Reprinted with permission from EconomicPolicyJournal.com
The law of unintended consequences continues to wreak havoc with the Fed’s
ad-hoc dart throwing exercises plans, as only yesterday, the New York Fed confirmed our expectations that it will have to ramp up its Treasury purchases by 50% over the next month to the tune of $27 billion (our estimate: $25.5 billion)–all, to keep up with the Jones’ refis, defaults and loan mods. It’s easy to lose sight of just how this latest round of so-called QE Lite came to be. And, as this is but a hint of future printing, upon which a hand-bound Fed will find itself with no choice but to embark, a brief recap is appropriate.
During and after the carnage of Fall, 2008, the Fed engaged in a multi-trillion dollar large scale asset purchase program, otherwise known as quantitative easing, or QE. It complemented the myriad temporary lending facilities it also had conjured, some as early as August, 2007. QE was essentially a series of permanent cash subsidies to those holding certain financial instruments–select primary dealers that transact directly with the Fed, in particular. But, anyone holding a similar class of security benefited from the price floor that the Fed established. This influx of cash had a side effect of funding a global risk rally that hit its stride in the second and third quarters of 2009 (which was also aided in no small part by 10 to 100 times levered bets from US Dollar borrowings at record low interest rates–also abetted by the Fed).
$300 billion in long term Treasury purchases and a near-zero interest rate policy kept yields suppressed across the curve. $1.25 trillion in mortgage backed securities and $200 billion in agency debt purchases single handedly propped up the financial side of the housing industry, and in turn, the housing industry itself, and in turn the global Ponzi scheme built upon housing and its related securitization. Other central banks joined the fray, and their actions sucked volatility and risk premium out of the entire global financial system, taking corporate risk onto their own balance sheets. The purchased instruments, in private hands, would ordinarily be hedged as interest rates fluctuated, but not so when bathed in the SOMA’s warm amniotic Sack.
Thus, nearly every signal available to investors–from interest rates to liquidity to volatility–had been distorted by the Fed’s actions to induce the Pax Reserva–that fleeting window in time when some semblance of normal emerged from financial Armageddon. Fleeting andsemblance are the operative words, because when one scratched the surface of the statistical recovery, there seemed little beyond a junk-off-the-bottom risk rally (including stocks) aided by a fiscally imprudent (read Keynesian) administration. The Pax Reservawould not last.
Fourteen months and one flash crash later, amidst daily rumors of an imminent Eurozone breakup, the world couldn’t get enough Dollars and govvies in the summer of 2010. May 6 was not only a day in which the Dow dropped 1,000 points, but one in which months of pent up volatility was unleashed in a matter of minutes. To be sure, dubious trading practices, such as high frequency trading, exacerbated the situation, but the unprecedented central bank intervention provided the framework.
With the Treasury on the hook for Fannie and Freddie paper, an up-trending mortgage default rate mattered naught, and what was sauce for the goose was sauce for the gander. With fundamentals out of the way and Bernanke willing to buy paper that would make Angelo Mozillo blush a shade less tan, anyone chasing incremental yield was happy to scoop up MBS paper guaranteed against default, yielding a few whole percentage points over Treasurys.
The result: 30 year mortgage rates tumbled 70 bps over the summer of 2010 to 4.35%, which lead to a second refinancing boom. While MBS securities are designed to payout in line with the terms of the underlying loans (15 to 30 years in the case of fixed rate loans), changes in interest rates to the downside will accelerate the MBS principal payments (prepayments) as the proceeds from refinanced loans are funneled to the holders of the MBS securities (a phenomenon known as negative convexity). In addition, MBS principal payments will increase as a result of loan modifications or defaults (which, as of March, 2010, Freddie has pledged to pay on any loan 120 days in arrears).
The Fed’s share of these prepayments led to an accelerated decline in the asset side of its balance sheet–effectively giving a tightening bias to Fed monetary policy as it accepted principal payments on its MBS assets. In addition, the Agency (Fannie/Freddie) debt that the Fed bought has been maturing and rolling off its balance sheet at the rate of a few billion per month. To recycle this money into the economy, it began mid-August purchasing Treasury securities at auction from its primary dealers in amounts equaling the expected influx of payments and maturations. Of course, there’s no guarantee as to where this money will be deployed, so while this is declared to be reserve-neutral, it is most certainly not effect-neutral.
So what’s it going to be then, eh…deflation or inflation?
