring money back to the fed. Alternatively, the when the Fed buys notes (or other assets) money supply increases. These operations also reduce or increase the leverage available further affecting the overall money supply.

Prior to October of 2008, increases in bank reserves ended up as currency in circulation. However in the fall of 2008 the fed began paying interest on excess reserves providing incentive for commercial banks to leave the money on deposit and out of circulation. This rate is equal to the upper limit of the fed funds rate of 25 basis points. The result is the increase in monetary base has had little impact on currency in circulation but has resulted in a dramatic increase in the Feds excess reserves account. This account increased from about 2 billion in mid 2008 to more than 750 billion in June of 2009.

University of Chicago economist Milton Friedman and others observed a long term relationship between money supply and inflation: (The quantity theory of money)

MV = PY

Where;

M= quantity of money

V = velocity of circulation

P = price level

Y = level of output of the economy

Friedman and other monetarists pointed out that change in money supply control the level of nominal output of the economy. Furthermore, in the long run, changes in money supply determine changes in prices or inflation. For Friedman “inflation is always and everywhere a monetary phenomenon, in that it can be produced only in a more rapid increase in the quantity of money than in output”.[1]

Inflation erodes purchasing power. This is how it affects the average family. For the US market, in the past 15 years the purchasing power of a US dollar has dropped to 67 cents. So a consumer needs fifty percent more dollars to buy the same basket of goods. Consumer Price Index (CPI) is the common measure of inflation along with the Core CPI which excludes the prices of food and energy. In the past 50 years the average annual change in CPI has been 4.2%, 4.1% for Core CPI. There has been a big range of values for CPI; greater than 14% in 1980 and -1.2% in June of 2009 (deflation). The Fed is believed to have a target for inflation of 2%. The Bank of Canada has an explicit target of 1-3% for Core CPI.

In July of 2008, prior to the default by Lehman Brothers in October of that year, US inflation levels were relatively high at 5.4%. US money supply was about 850 billion and had been stable at that level for several quarters. By June of 2009 CPI was -1.2% and money supply had doubled to more than 1.6 trillion dollars. In addition, through large scale purchases of agency debt and mortgage backed securities, the Federal Reserves assets base increased from about 900 billion to more than 2 trillion, though this was done in such a way as to avoid increasing money supply. The Federal Reserve funded the purchase of toxic assets through a special t-bill issued by the US Treasury. The deposit accounts of the Treasury are not part of the monetary base.

The challenge for the Federal Reserve is to shrink their balance sheet and reduce the money supply before inflationary expectations rise above their target. Moving too early will delay the economic recovery. Waiting too long will result in inflation. The incentives line up behind waiting too long.

Paying interest on reserves is a temporary solution. In the long run it adds to the monetary base. As well, commercial banks will find more profitable alternatives for the money. This is a big problem. 750 billion in the hands of commercial banks can result in as much as 7 trillion in additions to the money base.

Some options for the Fed to curb future inflation – exit strategy

1. The fed could use its powers to limit the leverage for commercial banks.

2. They can enter into reverse repurchase agreements (REPO) with commercial banks for the toxic assets on the feds balance sheet. If commercial banks enter into these agreements the monetary base will decrease through a reduction in the excess reserves account.

3. Treasury could issue debt and deposit the proceeds with the Fed.

4. Fed could issue its own debt directly reducing the monetary base, in competition with the Treasury.

5. Fed could let assets mature, or sell them into the markets.

Finally, the fed must be able to conduct monetary policy independent of political pressure. To avoid inflation there must be a shift from propping up credit institutions to one of price stability and oh yes they must get the timing very right.

We should probably get ready for inflation.

Milton Freidman, “The Counter—Revolution in Monetary theory,” Wincott Memorial Lecture, Institute for Economic Affairs, London, 1970.

The financial press appears to be drawing parallels between our current financial challenges and the depression of the 1930s. To some it may seem reasonable. Yesterday, British Prime Minister Gordon Brown, in the House of commons, referred to the economic environment as a depression, though he later explained that he simply got the words wrong meaning to say recession. This is how rumours start.

While drawing parallels may make it easier to explain complex subject matter, there are many differences between now and then.

1. In the 1930s there was no social security. Today these cheques, delivered monthly, provide a basic level of subsistence.

2.  Peoples’ savings are protected from bank failures through federal deposit insurance. In the 30s investors lost their savings when banks defaulted.

3. Governments around the globe have lowered interest rates in response to a weak economy. In the 30s the U.S. actually raised rates simply getting the monetary policy wrong. These rate cuts are significant. The Bank of England is currently at 1% for fed funds, the lowest level since the Bank was established in the the 1700s . Japan has lowered the rate to zero. Canada and the U.S. are at 1%.

4. There has been a global increase in money supply unlike the contraction experienced in the 30s.

5. International trade agreements now promote trade between economies. The escalating trade barriers introduced in the thirties had the opposite effect.

6. As a global trend, corporate and individual taxes are low when compared to the rising tax environment which typified the 1930s.

7. We now have single digit unemployment. In the thirties unemployment exceeded 20% in North America.

8. Governments have acted quickly, introducing a fiscal stimulus package in a globally co-ordinated effort. In the 30s Roosevelt’s “New Deal”  took several years to launch.

