US Monetary Policy: On a Magic Carpet Ride

By Vince Foster  JUL 02, 2012 11:30 AM

Think of it this way: Risk is not really an asset; it's a price. Are treasuries really "risk free" if they're effectively in default?


MINYANVILLE ORIGINAL On Friday morning, I had the opportunity to attend a breakfast and “Dialogue with St. Louis Fed President Jim Bullard” where he gave a presentation titled US Monetary Policy: Still Appropriate.  As you can see in the PowerPoint presentation, Bullard discussed the basic issues of the day, including the overall macro situation, the continued easy monetary policy response, the risks in Europe, high unemployment, and low inflation.
He also addressed “The Risks” and highlighted his main concern in the following bullets:
After the Q&A, I approached Mr. Bullard to ask him a couple questions.  I will say he was very engaging and quite candid.  We had what I would characterize as a spirited (albeit brief) discussion, and I left with the impression that my comments were respected.
Full disclosure:  I did not identify myself as a market commentator and I am paraphrasing our conversation (mostly one-sided by me) and my recollection of his comments shouldn’t be construed as me quoting him “on the record.”
Initially I intended to ask about the St. Louis Financial Stress Index that he cited in the presentation (slide 12) and the same concerns I had addressed two weeks ago in In The Parallel Universe, Credit Risk Is Interest Rate Risk.  Using his own “Taylor Rule implied” five-year nominal yield (slide 7) as an example, I pointed out that the index is overstating “stress” because many of the variables use risk premiums that are artificially wide due to them being spread vs. risk-free yields, which the Fed was keeping artificially low.
I argued that if he used his “Taylor Rule implied” five-year yield that he showed at 3.50% instead of the current  five-year at 70bps, the stress index would be much lower.  I suggested that these wide risk premiums were not discounting credit risk that the stress index implied but rather interest rate risk.  I posited that the Fed was contributing to the fear in the market by suppressing risk-free rates and this was causing difficulty in markets interpreting risk premium pricing.  He raised his eyebrows and responded that I was making an interesting point. 
He went on to say that while he favored QE II due to the rising deflation risks in 2010, he was generally opposed to Operation Twist.  I responded, in line with my thesis from Project Escape Velocity, that I thought Operation Twist might have more of an effect since by flattening the curve, it would flush the banks out of their bloated securities positions.  I reminded him that there was $2.6 trillion in bank securities portfolios that was poised to get released into the economy, especially if stocks continued higher.
I said, “There’s your genie out of the bottle.”
He seemed to agree that was a material amount of liquidity.  I then pointed out that this $2.6 trillion is mostly comprised of negative coupon negative convex long duration assets and that the Fed’s monetary policy had simply transferred what was previously credit risk into interest rate risk, but the balance sheet risk (net present value) was equally as dangerous.  I then proposed that the Fed had a very delicate balancing act by trying to keep the curve anchored while encouraging banks to sell their bonds to finance lending.  He seemed to agree.
I think Mr. Bullard understood what I was getting at and would concede that I was making some valid arguments. While I am not sure that he saw it as a major “risk” for the Fed to consider, he seemed to take it seriously.  I didn’t want to keep him any longer and there were other who wanted to speak with him so I thanked him for visiting with me and wished him good luck. 

