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Monetary Policy Chaos: Sell First, Bid Last, Ask Questions Later


It doesn't matter what the Fed thinks; it only matters what the market thinks.

The Fed's cost/benefit analysis (ex post QE) that was the catalyst for the decision to taper purchases may end up defining Bernanke's tenure. The move from a 1.50% 10-year to what looks to be an inevitable 3.0% test in a 12-month time frame is having a profound impact on investor psyche and P&L. It's a wonder if the Fed truly understood the systemic risk it was fostering by loading the market up with billions in extremely low (negative real) coupons.

What we do know now is that the Fed is finally admitting that the benefit of QE is questionable. This past week, the San Francisco Federal Reserve issued a report on the efficacy of QE. In this report, titled "How Stimulatory Are Large-Scale Asset Purchases?", the researchers conclude:
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. Research suggests that the key reason these effects are limited is that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

Thanks, guys, you've been helpful... but there's just one problem.

This past week, St. Louis Fed President James Bullard made one of the more interesting comments about the Fed's record in economic forecasting. As reported by Bloomberg:
Federal Reserve Bank of St. Louis President James Bullard, who has backed continued bond purchases by the Fed, said policy makers should be careful in changing course based solely on their economic forecasts, which have proven in the past to be too rosy.

Federal Open Market Committee forecasts "have tended to be too optimistic over the last several years," Bullard, who votes on monetary policy this year, said today in the text of prepared slides for a speech in Paducah, Kentucky. "Given this experience, I think caution is warranted in taking policy action based on forecasts alone."

When I saw this cross the tape, I was shocked at the revelation. With the Fed obviously ready to wind down QE, forward guidance of the Fed funds rate is the new Fed policy. This revelation begs the question I soon after tweeted: "If the Fed thinks they don't forecast very well, then how can they set policy on forward guidance of the forecast?"

You wonder why the market is confused and there is no bid in the long end. Recall that, during the June bond market meltdown, Fed officials were quick to communicate to markets that participants were simply misinterpreting Fed policy. This is all just a big misunderstanding. I wasn't buying it. It doesn't matter what the Fed thinks; it only matters what the market thinks. As I said on July 1 in Bond Market's Memo to the Fed:
Misunderstanding or not, the bond market has eliminated a lot of capital in a very short period of time. Leveraged long-term investors have been torched and capital deployment has been frozen. This unwind has been about a reduction in long-term capital and Bernanke's insistence on vague threshold guidance for QE now make it virtually impossible to put this long-term capital back to work. How can an investor have confidence to buy a long-term bond? How can a bank have confidence to make a long-term loan? The answer is that the risk premium is going significantly higher. In the ensuing months, we will no doubt see this how this market adjustment evolves into an economic adjustment.

The untold story about this market episode is the damage on investor psyche. It will be very difficult to make a long-term capital allocation decision under this dark cloud of policy uncertainty. Regardless of whether the Fed holds off on tapering or extends guidance on zero percent interest rates, confidence has taken a big hit. That will destroy investment in long duration assets, banking system credit creation, and capital investment. That is something that we can all understand.

This is exactly what is happening. Add the uncertainty surrounding the appointment of a new Fed Chairman, and you have a delicate environment for market liquidity. The consensus sees rising yields as a reflection of an improved economy, a great rotation, or concerns about tapering. This is all false. The rise in interest rate risk premiums is an indictment of monetary policy chaos.

In the last 12 months, Fed policy has gone from balance sheet neutral to balance sheet expansion to tapering balance sheet expansion to forward guidance to a lame duck and to now the notion of Larry Summers, which is a completely unquantifiable risk factor. This policy whiplash is seeing the risk premium embedded in the term structure of the yield curve massively steepen. The bond trading environment has become one of sell first, bid last, and ask questions in March 2014 when the new Fed chairman takes the helm.

Twitter: @exantefactor
No positions in stocks mentioned.
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