This week has been loaded with FED OFFICIALS filling the airwaves with thoughts about ending QE or just tapering, with the markets left to discern how, when and how much. Today, the NY FED President presented a speech at the Japan Society in New York City, titled, “Lessons at the Zero Bound: The Japanese and U.S. Experience.” President Dudley compared and contrasted the mistakes made by the Japanese and U.S. monetary authorities and what they had been able to learn from each other. The speech was not critical about recent Japanese monetary moves, which infers that the FED is very comfortable with current BOJ policy. The NYFRB president does tell seem to support Chairman Bernanke in being a ’37er, meaning the FED cannot allow the mistakes made in 1937 by the U.S. Treasury and Federal Reserve Board to recur. This belief emphasizes that deflation is the most powerful variable that can disrupt the political economy.
Dudley states: “With the benefit of hindsight, we now understand that the disinflationary consequences of the asset price bust and financial stress were vastly more powerful than was widely realized at the time.” Mr. Dudley further maintains that the Japanese erred in their quantitative easing program at first because they only thought to increase the size of the monetary base in hopes of creating inflation and bought mostly short-dated maturities and did not change the nature of the private sector balance sheet. The result was that Japanese investors just allowed the short-term maturities to roll off and resulted in no real increase in investor risk.
The U.S. FED took a different route by buying much longer-dated securities pushing investors into far riskier asset classes. In the FED‘s view, “… asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand.” This is the vanilla setup of Ben Bernanke’s PORTFOLIO BALANCE CHANNEL. President Dudley also reiterated the FED‘s original plan on how to EXIT from the QE program: “FIRST STOP REINVESTING,THEN RAISE SHORT-TERM INTEREST RATE,AND FINALLY SELL AGENCY MORTGAGE BACKED SECURITIES OVER A THREE-FIVE YEAR PERIOD.” (emphasis mine). Bill Dudley notes that the original thinking is now “stale” and therefore the FED has to rethink how to extricate itself from a much larger holding of asset-backed securities.
If the FOMC wishes to mitigate the negative results of a rise in interest rates due to FED normalizing monetary policy, it could move to avoid selling MBS and not cause a sharp rise in long-term rates. The FOMC is also worried that FED sales could disrupt the market and even expectations of future MBS sales could “… amplify such an upward spike in long-term rates.” It appears that some FED members also are concerned that the lack of FED assets will result in no FED remittances to the Treasury. The FED will no longer be receiving interest on its MBS holdings and will not be able to pay the Treasury money and reduce the deficit. In my opinion, AD ABSURDUM. Thus in order to prevent the possibility of any of these negative results the FOMC may decide “to allow the agency MBS securities to run off passively over time.”
The drum beat of solely allowing the FED‘s balance sheet to roll off is gaining acceptance. The FED is PLAYING DICE WITH THE U.S. FINANCIAL SYSTEM. As any trader knows, when a position goes awry and you say “I’m in for the long haul,” you are now an investor. Chairman Bernanke, as Shakespeare said: “Exit, Pursued By A Bear.”
***MORE TALKING: Tomorrow morning Chairman Bernanke testifies at 9:00 a.m. CST before the Joint Congressional Economic Committee. There is a prepared speech posted on the FED website at 9 a.m., although the INSIDE TRADERS ON THE HILL will have it before hand in preparation for the chairman’s appearance. The tweets will be relaying any mention of tapering resulting in high volatility across all asset classes. My readers are well aware that I have questioned the high volatility caused by headline-driven algo readers.
Today, the Financial Times had a comment piece by Professors Maureen O’Hara and David Easley titled, “The Next Big Crash Could Be Caused By Big Data.” As an example of the effects of “BIG DATA” on algo-driven trading, the authors cite the recent hacked Twitter feed from the AP about a terrorist attack on the White House. “Unlike the crash of May 2010, this was not an incident caused by rapid sales triggering more sales. It was not a speed crash; it was a big data crash.” As the Fed Chairman testifies and the tweets fly, be prepared by the volatility caused by the algo-driven readers. TAPER YOUR TRADING ACCORDINGLY and be patient.
***Also, Mark Carney gave his last speech as Governor of the Bank of Canada. Mr. Carney is moving to the U.K. where he will become Governor of the Bank of England. In castigating the Europeans and their role in being a drag on the global economy and a threat to the world financial system, Governor Carney pushed hard on the Europeans to create a European wide banking system and true labor market. “Deep challenges persist in its financial system. Without sustained and significant reforms, a decade of stagnation threatens.”
Coupled with what Fed President Dudley said in reference to Japan today, this is not bullish for Europe. Dudley maintained that the reason the U.S. was able to quickly act to recapitalize its banks because of the pressure capital markets exert on the financial system. Japan and Europe have both sustained a BANK-CENTERED financial system in which banks are the main providers of capital for the financial system. In the U.S., the corporate bond market, as well as shadow banking system, play a much larger role in the financing arena. It is much more important to sustain ZOMBIE BANKS in a banking-centered system. This is part of the reason that the European situation continues to drag, and why the mainstay of the European economy doesn’t need or desire drastic central bank action that could result in a weakened currency … a terrific dilemma.