Are We Witnessing a Tectonic Shift in Which Central Bank Policy Dominates Asset Prices and Risk Premiums?

By Vince Foster  JAN 22, 2013 11:52 AM

Investors can't afford to ignore the consequences of massive moves in the foreign exchange market.


Friday, Jan. 18, the Federal Reserve released the transcripts from 2007 FOMC meetings that included those fateful days as they grappled with how to address the housing “correction” and developing credit crisis.
At the August 7, 2007 FOMC meeting it was clear the Fed was not all that concerned with escalating systemic risk as the agenda was full of fond farewells, jokes, laughter and bureaucratic nonsense.  They concluded by debating the semantics of the statement.
Chairman Bernanke: Okay. Let me just get a sense around the table, if I could. I think President Hoenig makes the point that volatility in financial markets could be viewed as having an effect on the economy through uncertainty and those sorts of factors. One option is “financial markets have been volatile in recent weeks.” The second option is “risk premiums in financial markets have increased.” Who wants “volatility”? [Laughter] I see five. Who wants to make the change?
Mr. Kohn: I guess I would.
Chairman Bernanke: Oh, great. [Laughter] All right.
Mr. Mishkin: We flip a coin?
Mr. Kohn: You have the deciding vote.
Chairman Bernanke: Okay.
Mr. Lacker: One factor for me is that “volatility” is a very broad term, and “risk premiums” refers to a narrow set of markets, and this way shifts the focus off equity markets.
Chairman Bernanke: Okay. I apologize profusely for bringing this up. Why don’t we just leave it? [Laughter] So after all the discussion, my proposal is to follow President Plosser and to replace paragraph 3 with the June version. Please call the roll.
The statement:
Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
You may recall how the ensuing events unfolded.  Former Treasury Secretary Robert Rubin called Ben Bernanke, which led to meetings with Bridgewater’s Ray Dalio and former Salomon Brothers MBS market pioneer Lewis Ranieri.  Then only three days later on August 10, in full-blown panic mode, an emergency conference call led to a 50bps discount rate cut.  There were no jokes this time.  The Fed also changed their economic assessment to downside risks to growth due to market conditions.  As I wrote in Helicopter Ben Rides Again, this was an important distinction.
After two years of whistling past the housing market graveyard, the immediate policy 180 emitted a sense panic and capitulation.  Bernanke would link heightened financial market risk with heightened economic growth risk to justify the abrupt change in policy. This is very important. 

Once he moved on the theory that market “uncertainty” increased risk to economic growth, he set a precedent for preemptive intervention in financial markets whenever the Fed deemed it necessary to “mitigate” increase downside economic risks. This interpretation of the Fed’s mandate is a defining moment in Bernanke’s tenure. 

The following six months of FOMC decisions would read like a horror story as it pulled its economic assessment and slashed interest rates 300bps, taking the FF rate to 2.25% by the March 2008 meeting. Bernanke’s dovish reputation immediately began to manifest itself in the market. Despite the risk of slowing growth, discounts for inflation increased significantly. The dollar weakened, commodity prices soared, and the yield curve steepened.  Helicopter Ben had demonstrated his inflationary bias. Once he gave the green light, it was clear the market wanted to be in front of the curve. 

It is my belief that the interpretation of what caused the financial crisis has been extremely shortsighted.  The consensus sees the crash as the result of the housing bust and credit crunch, but markets don’t crash due to what everyone already knows, and they don’t crash because of deteriorating economic fundamentals. There must be a systemic catalyst.
In 2008 the markets were actually holding together relatively well despite the failure of Bear Stearns in March.  However the Fed’s massive easing campaign was taking its toll on the value of the US dollar.  Commodities were rallying in the face of decelerating economic growth, and with the price of oil doubling in less than 12 months, this proved debilitating to the US economy but even more so on leveraged risk premiums. The following is also taken from my article mentioned earlier:
By July, nominal GDP had flatlined.  But with the dollar continuing to deteriorate and oil prices up 100% from a year ago, inflation was delivering a crushing blow to an already teetering economy. The July reading for YOY CPI was 5.6%, but the PPI came in at a whopping 9.9%. Typically the PPI does not exceed the CPI as raw material costs get passed on to the consumer -- and aside from the 1970s, it rarely occurred. This unusual 400bps inversion driven by rocketing commodity prices produced a statistical fat tail.
In fact as I point out the ratio of inflation to nominal GDP was higher than the inflation spikes in the 1970s and 1980s.  This was the systemic event.  Inflation premiums spiked, the yield curve blew out to historic levels and risk premiums were soon to follow.
It is my belief that dysfunction in credit markets continued to worsen not despite the easing of monetary policy but because of the easing of monetary policy.  Initially, the housing and mortgage crisis was contained to those markets. It was not until the Fed opted to forego its inflation risk bias in favor of liquidity support for those markets that the crisis spread. The further the FF rate dropped below the rate of inflation, the wider the inflation discount and thus risk premiums became.

