Notes From Underground

The idea of Mr. Natural, the guru creation of R. Crumb, comes to mind as the analysts ponder today’s release of the March 18-19 FOMC Minutes. The market seemed shocked to learn that the FED had been misunderstood on its intentions to tighten soon after the conclusion of the its tapering program. When are the markets going to stop listening to the self-proclaimed seers of the Fed’s deepest secrets? The FOMC minutes let the financial world know that the summary economic projections (SEP) have as much credibility in interest forecasting as does the man behind in curtain in the Wizard of Oz. I will offer that the market must lean toward Janet Yellen being a labor economist with a strong moral bent of providing the foundation for any person desiring a job have a job. Again, that is a noble stance but not for the Fed chair. The violent move in the YIELD CURVE after the release of the minutes reflected the markets’ misinterpretation of Yellen’s press conference. If the 2/10 curve gets back above 240 basis positively sloped, it will result in a further selloff of the notes and bonds. The FED will err on staying at the ZIRP band until it is certain that the employment situation has dramatically improved. Quoting from the minutes: “Several participants cited low nominal wage growth as pointing to the existence of continued labor market slack.”

Further, “A number of participants noted that a pickup in nominal wage growth would be consistent with labor market conditions moving closer to normal and would support the return of consumer price inflation to the Committee’s 2 percent longer-run growth.” Adding to the market’s confusion with the FOMC release was the acknowledgment of a video conferenced Fed meeting on March 4, two weeks prior to the scheduled event. The purpose of the video conference was to get some clarity for all Fed members on the issue of quantitative thresholds versus qualitative language “… regarding the economic factors that would influence the Committee’s decision regarding the first increase in the federal funds target rate.”

I am a huge fan of utilizing qualitative analysis but I caution the Fed that if it regularly explains away non-action by a what they call outlying factors, the FED WILL RISK ITS CREDIBILITY. The market has been “trained” to think in terms of numerical thresholds but now it has to rely on the nuanced language of the Fed chair. If I am right in my thinking about the market’s unease with the Fed’s credibility, it will be revealed in a weakening dollar, stronger precious metals and, most importantly, an upward steepening in the YIELD CURVES. There is an IMF and G20 meeting this weekend so we will wait to see if there is any language in the communique about concern about the FED‘s recent change from numbers to words.

***As the world’s financial leaders are in Washington D.C. for the IMF and G20 meetings there will be pressure on ECB President Mario Draghi to drop the microphone and grab his checkbook. The jawboning of the markets with the threat of a quantitative easing program is losing its effectiveness. Many of the debt-stressed European countries are pushing for some debt of genuine debt relief. Today, Bloomberg had an article, “Draghi’s Hunt For QE Assets Leaves ECB Scouring Bare Market,” by Jeff Black and Alessandro Speciale. President Draghi and other European bankers have introduced the notion of the ECB buying up bundled loans from debt-stressed banks in an effort to stimulate the flow of credit. While this will not be a Fed QE program it would be similar to TARP and the Irish government’s efforts of creating a bad bank. By bundling various loans into asset-backed securities the ECB could then swap the ABS for euros resulting in a cleaned up balance sheet. French Bank President Noyer has suggested such a plan for the domestic French banks, relieving the stressed banks free of non-performing loans and an increase in lendable cash. This is what is being proposed in an effort to get the money flowing again.

Banks in Europe play a much more important role in credit markets as Europe has, by design, an underdeveloped corporate bond market. The European banks have enjoyed being the major financial intermediaries for many centuries but now they need to develop an asset-backed securities market to offload the burden of weak loan portfolios, especially in the face of the asset quality review.

To get the channels of liquidity flowing the banks need a major buyer of their paper. This is why Draghi is pushing for the creation of a large ABS market. The ECB will be the buyer of last resort. The question for the EU is: What entity will be the guarantor of the ECB‘s massive debt purchase? This plan is being pushed so as to circumvent the Germans by creating a “EUROBOND” through the backdoor. The ABS will eventually morph into a eurobond and German intransigence on the issue of guaranteeing sovereign debt will have been evaded. The immediate problem for Draghi is that the lack of ABS means the plan will take time and in that window the Germans may realize that they will be the co-signer to the ECB. This may be the reason that Bundesbank President Jens Weidmann surprised the markets last week with his seeming acquiescence to some type of QE program. Better to help design a program than to be burdened with a “Frankenstein” you didn’t create. Time is of the essence for bond buyers are eagerly chasing yield to the degree that Greece could bring a new five-year sovereign note to market and have it priced at 5 percent. Well, back to Mr. Natural and what it all means.

Tags: ABS, ECB, Fed, FOMC minutes, Janet Yellen, Mario Draghi, QE, yield curve, ZIRP

This entry was posted on April 9, 2014 at 8:45 pm and is filed under Debt Market, ECB, Fed. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.