The Federal Reserve’s Dual Mandate, Oil, and 2011-2012 Capital Flows

by JT McGee

The next two years are arguably the two most important years for economic recovery. The Federal Reserve, standing strong in its resolve to promote its dual mandate of growing employment and ensuring price stability, remains one of the most important institutions in the world.

In the past four years the world has fallen into financial crisis, and then later succumbed to horrific natural disasters. Recently we’ve latched onto the idea there is light at the end of the tunnel, only to exit from recession at the same time as a global food shortage.

Such events, I believe, have only complicated the economic landscape, and errors in judgment will be made clear when a tsunami of credit flows backwards from the US Pacific Shore to the Asian East.

The dual mandate of the Federal Reserve.

In Paper We Trust

The response to the financial crisis was as epic as the crisis itself. Around the world and one by one, central bankers pushed interest rates to record lows, and enacted quantitative easing programs designed to buffer financial markets as valuations plummeted and the credit markets froze.

Even the usually tight European Central Bank was quick to respond, pushing its benchmark rate to 1%. Of course it was Europe that actually proved to be the weakest international link with Greece, Ireland, and Spain all realizing the frailty of international monetary policy at one time—they wanted inflation where the unlevered nations wanted monetary patience.

The Federal Reserve, compelled by its unique dual mandate, was the only central bank to try zero interest rate policy, though the case can be made that virtually all nations reached levels of zero real interest rates. In the US, the target rate rests at 0-.25%; inflation is positive, but not high by official measure.

In the emerging markets, inflation runs rampant (as is the norm). India is overheated and official Chinese inflation statistics show inflation 250bp higher than one-year deposit rates, though most feel inflation is far higher than what is officially reported. A colleague in Shanghai says he thinks figures are more like 15%, though there’s no way to know; China isn’t much for being honest about its economic outlook.

How it will all change in 2011

Most central bankers acknowledge that the worst of the financial crisis is in the rear-view mirror.
Australia, Canada, and New Zealand are all developed nations, and all have raised rates. In a minor concession, it is important to note that each is a serious commodity exporter.

Every member of the charismatic BRIC is looking up. China finally turned wise, deciding that benchmark rate increases were more potent than reserve ratios. Its benchmark rests at 6.06% after several months of new reserve requirements didn’t do much of anything.

A new duo in Brazil in the form of a newly elected President and central bank chairman are interested in adopting what has long been considered the monetary policy playbook of the developed world by setting inflation targets at a cool 2% per year. To be fair, many in Brazil have tried such a policy, hence why they have a benchmark rate of 11.25%.

It is expected that the Eurozone will be next to act. This reserved institution is usually first to tighten on the prospect of inflation, and having already shored up most of the worries in its few laggards the ECB could tighten easily. So too could the Bank of England, which reports that inflation is nearing 5% even as Parliament pats itself on the back following progress toward fiscal austerity.

So where does all this leave the Federal Reserve? If you must know…it leaves the Fed two years behind.

Each of the countries listed above have only one mandate: to protected the value of their currency. While the Fed can make changes to monetary policy, it cannot undue crippling, anti-growth legislation; it cannot reduce the minimum wage, nor can it trim the growing collection of regulations. It is becoming evident that Bernanke would like to extend his reach; his last appearance before the House Financial Services Subcommittee was highlighted by a brief word of ineffective tax policy.

Paying tribute to the dual mandate, the Federal Reserve will undoubtedly be last to tighten. It would be overly optimistic to forecast future increases in the benchmark interest rate until the 4Q of 2011, if not until 2012 given the current status of employment growth.

Such a timeline means that the Fed withdraws from ZIRP by 2012, while positive real rates may not return until 2013, nearly two years after positive real rates reach Australia and New Zealand.

This dual mandate stuff is B-A-N-A-N-A-S!

Carry Trade Collapse

Because of the methods used to enact quantitative easing, any bond purchases by the Fed were sterilized. That is, no new cash was added to the money supply that actually circulates, and instead the Fed only displaced what would have been a massive demand for debt given the relatively low supply of risk capital with M0 level bank reserves.

We have two sides to one market in which government and banking institutions are the beneficiaries and the public made by fiat the benefactor.

Net longs in the commodities markets are writing calls at a record pace, making every commodity imaginable into a positive carry asset. Such occasions for easy exploit are rare, though they are at present unbelievably profitable. How else do you think bank balance sheets recovered so quickly? Sure, the Fed pays less than 1% on reserves held at the Fed, but that pales in comparison to the amount of money to be made in the commodity and currency markets. It makes sense why everyone wants to buy gold coins. The cost of money is virtually zero–gold provides a hedge to an inflationary, low interest rate environment.

The Sole Central Banker

Soon enough the Fed will be the only bank to inflate and US dollars will pour from our borders like we’ve never seen before in an attempt to soak up every last bit of yield against a dollar in decline.

While the current trade is one of 2009 dollars vs 2010 dollars (the effect of arbitraging the difference in borrowing costs and net change in purchasing power), the next nine months will bring a trade of 2011 dollars vs 2011 Renminbi, Rupee, Euro, Pound, or whatever else proves to be the temporary currency of choice.