The 2008 crash didn’t happen because people quit paying their mortgages. It happened because of a rapid repricing of risk premiums in highly leveraged (short volatility/short gamma) positions due to a spike in inflation discounts that drove an eventual spike in implied volatility. The correlations between the dollar, commodity prices, the yield curve, and the risk curve are undeniable.
Perhaps there is nothing more systemic than extreme volatility in foreign exchange markets.  While today’s headlines are focused on stocks reaching new post-crisis highs and junk bond yields reaching all-time lows, investors seem to ignore the consequences of massive moves in the foreign exchange market. Since 2007 the Federal Reserve’s easing campaign has dominated global currency markets as the value of the world’s reserve currency has generally been a one-way trade.  The Fed’s zero interest rate policy and quantitative easing has reflated dollar-denominated commodities, and this has benefited emerging markets and their currencies.  However, that all changed last September when Shinzo Abe was elected prime minister of Japan. 
Abe has pledged to end Japan’s persistent deflation by taking aim at the value of the yen, and the markets are responding accordingly.  Since Abe was elected, the USDJPY is up 13% and EURJPY is up 20%. On Monday, the Bank of Japan met and agreed to raise its inflation target to 2%.  Why does this matter to US investors?
With the exception of the aforementioned 2008 commodity spike, the last two times Japan was running 2% inflation the USDJPY was closer to 150 or 60% higher than where it is today.  The most recent period of 2% inflation that coincided with yen depreciation in the mid to late 1990s caused dramatic dislocations in global markets. 
Between 1995 and 1998 the USDJPY rallied from 80 to 147 which was an 85% devaluation of the yen. This yen weakness was reverberating throughout Asia as Japan’s trading partners would see capital flows increase and their currencies rise.  Between 1995 and 1997 the Thai baht, which, at the time was linked to the US dollar, rallied 50% against the yen, which eventually drove Taiwan to devalue. This lead to the subsequent Asian currency crisis.  As you will recall this Asian crisis was not just contained to the East.  The ripple effects could be felt in Cushing, OK, Moscow, and on a famous trading floor in Greenwich, CT. 
In early 1997 WTI crude oil was trading at $25/bbl, which was the highest level since the spike that coincided with the first Gulf War.  By the fall of 1998 the price had been cut in half to $12/bbl.  This collapse in oil prices had severe effects on Russia’s petroleum-based economy, eventually driving a devaluation of the ruble and default on Russian debt. 
The financial contagion would produce a flight to quality in US Treasuries and spike in implied volatility that would eventually see the demise of hedge fund Long Term Capital Management that employed highly leveraged fixed-income arbitrage strategies.  LTCM was a massive counterparty risk to every large Wall Street primary dealer, and with reportedly holding $125 billion in positions against $5 billion in capital, it nearly brought the US financial system to its knees. 
The NY Fed President Bill McDonough orchestrated a bailout of LTCM and Chairman Alan Greenspan cut interest rates to stem the fallout of the crisis.  These actions introduced the market to the eponymous “Greenspan Put” which was interpreted as an implied floor under asset prices. 
The 2008 financial crisis is a direct parallel to the failure of LTCM.  Both contained immense leveraged positions of illiquid securities that were short volatility.  Both also were not the result of economic conditions effecting trading positions, but rather a chain reaction in currency markets that saw a rapid widening of spreads in the face of spiking implied volatility.
Thai Baht vs. Volatility Risk Premiums

Source: Bloomberg
Click to enlarge
Since the Abe election the Thai baht is up 20% versus the Japanese yen and is already up 8% on the month for an annualized move of 400%.  As I mentioned above the euro is also up 20% versus the yen but is also spiking versus the Swiss franc. Coincident or not, it could be due to Germany’s recent decision to repatriate gold from the US.  Maybe the selling is coming from Germany who is reducing the needed safety of gold proxy CHF (CURRENCY:CHF) causing EURCHF to spike 4% in a two weeks.  The reasons are still not clear.  What is clear though is that FX volatility is on the rise and this should not be ignored for its influence can be systemic.
Bloomberg reported that Abe advisor Koichi Hamada said that too much monetary easing and yen weakness could be problematic, and that the 110 level would be too weak.  If the 110 level is a soft target, that would still be a significant 20% rally from current levels.  If the 2% inflation target is consistent with a level between 140 and 150, that would be a 50% rally.  What would that kind of yen depreciation do to the Thai baht?  What would it do to oil prices?  What would that do to emerging market debt?
Today could be a seminal event as we may be witnessing a central bank transfer of power.  The Federal Reserve’s monetary policy has been dominating asset prices since the era of easy money began in 1998.  We’ve now come full circle.  With the introduction of a 2% inflation rate by the Bank of Japan and a subsequent effort to devalue the yen to get it there, we may be witnessing a tectonic shift in which central bank policy dominates asset prices and risk premiums.
The FX market is very deep and liquid.  This kind of volatility is significant, and if it continues, it’s only a matter of time until it finds its way into the US capital markets.  On Friday the CBOE Volatility Index (^VIX) showed equity market implied volatility to be near the lowest level since the financial crisis.  At the same time junk bond yields are making new all-time lows and the spread between high-yield (HY) and investment grade (IG) is very tight, suggesting very low imbedded credit risk volatility.  It’s not US economic and earnings growth that will derail this rally in risk.  Like in 2008 and in 1998, it’s a systemic second or third derivative event that the market cannot discount.

Twitter: @exantefactor
No positions in stocks mentioned.