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Beware of Central Bankers in Helicopters


Juxtaposing Fed policy actions against the current economic landscape to see if it makes any sense.

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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