9. We have the experience of the depression as our guide.

For a great read and perspective of economic cycles I recommend The Ascent of Money by British Historian  Niall Ferguson. It it densely written, and therefore a moderately difficult read but gives an excellent review of how governments have dealt with crises beginning with the advent of money.

Bob Keyes, on January 7th, 2009 at 3:32 pm

Patrick, as an investment advisor, how do you balance the risks and need of an individual investor who is trying to make a return in a market dominated by big players/hedge funds/institutions who have a very different risk profile and appetite than a small investor has. Seems to me that the small guy is just along for the ride, be it good or bad, and has to try to anticipate the risk profile of those who dominate the markets because they are the players that will ultimately determine how well markets perform and react to events.

I think this is a great comment and reflects the attitudes of many small investors especially when reviewing the results of 2008. It seems to me that the central concern is… how can a small investor compete? The assumption here is that the bigger players have the advantage and seem to be the biggest influence in establishing prices. Lets look at some of the evidence.

We know that in the aggregate, the returns available to all investors is the return to the markets. That’s all there is. On average then, if costs are lower for those getting the market return, the average return to “passive investors” will be greater than the average return the “active investors” receive when costs are considered. This  simple important point was perhaps first introduced by Bill Sharpe in his 1991 article titled the Arithmetic of Active management.

There are several implications to consider:

Star Hedge Fund, portfolio managers and large institutional investors spend all of their time and effort trying to outperform their contemporaries. They spend money employing managers and analysts. They have marketing staff and advertising budgets. They trade to exploit opportunities so as to gain relative advantage. All of these initiatives cost money.  So if  manager A gets some advantage then, by definition, the other managers must do worse. The costs employed in these efforts  reduces the total return available to the group.  Though it may seem intuitive, it is worth noting that despite  the considerable “advantages” and effort employed, as a group they under-perform the return provided by the markets in which they invest . They must because of the costs of their operations.

Some active managers will do better, though any innovation is quickly adapted by the competition. It’s a big arms race and we all benefit in the outcome as prices of assets are refined. It helps our markets operate more efficiently. We need active managers to ensure that prices are fair. Their efforts act as a kind of subsidy to all investors, ensuring a reasonable relationship between risk and return. We need not jump to the conclusion the prices are always “correct” but there is significant pressure brought to bare so that investments move to equilibrium value, where risk and return are in balance.

It’s really tough to compete as an active manager. These people are smart, committed and well financed. The dream of opening a discount brokerage account and competing with these folks is probably going to turn into a nightmare. The occasional exception, like a lottery winner, doesn’t change the math. Unless you are born into this world wealthy, building your own hedge fund probably happens after you retire from you life’s work. Discount brokerage accounts have helped to reduce the costs for individuals to trade stocks.  But bringing a knife to a gunfight is not my idea of a relaxing retirement plan.  You have to look at the incentives. Discount brokerages do better when clients trade more.  Clients do worse when they trade more. It doesn’t matter if the cost of the transaction is zero. I will provide more on this in a future post.

Our mandate is to help small investors win by putting them at an advantage. We focus on capturing the return provided by the asset classes in which we invest. We focus on keeping costs down and minimizing taxes. We focus on providing service on financial issues outside of investment returns.  We play a winning game not a losing one.

Background
In 2003 the Canadian Federal government agreed to investigate whether an  account would be a useful and appropriate way to help Canadians save more money. This undertaking eventually led to the introduction of the tax free savings account (TFSA) for 2009. It has borrowed from the Roth IRA in style and intent.

Rules For TFSA

Contributions are not tax deductible. You must be 18 years of age or older, a Canadian resident and be able to supply a valid social insurance number to participate. Initial contribution limits are $5,000.00 per year and will be indexed to inflation. Excess contributions will be taxed at 1% per month so this is something you really want to avoid. Unused contributions will be carried forward indefinitely. Contributions are not related to earned income. Any amounts withdrawn are added to the contribution room the following year.

Income and capital gain are not taxable while retained in a TFSA or when withdrawn. Income earned or amounts withdrawn will not be added to income tested benefits or credits delivered through the tax system. In addition these amounts will not effect OAS, GIS or Employment insurance benefits.

The qualified investments mirror RRSPs. Arms length entities such as stocks, bonds, mutual funds etc… . Small private shares may qualify subject to certain conditions. Interest on borrowed money to fund TFSA is not deductible., though a TSFA can be used as collateral for a loan.

No attribution rules apply so the TFSA will be used for income splitting purposes. The tax free status is lost at death though a tax free roll-over is possible if a spouse or common law partner is named as beneficiary.

Strategies

These flexible plans do not replace RSPs. They will be used most effectively in conjunction with pension type investments.  If you contribute a maximum to an RRSP and have savings outside that plan then the TFSA should be maximized.

Perhaps the best uses will be around family income splitting strategies. Parents or Grandparents can transfer up to $5,000. per year for each young adult or grandchild. Recipients can take the money out without tax and new room will be created for future savings.

This is also a welcome new vehicle for those who have high pension adjustments and have little use for RRSPs.

Other Notes

For young adults, a  tax return is required to build TFSA contribution room

Anti Avoidance rules apply to guard against transactions designed to shift taxable income to TSFA

This introduction will be supplemented by additional strategies in future posts.