Archive for the ‘Monetary Policy’ Category

Tim Geithner’s replacement, William Dudley, offered some interesting remarks on the effectiveness of TALF, the expansion of the FED’s balance sheet, and alternative methods of providing liquidity to banks. Above all, Dudley stresses that while deleveraging is inevitable in a credit crunch, it is imperative to facilitate the volatility which comes with it:

In the current crisis, the deleveraging process at times has been very violent and dangerous, with powerful reinforcing feedback loops intensifying the process. During these episodes, bystanders who did not engage in excess may be trampled and fail. This may exacerbate the tightening in financial conditions, intensifying the constraint on credit availability and the downward pressure on economic activity.

We saw that happen to Lehman Brothers…

I specifically like his analysis of how deleveraging occurs, and why it has been central in reinforcing our tight predicament – although it’s a term tossed around endlessly by the media, the effects of deleveraging are seldom explained:

For example, in March 2008, in the run-up to Bear Stearns’ demise, the deleveraging process intensified. Market volatility increased; this caused lenders to increase the haircuts they assessed against collateral to secure their lending. The higher haircuts, in turn, squeezed highly leveraged investors who were forced to sell assets. This drove down asset prices and increased price volatility further, leading to still-higher haircuts. This intensified the deleveraging process, which led to more mark-to-market losses.

“Haircuts” effect margin requirements and collateral levels, and ultimately have to do with the dealer’s profit margin; if the dealer demands a greater cushion to execute a trade, the burden is passed to the buyer (e.g. a hedge fund).

If interested, here’s the full transcript of NY Fed President Dudley’s speech.

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Bill Gross wrote an interesting piece about being one step ahead of government policy on Seekingalpha today. He sees two vehicles to accomplish this:

  1. Municipal Bonds, since a default in New York or California is “unthinkable”…here’s a list of the most recent New York issuance. Gross’s logic being that a 5.00% coupon municipal bond is better than a 2.5% treasury bond (after tax considerations, the muni is more like a 6.75% coupon), since default risk isn’t one of his assumptions.
  2. TIPS, or Treasury Inflation-Protected Securities. Here’s how they work

Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases.

And Gross’s logic:

2½% real yields cannot possibly be maintained unless deflation as opposed to inflation becomes the odds-on favorite. What bond investors know as “breakeven inflation rates” are currently signaling a future where the U.S. CPI averages -1% for the next 10 years. Possible, but not likely.

Since interest rates are zero-bound, barring excessive demand at auction (like we saw with 3 month T-bills), there is low risk of principal depreciation – since deflation is already being accounted for in interest rates…we have a ZIRP for crying out loud. Our government is doing everything in its power to avert a period of deflation, and will happily substitute inflation (this can be extrapolated from our government running  a $1 trillion budget deficit, and the Federal Reserve relentlessly expanding the money supply).

Personally, I think this gets too complicated when you’re relying on the precision of our CPI (which is how TIPS value themselves) to emcompass all facits of inflation. Also, if the value of an inflation protected bond increases only with the value of inflation, you’re not really making money; not to mention that this increase in “principal” is treated as a capital gain, which is subject to federal tax.

Here’s a yield table for TIPS and Notes:


Those yields aren’t very impressive…I’ll take my chances with equities.

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There was a lot of news to write about on Monday…Seriously.

Besides Arnie calling California’s situation “a fiscal emergency”, the Dow crashing 680 points, more Goldman bonus cuts, Oil falling below $50…oh, and of course. It’s finally an official recession. However some of the biggest news comes from the FED concerning alternative measures to adding liquidity to the markets.

When the FOMC “cuts” interest rates, they do so by buying short-term treasury bills. This method of adding liquidity into the economy is hampered if there is no interest rate to “cut”.

3-Month 0.000 03/05/2009 0.04 / .04 0 / .000
6-Month 0.000 06/04/2009 0.32 / .44 -0.1 / -.102

This pickle we find ourselves in is known as a “liquidity trap”, where virtually all of the government’s supply of T-bills have been met with excessive demand (in this case, this is the quantification of a flight to safety).

What really set the markets off today (at least the bond market) was something Ben Bernanke mentioned in a Q & A held in Austin, Texas; when confronted with this very issue of a liquidity trap, he pointed out that the FED was not constrained to traditional metrics of expanding the money supply, but referenced a speech he delivered back in 2002, the last time the U.S. went through a deflation scare – one in which, like today, we straddled very low inflation coupled with the fear of slowing aggregate demand. Here are some excerpts from his 2002 speech:

“Deflation is in almost all cases a side effect of a collapse of aggregate demand–a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”

“Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has “run out of ammunition”–that is, it no longer has the power to expand aggregate demand and hence economic activity.”

Just to keep things in perspective with the crash of 1987….today’s drop wasn’t THAT bad.

