January 10, 2011
For new parents, it’s hard to imagine your bundle of joy evolving into a sassy, back-talking, semi-independent pre-teen, but that’s exactly what happens, right before your very eyes. The innocent questions of childhood (“Daddy, why is the sky blue?”) turn into annoying questions of authority (“Why do I have to clean my room?”). Your child of the 2000s is a ‘tween now, with a strong desire to push-boundaries and take risks, while accepting little of that boring adult quality we call “responsibility.” Oh, and there are amazing moments of sweetness and strong character to witness along the way, but don’t call them out on it in public, as ‘tweens embarrass and wilt easily!
Entering 2011, we are all squarely in the ‘tween years of the century now, just as eager as our children to experience something new and exciting, but impatient to get what we want. Only, what we want is a growing and sustainable recovery, and a new age of prosperity for our families, communities, and businesses. You’d be forgiven for acting the ‘tween yourself, and demanding, “Why can’t I have economic recovery now? I really want it!” But just as the words, “Because I said so!” are not particularly helpful to our kids, we are equally miffed to hear the equivalent, “…progress toward the Federal Reserve’s statutory objectives of maximum employment and stable prices is expected to remain slow,” in Fed-speak no less. So, in the spirit of good parenting, and in trying to prepare the ‘tweens of 2011 before they charge full-bore into the New Year, let’s take a look back at the year that was so we can navigate what lies ahead.
The Euro Zone Crisis. The year 2010 began with a very bleak outlook for Greece, whose debt-to-GDP ratio was already pushing 113% before the year started. The world woke up to a mounting sovereign debt crisis and a ‘contagion’ that threatened to take hold in Europe’s other highly indebted nations, Portugal, Italy, Ireland, and Spain. The phrase “flight to safety” was used repeatedly to characterize the flow of dollars away from risk assets and into the relative safety of U.S. treasuries, whenever a sovereign edged closer to default. Austerity measures taken up by European governments were quickly followed by public and private sector protests, as nations tried to squeeze their own citizens to get a handle on their budget deficits and growing debts. A euro zone rescue plan drafted mid-year morphed into a euro zone rescue fund by year end, with all member states, including the most troubled, guaranteeing the performance of …the troubled states! It is little wonder that we enter 2011 with this issue still squarely in the headlines and expecting to dominate once again.
Dodd-Frank Regulatory Reform. The bill signed into law by President Obama in July had been precipitated by collapse of Lehman Brothers and bailout of AIG more than 18 months prior. The Dodd-Frank Wall Street Reform and Consumer Protection Act sought to contain systemic risk and increase transparency, while regulating certain instruments such as OTC derivatives for the first time. High political drama marked the legislative process, as controversial amendments like the swap desk push-out provision and Volker rule were added in the late stages. The Coalition for Derivatives End Users, and the business community at-large, took every opportunity to educate policy makers on the increased costs in hedging business risks and the unintended consequences that would follow if congress slapped the same set of rules on big banks and end users alike. In the end, an end-user exemption – albeit a narrow one – was codified into law, and a rule-making process began in late 2010 to define undefined terms and fill in the regulation blanks. As we enter 2011, all market participants must assess their own derivatives use and understand which rules apply to their own hedging activities, to ensure they are in compliance when the law takes effect in July. Because of the importance of these issues to Main Street businesses and to economic growth, Congressional scrutiny of new rules is likely to figure prominently on the agenda of the 112th Congress. Thus, Dodd-Frank is assured to dominate derivatives news again in 2011.
Quantitative Easing. At the end of 2010 we marked the two year anniversary of near-zero interest rates, with rates being the Fed’s main policy tool to achieve its dual mandate of price stability and maximum employment. But we were also reminded that the Federal Reserve has other policy tricks up its sleeve when they embarked on a new asset purchase program, quantitative easing II (“QE2”), buying up U.S. treasuries to the tune of $600 billion over 8 months through June of 2011. With unemployment still exceedingly high at 9.4%, but inflation barely registering, the intent of the program is to provide additional stimulus by keeping longer dated interest rates lower and sparking a bit of inflationary pressure to kick start lending, spending, and hiring. QE2 was met with protests and threats of “currency wars” by emerging market finance ministers, who envision their own nations flooded with dollars and overheating, at a time when they are already dealing with double digit inflation in some cases. Back home, elected officials’ vowed greater oversight of the Fed, and proposed restricting its mission to the single mandate of price stability, which is the sole mission of other central banks around the world. Although the Fed has said it will evaluate the size and scope of asset purchases and may alter the program along way, so far in 2011 there have been no clear reasons for the Fed to curtail QE2 at this early date. Thus, QE2 will continue to significantly impact global markets and your derivative in 2011.
Mid Term Elections. November 2010 saw a sea-change in the political agenda. Mid-term elections proved to be a “shellacking” in the words of President Obama, with Republicans winning a majority in the House and making gains at state and local levels. Democrats retained the Senate, resulting in a divided Congress to start 2011. While the main political parties can agree on the results of the election, they certainly do not agree on the message that voters sent to their respective parties. Are Tea Party and Republican victories a repudiation of the Obama agenda? Or did the Democratic base just tell the president to stay the course and accelerate the pace of change that was promised? The stage is set for an epic, American-style political clash of ideas, and no issue is bigger, and none tied more closely to our recovery and our nation’s fiscal health, than tackling the budget deficit and national debt. The call to cut government spending is loud, widely heard, and will be heeded by many in congress. The elections of 2010 will give rise to vigorous debate in the 112th Congress of 2011, over every category of government spending, including spending for newly settled laws (note the symbolic repeal votes scheduled in the House for Health Care Reform, and possibly even Dodd-Frank, among others). As government spending is a significant part of the economy, the delicate balance between stimulus and belt-tightening can easily impact the pace and magnitude of economic recovery in 2011, and thus impact your derivative along the way.
Dogs That Did Not Bark. Nonevents, or “dogs that did not bark” in Sherlock Holmes parlance, were just as important to consider. We did not experience a sovereign default, despite so many predictions and worry along the way. We did not have a double-dip recession, though it threatened on several occasions. We did not see the breakup of the euro zone into ‘good’ and ‘bad’ debtor nations or any other combination, as had been suggested by too many pundits to count. We did not see the collapse of any “TooBigtoFail” entities last year, or collapse of the financial system, despite continuing concerns about the frailties and interconnectedness of our largest financial institutions. And we did not see the wave of municipal defaults predicted on more than one occasion, even though state tax revenues were down almost one-third in 2010. These nonevents would have placed tremendous stress on markets last year had they come to pass. And, not surprisingly, none of the above are ruled out for 2011.
So, now that we know where we’ve been, the ‘tweens of 2011 are ready to take on the year. Many of the same issues and challenges of 2010 will continue to dominate and impact your business risks and hedging in 2011. Informed by the past, Chatham Financial stands ready to help you navigate the present. Give us a call!