The Sub-prime Fed,
Has The Fed Already Gone Unconventional?
prudentbear.com
May 13, 2003
The Federal Reserve left interest rates unchanged. But in a profound shift from half a century of preoccupation with fighting inflation, the central bank signalled last week that it was prepared to cut interest rates later to ward off even the possibility of deflation. In less than half a year, starting with Benjamin Bernanke’s speech last November, the Fed has publicly moved from denying the existence of deflation to conceding implicitly that it now constitutes a greater threat than inflation.
To be sure, this is still being cast in a fairly anodyne manner, at least publicly. The Fed’s most recent comments on the matter acknowledge that, “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” However “minor” the probability, the change in emphasis suggests that in the eyes of the Fed, deflation has moved beyond a mere theoretical possibility to an actual threat that may demand a more robust policy response.
As for what is being said privately, the recently released minutes from the central bank's second-to-last major policy meeting on March 18 painted a considerably darker picture: policymakers were concerned that “part of the recent [economic] weakness” resulted from factors beyond the impending war in Iraq. The Fed also expressed considerable anxiety that there “was as yet no persuasive evidence” of the kind of investment turnaround they had been counting on for months to provide "needed support" to the economy.
As our colleague Doug Noland notes, it is dangerous to take anything the Fed says about “deflation” at face value. Credit excesses of the type that we see manifested on a daily basis in the American economy do not typically reflect classic symptoms of an economy in the throes of debt deflation dynamics. Nor does the current behaviour of the stock market. Rather, it is more pertinent to use the Fed’s rhetoric regarding deflation as a means of gauging possible policy responses to current economic conditions in which rampant housing inflation, overconsumption and debt accumulation vie with a struggling manufacturing sector and an ongoing deterioration in business capex. That the economy remains distorted and imbalanced is indisputable. But to characterise this condition as synonymous with “deflation” is analytically unsound.
It is clear, however, that a general recovery is not yet in the cards despite the Fed’s extraordinary efforts to sustain the credit bubble. Unconventional policy measures to stimulate further business investment and employment gains therefore loom closer.
Or is the Fed already travelling along this road without yet publicly acknowledging it? Consider the following speculation from CNN/Money’s senior writer, Justin Lahart:
“The fight to resurrect the economy has intensified and increasingly it looks like the Federal Reserve may resort to guerilla tactics. The signal? The Federal Open Market Committee's policy-setting meeting Tuesday. Although the FOMC, as expected, left the fed funds target rate on hold, the statement it put out following its meeting came as something of a shock. In it, the Fed said "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." Most observers took "a substantial fall in inflation" to mean deflation, the phenomenon of lower prices that can sap an economy. But it was not the Fed's apparent worry over deflation that got investors stirred up -- whatever the potential for deflation is, it was there before Tuesday. Rather it was the Fed's suggestion that there is some appropriate level for inflation. For a Fed that has, for years, decried the idea of establishing an ‘inflation target,’ this was a big shift…
Not everybody at the Fed has been against inflation targeting. As a Princeton economy professor, Ben Bernanke, who became a Fed governor in August, caused something of a stir in 1999 when he co-authored a paper -- ‘Monetary Policy and Asset Price Volatility’ -- that suggested inflation targeting was the right thing to do. The FOMC statement made investors think the Fed is coming around to Bernanke's way of thinking. This notion, in turn, led market participants to some of Bernanke's other ideas -- specifically the ones he put forth in a November speech titled ‘Deflation: Making Sure 'It' Doesn't Happen Here.’ In it, Bernanke suggested a number of tactics that the Fed might use once it runs out of room to cut rates. Chief among them was the idea that the Fed would adopt ‘explicit ceilings’ on Treasury yields, and would keep yields from rising above them by ‘committing to make unlimited purchases’ of Treasuries maturing within the next two years. "The thought is that the downturn in rates would lower borrowing costs and fuel spending,’ said Morgan Stanley economist Bill Sullivan.
Mortgage rates, for instance, are tied closely to Treasury yields. Bring Treasury yields down, and more households can refinance -- putting more money into their pockets. Corporate bonds, too, are tied to Treasuries. Lower companies' cost to raise money in the bond market, and they can borrow --and thus spend -- more.
With investors thinking that the Fed might be coming into the market, Treasury bonds have rallied sharply since the FOMC meeting, pushing the yield on the 10-year note to 3.63 percent from 3.89 percent.”
