Michael Lewis had an epic piece on Greece
by a similar title last month, and if imitation is the sincerest form of flattery, then this piece should be somewhat flattering if he were to stumble upon it. But where my piece lacks “epicness” in its writing, I make up for it by embedding a video. If only Les Grossman and the gang from Tropic Thunder
could capture something so bracing:
Apologies if you find it contrived, banal, or cliché, but the fact is this: When you talk about central bankers nowadays, and Fed Chairman Ben Bernanke in particular, in my mind it's really hard not to use footage from Apocalypse Now
for its imagery. The chairman, armed with his research economists, New York Fed Open Market Operations staff, and bags of money, is riding in low over the horizon, blaring Wagner's “Ride of the Valkyries”
and trying to shoot down savers and risk-averse investors. But I don't see anyone in the Fed's Blackhawks (the modern-day equivalent to the Vietnam-era Huey) having the combination of panache, bravado, or sheer insanity of Lt. Col. Bill Kilgore
And just like Kilgore making the declaration “You can either surf, or you can fight!” there's a certain level of insanity behind Fed policy and what that policy is trying to drive. It's like Bernanke is yelling “You can spend, or you can chase risk!” but there's no je ne sais quoi
to that, sorry. To clearly see what the Fed is doing, we need to juxtapose its policy actions against the current landscape to see if it makes any sense. Frankly, from my perch, it doesn't. I thought I needed to say that just in case folks thought my last piece was an endorsement of QE2. (See Why QE2 Won't Be Enough
What do I mean? Let's start with Fed policy. Here's a chart that takes a look at the Adjusted Monetary Base and Securities Outstanding on the Fed's balance sheet. To say these are linked is a bit of an understatement:
The monetary base is defined as the following, courtesy of Richard G. Anderson and Robert H. Rasche's Measuring the Adjusted Monetary Base in An Era of Financial Change
The adjusted monetary base is an index that measures the effects on a central bank’s balance sheet of its open market operations, discount window lending, unsterilized foreign exchange market intervention, and changes in statutory reserve requirements. Such an index is important because the long-run path of a monetary economy’s price level is primarily determined by the path of the central bank’s balance sheet, adjusted for the effects of changes in statutory reserve requirements.
So obviously, the monetary base can give us clues as to where prices are headed in the future. And indeed, as monetary base expanded, so did MZM:
Other than the dip where we knew the Fed was selling Treasuries to ensure there was enough Treasuries in the market when everything and everyone was in crisis mode, there's another takeaway from this chart: The only way the monetary base will continue to grow is from additional
purchases of securities. Purchases to just maintain the size of the Fed's balance sheet won't be enough to expand the monetary base. And there's a limit to what the Fed can purchase, not just in terms of asset types but also the size of the markets for each asset. The capital markets aren't infinite in size. Also, as all the charts also show, the country's money supply and the monetary base have flatlined in growth, and it coincides with the flatlining in Fed securities purchases. So the Fed has become the buyer of last resort and could ultimately be the only buyer of any resort.
But what's the basis for this policy in the first place? Enter Brian Sack, senior vice president of the New York Fed, and his explanation (emphasis, mine):
In terms of the benefits, balance sheet expansion appears to push financial conditions in the right direction, in that it puts downward pressure on longer-term real interest rates and makes broader financial conditions more accommodative. One can reach that judgment based on the empirical evidence from the earlier round of asset purchases, as mentioned before. In addition, the market responses to more recent news about the balance sheet also lean in this direction. The market response to the reinvestment decision at the August FOMC meeting seemed largely in line with the estimated effects from the earlier round of asset purchases, once we account for the size of the surprise and the anticipatory pricing that occurred ahead of its announcement. And the increased expectations for balance sheet expansion in response to the September FOMC statement also generated a sizable market response.
Really? Not when I look at a chart of the spread between 5-Year Treasuries and 5-Year TIPS:
The spread bottomed November 28, 2008, at -2.24%. The next day, December 1, the spread was -0.32%. And as I dug up old H.4.1 releases, I figured out why. From the November 28, 2008 release (emphasis, mine again):
On November 10, 2008, the Federal Reserve announced a modification of the terms of credit extended to AIG. Related to this modification was the creation of two limited liability companies, Maiden Lane II LLC and Maiden Lane III LLC. On November 25, 2008, the Federal Reserve Bank of New York began extending credit under the authority of section 13(3) of the Federal Reserve Act to Maiden Lane III LLC, a limited liability company formed to purchase multi-sector collateralized debt obligations on which the Financial Products Group of AIG has written credit default swap contracts. On November 24, 2008, the Money Market Investor Funding Facility was created to provide funding to a series of limited liability companies to purchase short-term US dollar-denominated certificates of deposit, bank notes, and outstanding asset-backed commercial paper.
So if Sack wants to equate Fed balance sheet expansion with the expansion of moral hazard, then I completely agree. Backstopping bad assets with the Fed's balance sheet was what really changed yields and inflation expectations, at least for a little while. So now the question is where is the next batch of toxic assets the Fed will need to buy to push things higher again? I don't know, maybe there are some poorly underwritten PIK loans it can buy. At par. In the meantime, Sack is right about risky assets rising:
Meanwhile, as Peter Atwater pointed out in Glass Half Empty: The Other Side of QE2
, banks are being forced to source funding at shorter and shorter maturities to still earn yield from assets. Interest paid on 5-Year CDs have only fallen about one-fourth the drop in yield seen in 5-Year Treasuries. And if you were managing your balance sheet properly, matching the maturities of your assets with the maturities of your liabilities, you wouldn't extend credit for two years or five years: The spread is negative
. It costs more to borrow than you can make lending the money to a low-risk borrower (the US government in this case). The only ways you can earn yield are taking on risky borrowers (take on credit risk) or lend on a longer maturity than you borrow (take on yield curve/maturity risk). But as Atwater points out, the risk premiums for lending are shrinking, so the amount of risk you're taking on isn't symmetric to what you're being paid to take it.
So the Fed's behavior is reinforcing bad behavior by banks; “funding short/lending long” is a big reason why we're here, with this economy, in the first place.
But the problem is only made worse because of the convexity of interest rates:
In a highly convex world, small rate moves can have huge impacts on the price of a security. So volatility must not only be kept at a minimum, it must be nonexistent if this whole scheme by the Fed is supposed to work.
But it's obvious the Fed sees below-trend growth and inflation, take a look at that chart of 5-Year CMT – 5-Year TIPS spreads again. So in that context, the Fed would be happy to see a lower dollar, thinking it can manufacture inflation. It wouldn't surprise me if the Fed had an implied Dollar Index
level it wanted to target to get there, either. And it's not alone in thinking it can manufacture inflation; others think the Fed can too
. Whether or not it can is up for debate. But in the meantime, the dollar has gone lower on the daily chart, at least until the past few days:
We may be on the cusp of a bottom for the moment. The funny thing is the weekly chart:
While the market seems determined to test the 76 level, the dollar has been in an uptrend for more than two and a half years on this chart. It has been a bumpy ride for sure, but the floor under the dollar is undeniable. And given the environment we find ourselves in, we could see a retest of 89 before we see a retest of 76. I don't know for sure, but I do like to consider things nobody else seems to be thinking about. Because we got to where we are by seeing a series of "black swan" events occur, which, when woven together, create "one of the blackest of black swan scenarios" anyone could have imagined.
And yet, here we are.
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