Client Questions Jude Wanniski and Paul Hoffmeister September 28, 2004

Q. As the Fed has been increasing the funds rate since last spring, the yield curve has been flattening, with the 10-year note coming down to the 4% range. What’s going on in your model?

A. We assume the major components affecting the price of the 10 year Treasury are 1) the inflation premium or rate of change of the price level; and 2) the abundance of capital. With real asset prices finally catching up to gold after 30 years, the inflation price factor in the 10-year should gradually lessen as long as the volatility of gold is low. While we still see $350 gold as the equilibrium, based on its 10- or 15-year moving average, all commodity prices have pretty much adjusted to gold at $400 and the bond market recognizes that at this level the purchasing power of the dollar will be sustained. Additionally, tax rates on capital are at their lowest levels since 1933.  The combination of these two components suggests downward pressure on the long end of the yield curve. If gold continues to rise as the demand for liquidity falls -- given negative factors affecting the outlook of the business community, especially the rising oil price -- the bond market will begin to add back an inflation premium. Otherwise, I continue to think chances are the 10-year will be happy no higher than 4.25%, the position I’ve had all year.

Q. How high do you think the Fed will take the funds rate, and how is that affecting the markets and the economy?

A. The Fed’s quest for a neutral funds rate, where it believes it will balance its goals of price stability and output, is taking it further away from the optimum rate, which is where it would be if gold were fixed at $400, closer to 1.25% than the current 1.75%. The FOMC statements are also drifting in the direction of gobbledygook, as Bloomberg’s Caroline Baum noted this week. One part of the statement says there is now equilibrium between inflation and deflation, but another says the economy is doing better and can do without as much monetary accommodation. A fixed dollar/gold price provides the market with perfect certainty on the value of the unit of account and the Fed is now providing perfect uncertainty. A higher funds rate puts no downward pressure on the gold price, if anything doing the opposite the rationale does create uncertainty in the business world about the Fed’s intent to slow the economy in the process. I’m now engaged in limited discussions with Fed officials about monetary theory, hoping to move the process back in the direction of commodity targeting instead of inflation targeting.

Q. Wasn’t the tax bill supposed to have increased the demand for liquidity in your model? Since it passed, gold is still going up.

A. The bill being enacted – the so-called tax extenders – has very little kick, first because they simply keep in place tax provisions that would have expired at the end of the year, second because they have few supply-side effects. Gary Robbins of Fiscal Associates, upon whom I rely for technical analysis, tells me the net, net effect of the bill provides slightly better than $1 return for every $1 loss in a static analysis. We await the corporate taxation bill that has much more promise, if it ever gets to a point of enactment. House conferees are only now being named, which suggests it may be impossible to get it finished before Congress leaves next week for electioneering. If President Bush wins re-election with a GOP Congress, it would pass in a lame-duck session. If Senator Kerry wins, probably with a GOP Congress, who knows?

Q. At the moment, who do you think will win?

A. Kerry has improved his chances considerably by bringing Jim Carville aboard and sharpening his position on Iraq, which I think will decide the outcome of the election Nov. 2. Kerry is correct in arguing Mr. Bush has lost credibility with the rest of the world in his handling of Iraq, which means conditions will continue to get worse on the ground unless there is a new American President. Kerry has to make the case that he can persuade the rest of the world to assist the U.S. in working with the nationalist leaders of Iraq who will not stand still for an Iraqi government being shaped by the exile groups who now control the interim government. Kerry’s domestic/economic positions are so vulnerable to attacks by the President in the second and third debates, and in TV spots, so the debates and the situation on the ground in Iraq will decide the outcome in the last weekend of October.

Q. Your report on the possibility of Israel bombing Iran on the nuclear issue was pretty scary? Anything new on that?

A. The issue should be resolved, maybe even in time for President Bush to claim credit for getting Tehran to agree to a diplomatic solution before the November elections. Polls do show that a majority of Americans worry that Mr. Bush will lead the country into another war in a second term. If you watched the Lehrer News Hour last night, you would have seen the Iranian foreign minister explain that his country will do absolutely everything the International Atomic Energy Agency asks of it, to guarantee the world that it has no nuke program and does not wish to have one. The neo-cons might not take yes for an answer, but if I were Karl Rove or Colin Powell, I would grab this opportunity to demonstrate that Mr. Bush knows how to use diplomacy as well as force. He could do the same with North Korea.                                                 

Jude Wanniski

Q. Do you have any thoughts on the problems at Fannie Mae?

A. There have been a lot of bearish investors on Fannie Mae (FNM) over the last year because of fears that rising interest rates could have a catastrophic impact on the company`s huge and complicated bond inventory.

On Monday the Office of Federal Housing Enterprise Oversight (OFHEO), FNM`s Federal overseer provided a 211-page report concluding that company`s management manipulated accounting principles to meet Wall Street expectations and smooth earnings. Initially, I was somewhat skeptical about the report; but understand perfectly why the stock has "fallen off a cliff" in the last several days, to $66 from $76. In this market, a company is held guilty until proven innocent once hints of accounting fraud spring up.

I`d have to look at Fannie more closely, but my recent experience with Freddie Mac forces me to question whether the OFHEO has got this accounting issue right.  Freddie Mac (FRE) was scrutinized about its accounting practices, and it has turned out to be somewhat unwarranted, in my opinion. Of course, like FNM, FRE has a huge, complicated inventory of mortgages that it hedges. The very subjective hedging accounting is where much of these accounting questions/concerns/allegations are raised. FASB Rule No. 133 concerns hedge accounting. The "gist" of the rule is: if a company has a hedge derivative directly matched, then the company is not required to report the gains/losses of the derivative (due to volatility). If the derivative is not exactly matched (an unmatched derivative would be like hedging our Supply-Side Portfolio with a short on the S&P 500 index), then the gains and losses must be reported.

The "Hippocratic Oath" of accounting is to report financial results either exactly or conservatively.  Freddie Mac did not report $7 billion in hedging gains because those losses would ultimately occur.  So, in fact, the company was trying to state earnings conservatively based on FASB Rule No. 133.  But this makes it easy for skeptical critics to argue that the company was creating a "cookie jar" where they can reach in for gains anytime losses
occurred.

My sense tells me that Fannie Mae was doing the same thing. Accounting is always a judgment call, so company management could have lost its integrity and exploited this accounting rule to improve earnings. The case of Freddie Mac forces me to not cast stones so quickly that a severe fraud occurred; even though I think regulators (OFHEO and the SEC) will be able to make criticisms of subjective issues.  The most likely problems at Fannie Mae are probably with internal controls being wholly inadequate for such a complex financial institution.

Paul Hoffmeister