Janet Yellen and company are discussing the wrong issue. A FED FUNDS rate hike has already taken place due to the increase in LIBOR rates, which has led to a pricing of the December eurodollar futures contract, currently trading at 99.08–an effective six month yield of 92 BASIS POINTS. This due to the Oct. 14 regulatory compliance deadline for money market funds. In order to ensure there’s enough liquidity to protect against unknown outflows, institutional prime funds are shortening the maturities of their commercial paper, CD holdings, pushing up the CP/CD rates and LIBOR with it. Some prime funds have converted to government-only to circumvent the impending regulations, which has created more demand for U.S. Treasuries. (According to the SEC’s July money market report, govt funds had inflows of $77 billion while prime funds saw outflows of $41 billion.) As a result, the TED spread has widened 15 BASIS POINTS during the past two months. The September eurodollar/fed fund futures spread is trading at 53 basis points. WHAT THE FED HAS TO DO IS BEGIN SHRINKING ITS BALANCE SHEET BY 100 BILLION ASSETS A MONTH. Why?
The rationale put forward for a FED rate hike is so the central bank will have room to CUT when the economic indicators reflect a renewed slowdown. At this moment, it is a ridiculous idea since the other major central banks in a high state of liquidity pumping. If the Fed had wanted to be prepared to return to normalcy it would have been when the jobs data began dropping through the original thresholds of 7%. (Remember when the FOMC believed that represented a key level? Then it was 6.5% and the goalposts were kept moving lower.) Just leave the FUNDS rate where it is and shrink the balance sheet because with global interest rates so low the next time the FED has to ease it will be through more QE. Monetary policy at the zero bound has to be far more creative than merely lowering the FUNDS rate.
The FED is terrified of shrinking its balance sheet because of the May/June 2013 market meltdown known as the TAPER TANTRUM. BECAUSE THESE ACADEMICS RELY ON MODELS AND NOT MARKET KNOWLEDGE THEY ARE MISSING A KEY INGREDIENT TO WHY THIS TIME IS DIFFERENT. The ECB, BOJ and BOE are PURCHASING A COMBINED $200 billion per month in assets, providing a strong support system for FED ASSET SALES. $100 billion per month won’t destroy the global bond markets. If the ECB wants to keep pumping liquidity let them be the purchaser of last resort.
1. The 10-year Treasury/bund chart is locked in a very tight range as ECB purchases of sovereign debt make all yields a relative play. Yes, FED selling may put some upward pressure on U.S. long-term yields but it will be minimal because of the BOJ and ECB programs.
2. The FED‘s removal of liquidity from the U.S. banking system will have minimal effect on rates because most of the excess reserves are parked at the FED anyway. The ECB and BOJ have eased the burden of the Fed being the major provider of liquidity.
3. The effect would be a steepening of the U.S. yield curve, which would aid domestic bank earnings and probably increase the desire to make loans.
4. Because many global financial loans are based on LIBOR, after the regulatory impact from the October rule change USD LIBOR rates may fall as short-term lending has some certainty. The DOLLAR may not rise if short-rates stay at its present levels because it is not the long-end that is the key variable for the DOLLAR. The FED needs to lose its fear of the TAPER TANTRUM and do the RIGHT THING. SHRINK THE BALANCE SHEET BEFORE RAISING THE FED FUNDS RATE.
This is just an opinion based on market function rather than models. Proceed on a monthly basis and if I AM WRONG THE SELLING PROGRAM CAN BE CURTAILED. BOJ Governor Kuroda and ECB President Draghi are providing the perfect opportunity for Janet Yellen to take the ROAD LESS TRAVELED. Janet, do not yield to fears of a taper tantrum.