1-Month Timeframe

10-Year Note, 1-Month Timeframe

10/16/87 - 11/16/87

10-Year Note, 1-Month Time Frame: 10/16/87 - 11/16/87

Now it was this idea, his non-traditional method of providing liquidity in a ZIRP environment, where the yields on 10-year notes began to tank:

“So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.”

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.”

Keep in mind that the above quoted section is from 2002, not today…though it’s funny how relevant it is.

It’s also interesting how the bond market reacted like this was some sort of new idea; Bernanke has always maintained the reputation of being an expert on the Great Depression, and his ideas for monetary policy in a zero-interest-rate environment have been public for quite some time (6 years, to be exact…I suppose the efficient markets hypothesis has selective cognition).

Either way, this would be a ground breaking policy: Bernanke’s mention of the strategy in his speech today pushed the yield on 10-year Treasuries down 22 basis points and the 10-year’s yield to 2.70%, its lowest since 1955.

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Halt trading – give these computer drone traders a vacation, and let them come back to reality. Let congress vote on the future of General Motors, Ford, and Chrysler; whatever the result may be, let it settle without any trading.

If they choose to let the Big 3 file bankruptcy, they should facilitate it such that the American Autos have temporary access to a credit line. This would allow them to carry on business as usual without closing their doors; as they try to keep creditors away, they can straighten out their business model and break the unions, all while preventing a Chapter 7 bankruptcy – which would lead to liquidation and 100,000 jobs lost.

From here – during the halted trading – the SEC should reinstate the uptick rule, which should temper the volatility going forward (as we saw, banning short selling on Financials is NOT the answer…as soon as it is lifted? Bombs away!)

There should be nothing hindering any of the above actions, except the bureaucratic nature of our government, which we no longer have time for at this juncture.

While we’re at it, we might as well consider an interest rate cut, as it should at least have a placebo effect on the markets…the reason I say that is the effective Federal Funds interest rate has been well below the targeted 1% for quite some time:


As for Barack Obama, he should take preliminary action in appointing some cabinet members; get an all-star team of financial geniuses for a special committee – Buffett, Summers, Volker, Soros, Roubini – some of the smartest people in the world live in this country, and their talent should be utilized.

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I’ve been preparing for the “FED Challenge” which takes place on November 5th, down in Baltimore. If we win this first   round, we’d go to the regional competition, and then (improbably) to the national competition, which was won by Harvard last year. I thought I’d post the general points I’m going to make, but keep in mind, as the FOMC, we only make a decision about the Federal Funds target rate, nothing concerning a bailout package.

1. Keeping rates low for an extended period of time will:

o Steepen the yield curve; sign of future economic prosper, and a favorable development for the banking system.

o Should lower the interest rates on ARM’s pegged to prime.

o In time, as panic subsides, LIBOR will drop – many loans are pegged to LIBOR.

2. Today, the Federal Funds rate has become second fiddle to the unprecedented action taken by the treasury, and our Federal Board of Governors to insure commercial paper markets.

3. Fed target rate may be at 1%, but the effective rate is at .3% from the new initiatives of paying interest on bank reserves. This has rendered the targeting of the funds rate somewhat less important than before.

4. In terms of Foreign Exchange Markets, despite our low interest rates, the dollar should remain strong relative to the Euro nations and EM, since they are very unstable – in part due to the nationalization of much of their banking system. While a stronger dollar will likely hamper the 5.9% increase in real exports we saw in the 3rd quarter, the dollar strength should place a ceiling on commodity inflation, since much of the increase in commodities over the summer was tied to a weak currency.

5. Reverting back to 1980 is something that few want to see; the recession was severe, with the economy contracting at a 7.8% pace in the second quarter of 1980. The unemployment rate by November 1982 moved to 10.8%, which thankfully has not been surpassed. This time around, GDP is seen contracting at a pace in a range of 2% to 4% over the next couple of quarters, and unemployment is expected to move up to about 7.5%, or possibly over 8%.

6. A scenario of even greater concern is deflation.

o We have sustained tremendous asset depreciation across all sectors of investment, resulting in an evaporation of wealth. Japan’s period of deflation was sparked by a large price bubble in real estate and equity markets (very pertinent to today…When assets decrease in value, the money supply shrinks, and this is deflationary).

Many worry that this could trigger a downward spiral of falling prices, since aggregate demand would be crippled from lack of disposable income and insufficient access to credit. I, however, do not foresee this happening. Only if the banks hoard the money provided from the TARP could we experience an extinction of liquidity, and possibly lead to deflation. Another worry is that the bailout plan will ignite a period of hyperinflation, since more money is being added to the economy everyday. however this fear may not materialize either, since the cash infusion will ultimately serve as a replacement for money which was lost in aggregate investment.

