Notes From Underground: Tapering Is Tightening? So Spoke The Market

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.

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18 Responses to “Notes From Underground: Tapering Is Tightening? So Spoke The Market”

  1. asherz Says:

    Tapering may not be tightening but reducing the required daily “fix” is enough to cause severe withdrawal symptoms. QE which was supposed to jump-start the reeling economy has in fact been a life-support devise, whose elimination or reduction may cause the patient to return to a comatose state.
    Jeremy Stein said it like it is as Greenanke theories are now in their third Fed created bubble, all leading to much pain after the party has ended. Moral hazard has returned with avengeance and one begins to wonder in this 100th anniversary of the Federal Reserve may ultimately be commemorated in sadness and mourning.

  2. kevinwaspi Says:

    If the goal of QE was to lower LONG rates, and in turn, the discount rate to value assets, bringing about about higher higher asset prices, BUT today’s statement does not see rates moving higher anytime before 2015, perhaps some market participants should show Ben what THE MARKET has done to rates in the past six weeks, much less today. I see the Fed painting itself deeper and deeper into a corner of needing to expand or extend QE to keep rates from rocketing higher in the face of an ever ever slowing global economy. 3 -3.5 percent GDP growth here in 2014 seems a wild fantasy!

  3. Lou Baron Says:

    In reply to Asherz and Kevinwaspi … Asherz, I’m sorry I don’t see it that way. First I don’t see it as heroine withdrawal; I see it as getting a severely injured patient healed. And I don’t see the patient becoming comatose again just because the doctor “tapers” the medications and pain killers. Some of the major organ systems (housing, the banks, corporate balance sheets, etc) are much stronger now than when the patient was first brought in. And I don’t read anything into the market’s short term reaction. In my opinion was just traders and algos (thanks Yra for that term) exhibiting knee jerk reactions – and when they want to take it up any news is an excuse, and bad news is ignored, and vice versa. I personally didn’t hear anything onerous today to make me want to sell my stocks, close my business and run for the hills. I’m in real estate and with respect to the recent housing bubble, who are you going to blame? – lenders for poor credit decisions, borrowers for taking on debt they couldn’t responsibly afford, or the Fed for an easy money policy? So who do we blame for the current “soft” economic situation? The Fed for QE, the banks for ridiculous stingy underwriting, or the corporate herd mentality that prefers to build the balance sheet out of fear instead of building the business out of optimism. Personally I think the Fed is getting better and better at its job, otherwise this last housing bubble would have resulted in something perhaps equal to or worse than the Great Depression. The economic malaise of the American middle class, of which I’m a member, is in my opinion due more to globalized (which I like despite of its effect on our American middle class America – “you’d better be willing to work for less buddy because somebody in another country is certainly willing to do your job for less – although to them it is MORE”) and it is also due to the need for workers to have something more to offer in the American workplace than just a college degree and hard work – you’d better be pretty smart and highly skilled if you want a seat at the table of American affluence. And getting more and more people there is not the Fed’s job. And Kevinwapsi … the last six weeks of rising rates is the market response you fear that will plunge our economy back into something bad? As I remember our economy had been able to do just fine with much higher rates. If rates rise to prior “normal” levels that shouldn’t hurt us. If you can’t afford 5% rates then maybe you should rethink your business plan, but if rates go to 15% than I’m with you … very high rates can put a damper on most businesses. But as I see it today’s reaction was just traders doing their thing and not anything to do with economic fundamentals and a true shortage of liquidity, or the start of a shortage … but I could be wrong. I offer all this in a friendly spirit of debate and did not in any way intend to be confrontational, rude or poke fun at anybody. Lou in Sacramento

  4. danderose Says:

    Lou, all in good fun indeed. What’s a 3trillion dollar balance sheet amongst a perfectly well functioning western society anyway? Well, unless there exist the very fault lines Big Ben insisted upon for years: low inflation and high unemployment. With the Fed missing both of the mandates, and the former more so now than anytime previously (see Bullard in the statement today), it’s concerning that he would be willing to pivot to tapering here. I don’t so much think it’s any potential kevinwaspi business models that would blow out at 5% interest rates. It’s that the entire economy would blow out at 5% interest rates. Give Ray Dalio and a ‘beautiful deleveraging’ a gander and you’ll see negative real rates are the medicine the economy needs to heal. Now maybe the economy has healed and this medicine is no longer necessary but then the aforementioned mandate would be achieved on both ends, not missed. As to corporate pessimists sitting on cash, that’s called responsible corporate management when top line growth is 1-2% as it was in Q1. That excess cash is the result of a distorted yield curve described nicely by Stein (October 11,2012) changing the capital structure but not any viable investment thesis (reason for distortion described above).

    As a sidenote, I admire your optimism. Maybe a permanently high plateau indeed.

  5. Lou Baron Says:

    Dan, thanks for your reply. That’s why I attend this class. If it isn’t the professor, it is my fellow students who make me want to do some more homework – I will give Stein and Bullard a gander. Thanks. Lou.