I have a feeling anyone in charge of US monetary policy is going to need it.  
What if the inflation genie is already out of the bottle?  What if, instead of reacting to headlines out of Europe or pricing a multiple off weak earnings or economic growth expectations, the equity market is discounting the fact that the inflation genie has already escaped?
One of the ideas my firm has been exploring is whether the Fed’s negative interest rate policy has actually turned market discounts upside down.  We posited this thesis in Trading The Wrong Playbook Bubble when we suggested that the Fed had taken the discount out of the discount rate.  It’s quite possible that when the Fed engineered a negative interest rate regime, it flip-flopped the market discounting mechanism.
During the era of tight money (1980s-1990s) when the Fed generally kept real interest rates positive, it was the bond market and the yield curve that would consistently provide market discounts of future economic growth and inflation.  Generally, the market would price risk assets accordingly.  Not until Greenspan introduced his eponymous put when he bailed out Long Term Capital Management in 1998 did asset prices begin to see market cycles deviate from “real” economic and fundamental reality leading to the frequent boom bust sequences that followed.
Consider the possibility that today it is the “risk-free” asset that has deviated from reality and it’s the risk assets that are forecasting future growth and inflation.  It’s quite possible the equity market is telling us that a surge in liquidity is coming down the pike.
Think of it this way: Risk is not really an asset; it’s a price.  The consensus views US Treasuries as the risk-free asset because the US will never default.  But is that true?  Conceivably, we are currently in default.  If you inflate the currency to pay the coupon, is that not in reality a default?
The fact of the matter is that when the Fed prints money to monetize the nearly 100% of net debt issued in order to generate negative interest rates as they did during QE, it is in effect facilitating a default. Somehow investors don’t see it that way or else they don’t care. They will not accept any principal risk and are willing to pay any price to achieve that objective.  The problem, of course, is that at these historic levels, it’s the price that’s at risk and not the asset.
You could argue that since the Fed turned the discount mechanism upside down, the security price that is the most inflation sensitive, risk-free yields, are the lowest in history -- and not because they reflect massive deflation, but because they reflect massive inflation.  The trillions in excess liquidity that the Fed pumped into the banking system is all parked in the bond market.  Because of the consensus fear of deflation, this embedded inflation sits comfortably idle in risk-free assets on bank balance sheets. But if the stock market is really the leading discount mechanism and price is marching towards new highs, then we could be on the verge of an excess liquidity explosion whether the economy wants it or not.
This past week, I was having a discussion with a friend in the business that covers large institutions including many well-known hedge funds.  I was contending that sentiment remained very bearish despite the price action and pointed to the continued S&P 500 crash put buying into the June quarterly and month end expirations.  He was convinced sentiment was excessively bullish because his accounts were overwhelmingly long and looking for research ideas.  I could not argue with what his market intelligence was telling him; all I could do was point to what market price was telling me.
I sent him a chart of the VIX futures curve vs. the same date in 2007 to show the difference in the skew.  Recall June 2007 was right before the Bear Stearns credit HFs imploded, which was the first domino to fall in the financial crisis.  What’s interesting is that back then when tail risk was enormous, the VIX curve vs. spot was highly inverted with spot near 20 and the back months flattening between 17 and 16, which implied that the price of tail risk was virtually zero.  Conversely, today, the VIX curve is extremely steep with spot below 20 and back months near 30, meaning that the price of tail risk is very expensive.  Is sentiment excessively bullish?  Watch what they price, not what the say.
Rarely do I read something original that no one is talking about but in a brilliant and well written First Quarter 2012 letter to investors, titled Volatility at World’s End, Christopher Cole, founder and portfolio manager of Artemis Capital Management, puts forth a compelling case for how the market is mispricing deflation vs. inflation risk.  Cole walks us through a very detailed explanation of how mispriced tail risk is today vs. historically and ponders, “I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.”
Some excerpts that are worth highlighting:
Tail risk insurance is at the most expensive relative levels in over two decades of data reflecting a profound emotional fear of deflationary collapse...  Since the 2008-crash, the SPX options market has consistently assigned a 21% probability of a -50% or more crash in the S&P 500 index for any given year (logarithmic price changes).  The realized historical probability of a -50% or greater crash is only 2.93% (using DJIA data to extend samples to 1928).
You are not smart for hedging what everyone already knows (including policy makers).  Can we really call a deflationary crash a “black swan” if the market assigns a 1 in 5 chance of it happening every year?
In hyperinflation everything we think we know about volatility will be backwards...  literally it will be like watching options through the mirror.
The problem is that this volatility paradigm, entirely valid in today’s deflation fearing market, is completely wrong in a world where prices rise faster than they fall...   like in hyperinflation.
What many fail to realize is that a far-OTM call option will exhibit powerful double convexity during an inflationary shock.  The premium will be heavily influenced by both rising volatility and interest rates and these two variables are self-reinforcing in hyperinflation.
Is hyperinflation a legitimate risk?  Cole himself says that he’s not calling for hyperinflation necessarily but rather that the tail risk of such an event is mispriced.  It’s hard to imagine a situation like Weimer Germany circa 1921-1924, but as Bullard and Cole suggest, but it's not hard to imagine turn to 1970s-style stagflation (high inflation plus high unemployment).  With that era of inflation due to an expansion of government (Great Society), war spending (Vietnam), currency debasement (shutting gold window), and ultra easy monetary policy (Arthur Burns), it would seem that similar conditions are in place today.  We would just have to see the unprecedented expansion of money from QE make its way from the financial system into the real economy.
Since the financial crisis ended, there has been a fascinating divergence occurring between the market discount of equity prices, which continue to make higher lows and US Treasury yields, which continue to make lower lows.  I have the feeling that these discounts are about to re-converge.  Are stocks discounting a rising inflationary environment, and will a rally to new highs finally prick the bond market bubble and unleash this flood of liquidity into the system?  It’s difficult to handicap and the situation is very fluid. But equities made a bold statement last week and we do not want to fade a market that continues to make critical multi-year pivots support while poised to challenge the previous pre-crisis highs of 2007. 
It’s very possible that Bullard’s inflation genie is already out of the bottle, but he’s just sitting in the bond market ready to hop aboard the magic carpet.  Ironically, Helicopter Ben may have fired up the engine with Operation Twist with the stock market taking us on the ride.

[Editor's note: See also: Central Banks: Purveyors of Today's Notgeld.]
Any place it goes is right
Goes far, flies near, to the stars away from here
Well, you don’t know what we can find
Why don’t you come with me little girl
On a magic carpet ride

 -- "Magic Carpet Ride," John Kay and Rushton Moreve, Steppenwolf
Twitter: @exantefactor
No positions in stocks mentioned.