Given all of this information, we should leave the federal funds target rate at 1%. As a central bank, we have done as much as possible for the time being – we will need to wait to see how our actions are greeted by the macro-economy. Further, it is not the cost of money which is the problem, it’s the availability. We should not treat the matter of cutting rates below 1% lightly. The FOMC would virtually surrender all monetary policy. We have seen, and continue to see that Japan has been trapped within a period of near zero interest rate policy for over 10 years. Therefore, in order for rates to stay at 1%, we should consider maintaining our position on quantitative easing (flooding commercial markets with liquidity to promote private lending) and reevaluate our stance should economic conditions deteriorate beyond our current expectations.

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Unless you live in a box, it’s pretty hard to ignore the wide spread selling epidemic of the past week/s:

All of the technical indicators suggest that the market is oversold; the relative strength index is below 35, the Dow Jones Industrial Average is 15% below its 50 day moving average, and the volatility index is above 50 (All of the previous lows of this past year have not breached 33-37 level).

Of course, this does not matter though. Charts are not relevant when there are hedge fund liquidations, and when we are beginning what should be a very bad earnings season. We are feeling the ripples of the shoes which have dropped.

That said, I think a short term bottom will be formed soon. One necessary step has already taken place today; The coordinated rate cut was a great response to this turmoil, and honestly I’m pleasantly surprised at the efficiency of our Federal Reserve, and other central banks around the world.

Potential-positives which we can expect to see in the coming months:

  • The SEC repealing the ban on short selling, and reinforcing the uptick rule. The clearest and most likely imperative of all.
  • Since no one is willing to lend to each other, the FED can act as a clearing house between commercial banks, which could eventually bring down LIBOR rates as things settle down and improve the probability that banks will lend to each other in the near future. In order for our financial system to improve, Wall Street will need some form of guarantee, even if it is not really needed. The FED will simply have to hold their hands and see things through until conditions improve (by this, I mean regulation. Free market enthusiasts had their chance, and made monumental mistakes along the way. Sorry guys).
  • We are witnessing a panic, and people become irrational in such circumstances. Much of the action is an appropriate response to an overpriced market, but is also a function of a “sheep” mentality. Market participants will eventually search through the rubble (probably after earnings, or 2-3 weeks), and differentiate between sectors of weakness, and sectors of strength. Many companies are priced at values reflecting little to no profitability, and those are ones which are unjustifiably taken down.

I don’t believe that these positives existed even 2 weeks ago, because only now is their broad recognition of the severity of the situation, and the markets are being purged for their lack of accurate pricing. The other reason is that policy makers are a reactive bunch, not proactive. This is why, only now, are we burdened with the urgency to make appropriate decisions regarding the turmoil going forward, because we have to for the sake of our global economy.

If the market can be convinced that these policies are ahead of the curve, then I think they will eventually see the same potential, and the precipitous selling will ease. The long term bottom is outside my scope of comprehension, because I’m still trying to figure out the full effect of hundreds of billions of dollars vanishing from an economy.

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The Federal Reserve took advantage of the new powers it was granted in the financial stabilization bill by announcing that it will begin to pay interest on reserves it holds on behalf of depository institutions. This gives the Fed the ability to engage in a quantitative easing of monetary policy and which can be as powerful as interest rate cuts, probably more so in the current environment.

From Bloomberg:

Today’s steps follow a hoarding of cash by banks that sent the premium on the three-month London interbank offered rate over the Fed’s benchmark interest rate to a record.

Implementing part of last week’s emergency legislation to shore up the financial industry, the Fed said today it will begin paying interest on the cash reserves banks hold at the central bank. The step should give Fed officials greater power to inject cash into banks without interfering with their benchmark interest rate, which stands at 2 percent.

They have also managed to double the size of the Term Auction Facility (a short term liquidity metric used by banks) from 150 to 300 billion, which would not have been possible without this new provision of paying interest on banks reserves.

Here’s some analysis from Tony Crescenzi, an economist and CNBC contributor:

In the past, when the banking system has been flush with cash, banks have attempted to sell their excess money to other banks, often chasing the fed funds rate lower in an effort to avoid holding balances earning no interest

(remember: supply and demand. When there are more sellers than buyers, there will be a change in price. In this case, money rates will not go from the targeted 2% to a lower 1.5%, because banks will choose to “sell” their excess money to the FED instead of dumping it on the open market). Here’s some more:

In recent weeks, for example, the funds rate has fallen to close to 0% nearly every day because banks are competing with other banks to find buyers (borrowers) for their excess funds.

the expansion of the Fed’s balance sheet will be new money, which if lent can multiply substantially. The rule of thumb is that each dollar of reserves can result in $10 of new lending (because the first bank can lend 90 cents; the second bank 81 cents; and so forth, after deducting the 10% reserve requirement).

Whether this happens is, of course, up in the air and depends upon a restoration of confidence first.

This sounds like a recipe for inflation, to me, but financial stability is on the top of the FED’s list at the moment.

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