  1. Does the dollar lose out as inflation tears from the United States to the rest of the world?
  2. Do emerging markets have the policies in place to displace any foreign “hot” money with higher rates of their own? Is another Asian Financial Crisis ala the late 1990s in the works?
  3. What happens when the world drowns in dollars?

I’m not one to say that you should hedge yourself with metals (I closed all my metals positions recently), nor do I believe you should go stock your pantry full of canned food. In fact, I think the best opportunities are in growth, not contraction, and I don’t think investors should be conservative here.

You cannot plan for doomsday, and it doesn’t make sense to invest for it. How do you define wealth in a society without it? And does it really matter if you have a closet full of bullion if there is nothing to buy? If that’s what you’re looking for, then this blog isn’t for you.

Some are saying buy this, that, and the other, but I’m going to make it quite simple: it will not matter what you own, but that you own it. Cash is not king, but cashflow positive assets are, especially if the underlying product is inflation-resistant, and at best, extremely cyclical.

Silver and gold are the popular choices, but meh, they’re already several times higher than they were years ago and each will lose out when negative real interest rate demand internationally disappears.

Oil is Obvious

Instead, I say the best buy is in oil. It shares its commodity awesomeness with gold and silver, but it is less sensitive to uncertainty, and retains all the wealth preservation properties. Also, demand rises in good times, not just in bad, and I think its status as a cyclical commodity makes it the bee’s knees for both recovery and zero real interest rate policy.

Finally, the oil market is not yet speculation haven, nor is it driven by jewelry, and it is sold exclusively in dollars, a currency that the above 1200 words make clear is poised for further correction. In the short-term, most see the growing oil reserves as something that will hold down the price of oil. I might subscribe to such theories in the short term, but in the long-term, that only makes the case for further restrictions in production from OPEC. They still call the shots, after all, and I see opportunity when OPEC makes long-term production decisions based on short-term oversupply. MMM…profits.

I liked oil in 2009 at $40 a barrel; I’ll like it this summer at $120 a barrel. While I don’t think you should go pile into the futures market, I think there is ample opportunity for profit/lifestyle-hedging in purchasing shares of the major oil producers.

Oil makes a great anti-inflation, bullish investmentFor those who want limited exposure to volatility, Chevron Corp. (CVX) is a high-yield, integrated play with a forward PE of less than 10. Plus, future stock buybacks offer excellent opportunity to growth in shareholder value without that nasty dividend tax. (Sidebar: I wish more companies would realize the long-term value of buybacks over dividends.)

Of course there is no harm in going entirely broad-based, either. The Energy Select Sector SPDR ETF (XLE) is a great, balanced play on my favorite cyclical commodity.

The only thing that might throw a fork in our plans here is a reversal of the Fed’s dual mandate. Considering the fact that employment remains the number one driver of true economic recovery (especially when unemployment means exhausting further the federal coffers) that risk is virtually nil.

For all other investments not related to oil, think global. Oil companies, regardless of where they trade, are anti-dollar as oil trades only in US dollars. Companies like Philip Morris International Inc. (PM), of which a majority of earnings are non-dollar denominated, also make for great plays on any dollar dip.

It is difficult to forecast how the dollar will stack up against international currencies come 2012. I think it is safe to say that there will be no better place to borrow in 2012 than in the US, and no better place to store wealth than a place that is…well, not the US.

{ 6 comments… read them below or add one }

Max February 22, 2011 at 07:44

Excellent synopsis. I would like to use this for a student overview about the financial crisis and monetary policy. (We are talking about zero real interest rates and zero-interest rate policy in our economics classes this week).

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JT McGee February 22, 2011 at 08:15

Sweet. I’m pretty stoked to know this is being used elsewhere. 🙂

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goldbuyer February 22, 2011 at 08:13

so dont buy gold because it is already rising? that isnt a very good reason.

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JT McGee February 22, 2011 at 08:18

It’s more like: don’t buy gold because there are better opportunities out there.

Really, it comes down to the following:

Gold = inflation protection/play on negative real rates
Oil = inflation protection/play on negative real rates/play on economic recovery

Even if negative real rates disappear (which they already are in a number of developed nations, soon emerging markets, too) then oil is still good to go. Not so much on gold. Also, investors are more likely to price today’s oil prices into the future, where gold miners have already proven incapable of even keeping up with gold, let alone beating it.

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Neil February 25, 2011 at 07:06

I laughed a little when you said oil “is less sensitive to uncertainty,” especially with everything that’s going on in the Mid East right now.

I would argue that oil, and most precious commodities, are an extremely safe bet when there is uncertainty.

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JT McGee February 25, 2011 at 14:12

Less sensitive to economic uncertainty relative to gold and silver. We’re always going to consume oil, we’re not always going to NEED large amounts gold and silver, both of which are fueled mostly by investment interest.

Oil, without massive speculative interest, is still greatly in demand, all the time, and its supply is regulated by a collection of nations that don’t mind to supply far less oil than what the market wants. That makes it a far better investment, in my opinion, than gold and silver.

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