Lahart posits the notion that the Fed “might be coming into the market” to introduce “yield ceilings.” A similar idea was broached last Thursday by the Washington Post’s John Berry, long considered to be one of the main mouthpieces of the Fed. Berry notes the difficulties facing a central bank as interest rates head to zero, especially its inability to lower the interest rate target below zero which, in the event of deflation, means that real-adjusted interest rates will remain positive and therefore not provide the stimulus needed to allow the economy to escape the deflationary spiral. However:
“Greenspan and other Fed officials have stressed that they have a variety of tools they could use to stimulate economic activity even if their current 1.25 percent target for overnight rates was cut to zero. For instance, they have said that, in addition to overnight rates, they could also target some longer-term rates, such as that on two-year U.S. Treasury notes, and buy enough of the notes from private owners to pump an unlimited amount of money into the economy. Consumers and investors would be expected to use the added money to buy enough goods and services, and assets such as homes and stocks and bonds, that the price level would begin to rise again, ending the deflation.”
One well placed line about deflation intolerance in the FOMC statement Tuesday, followed by a few planted articles by Lanart and Berry: one gets the sense of a veritable public symphony being orchestrated by the Fed. It seems more than coincidental that just as this cacophony of speculation has reached its peak, Merrill Lynch’s bond strategist has begun to openly extol the merits of a “yield flattening trade”. The reason? The Fed will shortly be pegging long rates, he argues.
This sort of activity is certainly consistent with a model of “moral hazard melt-up” that we have sketched out in these pages in the past. In the first instance, we argued that any support lent to the market would likely remain covert providing that a sufficiently large critical mass of fund managers understood that there were support mechanisms at work in the market. The references to “unconventional measures” in the Berry and Lanart articles help to create this “understanding”.
Such an implicit understanding on the part of these managers would facilitate their ability to trade on the back of periodic covert interventions, thereby supporting government objectives. In these circumstances, policy makers would likely do nothing to disavow such a belief (and might in fact quietly encourage it as they appear to be doing in the Berry piece), since the herding dynamics of these portfolio managers would enhance the authorities’ objective of supporting the market.
In retrospect, it seems clear that the March 25th speech by Vincent Reinhart (analysed on these pages a few weeks ago) was designed in part with the objective of getting investors comfortable with the various steps available to the Fed under the unconventional policy rubric. That it has surfaced recently in so many different places suggests that it remains the Fed’s sincere hope that by talking up unconventional measures (or at the very most, implementing unorthodox policy covertly), they can get investors to do the heavy lifting for them, and so avoid all the complications and challenges that would invariably arise should they explicitly announce to the markets that they are intervening to fix the yields on long term government paper.
Faith in the virtues of a hint of action was perhaps more credible when the market’s belief in the Fed’s omniscience was almost universally held. More recently, it is safe to surmise that the near universal veneration in which Mr Greenspan and his colleagues were once held has dissipated, thereby diminishing the Fed’s power to achieve policy objectives through the simple expedient of jawboning.
Consider last week’s auction of the 10-year note. One would have assumed that ample hints suggesting an imminent embrace of “yield capping” at the long end of the Treasury curve would be sufficient to encourage a revival of herding dynamics, yet the bid to cover ratio on the auction was 1.22 – the lowest in decades. Jawboning doesn’t seem to work like it used to. Recognising this, perhaps the Fed feels the need to do something more tangible?
One tantalising bit of evidence that something more may be afoot is the odd delinkage between the level of Treasury bond yields and the US equity indexes since the end of the war. Between April 2nd and April 30th, the Fed’s financial statements indicate that they have concentrated their buying in the 1-5 year maturity and been net sellers of Treasuries in the 16 to 90 day maturity. This is consistent with the a pattern in place since January, where they have bought $28 billion in the 91 day to 5 year maturity spectrum and sold a similar amount in the 16 to 91 day area. Although not definitive proof, there does appear to have been a focus by the Fed in its open market operations on buying longer dated Treasuries, and selling shorter dated paper. At the very least, this does point to the possibility that the Fed has already begun, unannounced, to peg Treasury yields.
But there are huge difficulties implied in this new monetisation effort: Given existing expense ratios on money market mutual funds, the fed funds rate cannot go to zero without ruining that business. The second is the inherent paradox of any Treasury yield pegging operation, noted by DresdnerRCM strategist Rob Parenteau:
“If the Fed's objective is to create a surge in the money stock such that product price levels rise, every holder of any fixed income instrument that is not pegged and not inflation linked (like TIPS) will require a higher inflation risk premium, and so all yields except the pegged yield will back up. This even becomes a problem for holders of bonds pegged by the Fed: once the peg is removed, holders of these bonds will be subject to capital losses, assuming the Fed pegged the relevant yield below what otherwise would have been the market clearing level. These results can only be avoided if the Fed commits to remove the pegs once it believes enough monetization has occurred to yield say 2% product price inflation. But even if the Fed could claim to have the equations required to know precisely when to remove the peg, the credibility of this commitment among the Lacy Hunts and Van Hoisingtons of this world is likely to evaporate after the first several weeks of explosive money stock growth.”
