Today was the most anticipated FED news conference since TRANSPARENCY became the buzz word of the post-Greenspan era. The FED Chairman took center stage (he was deputized) to bring clarity to the issue of ending the FED‘s large-scale asset purchase program. Mr. Bernanke made sure that the financial world understood that tapering was not tightening. Well, the market may have heard but it did not listen. The Chairman’s words gave impetus to a selloff of EQUITIES, BONDS and precious metals. Overall, the rise in interest rates evidently led to a deleveraging of a mass of positions dependent upon massive leveraged positions, especially in EMERGING MARKET CURRENCIES. The Brazilian real made four-year lows and the Mexican peso was also under severe pressure as higher U.S. interest rates are expected to force a repatriation of funds back to the safe waters of the U.S.
Earlier in the day, CNBC’s Rick Santelli ranted about what questions the press OUGHT to be asking the FED. In my opinion, the most important question was: “Why is the FED continuing the QE program even though the U.S. economy was in growth mode? What Is The Fed Afraid of?” In listening to Santelli’s question, I was forced to return to Fed Governor Jeremy Stein’s February 7 speech, “Restoring Household Financial Stability.”
The main thrust of the speech was that the FED‘s policy of QE may be causing a dynamic of overheating in credit markets as investors reach for yield. “A period of prolonged low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ financial leverage.” He notes that the ultra-low yields in the junk bond market can cause problems for the entire financial system as much of the collateral usage is out of the FED‘s “range of vision.” The issue of collateral transformation, which encompasses a daisy chain effect as lenders accept more risky assets in repo for the needed pristine paper. So, the end result is that the FED FEARS FINANCIAL INSTABILITY.
It is Stein’s work that I believe unnerved Bernanke and began the issue of TAPERING in a way to put some fear into the credit markets. Governor Stein noted that monetary policy was not an effective tool to deal with financial stability because “it gets into all the cracks.” The issue gets put before us, again. The FED does not have to invoke monetary policy in an effort to curtail the negative effects of QUANTITATIVE EASING. As Jeremy Stein asks, “What are the respective roles of traditional supervisory and regulatory tools versus monetary policy?” This is a very critical issue and speaks to possible FED actions that will curtail the impact of the FED‘s four years of aggressive easing. The FED may be more willing to squeeze the TOO BIG TO FAIL through regulatory moves than to raise interest rates.
Again, back to Stein: “One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability.” Thus, to focus on monetary policy does not alleviate Chairman Bernanke’s greatest fear: FINANCIAL INSTABILITY. The FED can certainly defeat Jamie Dimon’s screaming by saying: We bailed your sorry asses out so shut the hell up as we struggle to unwind the flotsam and jetsam left over from the systemic bailout.
***An interesting statement in the opening statement from Bernanke: The FED will not sell MBS in the process of normalization. I found this bothersome as it means that the FED is far more concerned about sustaining the fragile housing recovery by not putting massive amounts of mortgage-backed securities into the market. I throw out this question: Will this have a FLATTENING EFFECT on the 5/30 part of the U.S. curve? This is just something to think about as the FED’s policy begins to unfold and the market absorbs what it has been given. Bernanke stated that the housing recovery was helping consumers by increased wealth through higher housing prices. It seems the FED wishes for that wealth effect to continue.