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Helicopter Ben Rides Again

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As long as the Fed focuses on growth at the expense of inflation, the market will continue to price risk premiums accordingly.

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MINYANVILLE ORIGINAL When Ben Bernanke took over as Chairman of the Federal Reserve in February 2006, current policy was operating under a tightening bias and the Fed Funds (or FF) rate was 4.50%. The housing market was topping and the Fed was clearly aware activity was slowing.

From the minutes of Alan Greenspan's last meeting in January 2006:

Activity in the housing market appeared to continue at high levels, although there were some indications of slowing... Moreover, the stock of homes for sale increased to the upper end of ranges seen in recent years.

During the real estate boom, the supply of homes on the market kept a steady rate of three to four months. But in 2005, the month's supply began an ominous uptick. By early 2006, which is when Chairman Greenspan would leave the Fed, the housing supply was at six months.

At Bernanke's first meeting in March, he maintained Greenspan's tightening bias and raised the funds rate to 4.75%. Bernanke was fighting a very dovish perception from the market due to his famous "helicopter" speech in 2002. It became clear he was eager to counter his critics and demonstrate his inflation fighting credentials. In the face of noticeable deterioration in housing, Bernanke would raise interest rates at the subsequent two meetings until he got to 5.25% in June 2006 while continuing to cite inflation as the primary risk.

From the June 2006 minutes:

Sales of both new and existing single-family homes in April and May were significantly below their peaks of the summer of 2005, though new home sales continued to regain some ground after having fallen in February.

The supply of homes on the market continued to rise throughout the year; as such, housing price appreciation continued to decelerate. Bernanke ceased tightening in August and removed the tightening bias, but was still adamant inflation was the primary risk.

As the US economy entered 2007, the supply of homes on the market continued to swell to seven months, and home price appreciation was rapidly decelerating dropping from 15% YOY (year-over-year) growth at the beginning of 2006 to 0% growth in early 2007. Many thought the real estate bubble was crashing at that time. Nevertheless, in January 2007, the Fed remained tight and kept the FF rate at 5.25% though noted growth and inflation were likely to moderate.

Despite the continued deterioration in housing, the bond markets would start to see some unusual price action in June as the yield on the 10YR shot up 50bps from the levels in May, reaching new highs. In the minutes from the June 28 FOMC meeting, the Fed characterized the move as a positive "appraisal" of economic prospects:

Over the intermeeting period, however, investors seemed to reappraise their beliefs that the economic expansion would slow and that monetary policy easing would be forthcoming. This reappraisal seemed to be based in part on the release of some economic data in the United States and abroad that were more favorable than expected.

Earlier that same month, it became apparent that the now-infamous Bear Stearns High-Grade Structured Credit hedge funds were under severe pressure. The Bear Stearns funds collapsed and filed for bankruptcy on July 31. In hindsight, the spike in bond yields was the result of highly leveraged hedge funds selling liquid Treasuries to meet margin calls in illiquid mortgages, not a reappraisal. In what was a display of tight policy confirmation bias, the Fed completely misinterpreted the price action and the fact that the first domino had fallen.
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