  6. Kevin Says:

    While Bernanke may claim “tapering is not tightening” the market has sniffed out an asymetry in outcomes. Policy makers love ambiguity, but when that ambiguity migrates from direction to timing, then the markets can force the issue, e.g. start pricing in the interest rate upcycle. This may be “just traders doing their thing” but I expect this to continue until there is a push back or climb down from policy makers. That could be at yields a lot higher than 2.35% for 10yr…..

  7. geopolitical businessman Says:

    Meanwhile, “the Spanish government insisted that the worst of the economic crisis had passed” via reuters

  8. yra harris Says:

    Geopolitical—reminds one of the scene in Camus’s PLAGUE–when the doctor is charting the number of deaths declares that the Plague is over and the next day he dies—

  9. yra harris Says:

    Or as JOHN Belushi says to the Delta House in Animal House—it ain’t over till we say its over—thus spoke Mr.Market.

  10. ronald ferrill Says:

    Can you explain (or guide a simple mind to a resource) why selling MBS would flatten the 5/30 yield curve? Probably an obvious answer, but I sense that getting that concept right might open the doors to other deeper understanding. If I missed the point don’t hesitate to call me names (I played rugby after all)

  11. asherz Says:

    Camus or Belushi? Get more current, from our Commander in Chief.
    “The war on terror is over.”

  12. yra harris Says:

    Ronald–sorry .I meant to convey that the FED not selling off the MBS would result in a possible flattening as the FED would not provide liquidity at the short end of the market—-if I am unloading my shorter dated instruments it will push they rates higher but the lack of paper via my holding onto the MBS’s which are longer term will keep a bid to them—not sure I am right about the impact as the move on the short end to higher levels may well in fact shift the entire curve—threw it out for discussion and as I said I will be watching the market closely.If James Bullard fears on inflation are correct the 30’s should be a screaming BUY as a value because at that end of the curve rates are at least a positive yield–just some more food for thought

  13. kevinwaspi Says:

    Excellent discussion all, and I take no umbrage with Lou’s optimism, I applaud it and his business endeavors. My only point was the following: If the Fed defined the lens used to look at the economy and initiate policy in response to it, yesterday’s announcement seems to be using a different lens to view the same data. I do not see top line growth in business revenues, nor expansion of profit margins or capital expenditures that give me comfort with a “recovery”. I do not see labor participation rates moving higher, average earnings, hours worked, or any other labor market indicator indicating an acceleration of recovery. I do not see base metal prices, shipping, or inventories indicating an acceleration in production & consumption. I DO see a pause/end in the decline of housing prices, and perhaps in select areas, some quick upticks. Looking outside of the U.S. Europe and China are not on the healing side of the curve, they are (in the case of Europe) still holding their breadth on the next bank surprise, and in the case of China, seeing a command and control economic “miracle” become subject to the gravity of market forces.

    I never liked the lens the Fed defined, and have believed that beyond 2010, the policies have been too accommodative, too long. The growth in the Fed’s balance sheet has distorted markets in all corners of the globe with many unintended consequences attached. My only point was it would be a damn shame to see all of those distortions and unintended consequences be the legacy of this policy, with the market actions creating a 1937 replay (rates rising TOO FAST, not TOO HIGH) that would squash any intended benefits of the policy. Keep up the good debates all!

  14. richard4691 Says:

    At the beginning of the week, Obama talked about Bernanke wanting to leave. What’s your view on how that plays into tapering talk? Perhaps it is a way to prepare for the handoff to the next Chairperson. Let the markets drive up rates, so there is something to lower in the next crisis moment. Meanwhile the data driven policy adjustments at the margin would not be a bad thing in general. Wall Street loves to read Fed tea leaves no matter what the Fed says or does. It is the targeting of the unemployment rate that bothers me, since the fall in this figure can be engineered and the participation rate is worrisome. Personally, I think Obama wants to leave a Democrat in charge of the Fed and perhaps have greater influence over the policy, although I dont know what that would mean really. I can easily see a frightening period of drift ahead between the time it is known that Bernanke will leave and the replacement has not been through the Congessional approval process and shown her or his colors to the market.

  15. yra harris Says:

    Richard-I am not sure how the Bernanke position plays into the tapering issue.I do not know whom the President will put forward–my choice would be a steady hand with repsect for markets,i.e. Don Kohn and not someone econometric model dependent.Obama will be careful as his base will not want to see a wall streeter fill that role–like a Summers or geithner.If the Jeremy Stein ideas on financial regulation being an important aspect of financial stability–then Sheila Bair ,Jeremy Stein,Chris Whalen or Simon Johnson would be my choice and of course the old man Paul Volcker would always work for me.

  16. onthegroundinasia Says:

    What do you think of the rumor (started by me) that Bernanke is merely testing the market with his tapering comment but with no intent other than to see what transpires. As you say, he has yet to do anything. After all, he is a smart guy and tricky.

  17. yra harris Says:

    on the ground–not far fetched idea and certainly fits well with the theme of Jeremy Stein scaring Bernanke out of his “Minsky Moment”

  18. Chicken Says:

    At this point, I just wanna know which sector banks are targeting for their next destruction derby.

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