Parenteau’s references to bond fund managers, Lacy Hunt and Van Hoisington, points to a fundamental difference in today’s debt markets: forty plus years ago, one did not have a whole generation of money managers with direct personal experience of high inflation as one does today. So if by pegging long-term bond yields, the US economy drifts into outright monetization, the markets may well prove less accommodating than the Fed currently envisages.
In fact, the resultant complications are even worse than those outlined by Parenteau. Regardless of which duration the Fed chooses to peg, if the bond portfolio managers of the US and international community believe that the Fed will ultimately be successful in reinflating, then they should SELL long term private securities to the extent they see the Fed pegging the long Treasury. A successful reinflation effort, from these low rates, would be hugely negative for unpegged fixed-income debt securities. Thus, spreads could widen a lot, and the private debt yield curve should steepen on initiation of this strategy if it is deemed likely to work. This could prove highly disruptive to the leveraged speculating community. Additionally, if the Fed is unable to convince the markets that they will cease the ongoing monetisation program once inflation again reaches 2 per cent (and who is to know this until well after the fact?), one ends up having to go down the slippery slope of pegging the entire stock of public debt.
But even this might prove insufficient. Despite what the Fed might say about the proposed policy not being unconventional, we no longer inhabit a 1950s-style monetary universe. The debt market is exceptionally large and far more diverse today. Hence, the question invariably arises as to what to do with private debt or quasi-private debt of the sort issued by the GSEs? Would the Fed be prepared to buy this sort of debt directly, and build a portfolio of corporates, FNMA and FHLMC securities? And what about the mass of debt that has been securitised through the CDO market? What about the effects on the several trillion dollar derivatives markets? Does the Fed commit to acting as a backstop there as well?
In theory, the Fed might hope that by pegging the mortgage rate that they could hope to gain direct leverage over the pace and volume of mortgage refis and corporate borrowing, but not without becoming a seller at other parts of the Treasury curve to a nearly equal degree. Indeed, even if the Fed has the finesse to execute such operations, there is no guarantee that the market will play ball. Fixed income and hedge fund managers may well push out credit spreads, forcing the Fed to shift toward direct purchases of mortgages and private credit instruments and blow up its balance sheet rapidly and monetise even more rapidly that it may desire. In response, foreign investors may not like what they see and may therefore drive the dollar down sharply, with the negative attendant consequences implied for both US stocks and bonds.
In reality, the Fed is left with very few good policy options, conventional or otherwise. At one level, Alan Greenspan seems to understand this, as illustrated by his recent comments on financial derivatives. While praising the role that complex derivative contracts have played in fortifying banks against repeated external shocks which the financial system has experienced over the past few years (his traditional line), the Fed chairman also specifically expressed concerns regarding the size of JP.Morgan/Chase’s massive derivatives portfolio: “When concentration reaches these kinds of levels, market participants need to consider the implications of exit by one or more leading dealers.” Which invariably begets the question that Mr Greenspan himself refuses to address: to what extent are JP Morgan’s problems but a symptom of broader incompetent monetary management by the Fed itself?
Listening to the musings of the Fed chairman, one has the sense of a man who recognises the symptoms of a profound illness, but fails to see his role in perpetuating it. In spite of his repeated proclivity to expand the boundaries of moral hazard over the past decade, Greenspan is clearly uncomfortable with the idea that such huge exposure may ultimately have to be assumed by the Fed. And yet the logic of the unconventional policy options publicly mooted by his colleagues invariably moves the central bank further in the direction of perpetuating a financial horror show. Here is the market’s Dr Frankenstein, in effect trying to repudiate his own creation. But just as Shelley’s Frankenstein was ultimately rendered helpless in dealing with the awful consequences unleashed by his man-monster, so too, all the Greenspan Fed can do today is postpone the day of reckoning for the American economy at all costs, and hope for a miracle. He is trapped in a credit bubble of his own creation. Mr Greenspan would undoubtedly like to buy the economy some time as another refi wave works its way through the economy for a quarter or two, perhaps on the hope that this is all the time required to bridge the economy over into the land of more robust capital spending. But the reality is that the US central bank’s egregious policies, no matter how unorthodox, can only exacerbate, not rectify, the extreme stresses now apparent in every aspect of the American financial system. No doubt, Mr Greenspan and his colleagues will continue to publicly muse about untangling these multifold challenges to executing unconventional monetary policy, but the patient’s condition is already terminal, no matter what “remedy” the Fed seeks to introduce. |