We’ve avoided this discussion in the past because rarely does inflation or deflation alone persist across an economy. Most times, there is a mix, with one more visible than the other. From the Fed’s perspective, debt deflation is currently most critical, yet its advisors and peers also see hints of inflation, notably in the food sector. Overall, this is a marked reversal from the beginning of 2010, when the Fed was crowing at every opportunity about the tools it would need to fight future inflation. Indeed, as Congress was making up its collective rassoodocks whether or not to reappoint Bernanke in January, 2010– a time when “green shoots” was still uttered by a few without a smirk–we were discounting the Fed’s inflation warnings:
Since October, 2009, the Federal Reserve has increasingly hyped the inflation meme by publicly touting the more than $1 trillion in excess reserves (held by banks with the Fed) which, as the theory goes, could come flying out into the economy in an HFT-New York second, in one hyperinflationary swoop. If all the world’s a stage, then Bernanke will be winning an Oscar for this performance, because the futures and currency markets are pricing in a Fed rate hike in the second half of 2010 and a robust US economy. Rather, we have postulated that this tightening theater is mere preparation for QE 2.0, which has been confirmed today (at least with respect to more Agency MBS purchases by the Fed). We suspect the Fed will wait until the US Dollar index rallies to at least 81 or 82 before announcing the next round of long term Treasury purchases. Make no mistake, however, those pesky excess reserve dollars will eventually get itchy to rejoin their friends in the economy (perhaps when they amount to $3 trillion sometime in 2011), and the Fed will need all the tools it can strap around its bloated waist to reign them in.
Expectations of a rate hike have been pushed out to Q3 2011 and, with serious talk of the next round of easing, it’s time to start thinking about those excess reserves again and how they might find their way into the economy against the best wishes of the Fed.
The Fed is perceiving its greatest enemy–deflation–at work, as evidenced by Bernanke’s post-Jackson Hole speeches. Recent data from the real time consumption-side GDP measurements of the Consumer Metrics Institute demonstrate that current consumer retrenchment is approaching the extreme levels seen in the last election cycle that preceded the panic of 2008.
Consumption is unlikely to rebound until the uncertainty of the election is over, and the Fed is acutely aware of this. Accordingly, we’re fast approaching the window of time in which the Fed would attempt to reclaim the Pax Reserva with a second great reflation attempt. On that note, Morgan Stanley recently hypothesized that the Fed may open the door to QE 2.0 as early as the September 21 FOMC meeting so as not to be perceived as attempting to influence the upcoming election at its early November meeting. [Update: this hypothesis has since been withdrawn] If this is the case, it would be characteristic for hints to be dropped in Fed speeches over the next week.
The effects the next reflation will have on the markets and economy depend on its magnitude and timing, as well as concurrent fiscal initiatives, including the 2011 tax cut expirations. With all the variables and skeins of potentiality, we are indeed living in kaleidic times. What we can say is that if the Fed undershoots or simply maintains present policy, deflationary forces, especially with respect to interest rates, could certainly persist. This appears to be the case with the current Treasury buybacks–just enough buying pressure to keep yields low, while having little stimulative effect on the money supply (when measured year over year, non-seasonally adjusted).
If, on the other hand, the Fed overshoots, inflation expectations could immediately reverse. It’s instructive to remember that on the original Treasury QE announcement of March 18, 2009, the 10 year yield dropped an eye watering 55 basis points that day to 2.47%. However, it dramatically reversed to the upside over the next three months to reach a high of 4.01% and, to this day, has not reclaimed the prior low. Notwithstanding the current intermediate down trend in yields, they are susceptible to an upwards reversal on a change in inflation expectations. The most likely candidate is the Fed’s next reflation announcement, but any number of other events could be catalysts as well.
While it is assumed that future Fed accommodation will come from asset purchases, it is also possible it would lower the interest rate on excess reserves (IOER) it pays to banks to keep their money tied up at the Fed, currently 0.25%. While this route is much less likely, it is instructive to understand the dynamics of the IOER and how it relates to other rates because it will have implications for recognizing when the Fed has truly lost all appearances of control. We wrote about these relationships here in August:
What is relevant is the spread of IOER to other short term rates on the lower end of the yield curve–namely, (1) the Federal Funds rate paid on uncollateralized overnight loans between banks and other large financial institutions and (2) short term Treasury Bill rates. As of Friday, August 5, the Fed Funds rate was 0.19%, and the 1, 3 and 6 month T-Bills were yielding between 0.15% and 0.19%. Even 1 to 2 month investment grade commercial paper has been yielding less than the IOER.
This means that banks can leave their excess money at the Fed and get paid 0.25% every night, as opposed to lending to another bank at the lower rate of 0.19% or locking the money up in Bills or commercial paper for a month or more. [It’s also important to know that the reason the Fed Funds rate, which is uncollateralized, is less than the IOER is largely because the biggest lenders are Fannie and Freddie, both ineligible to park their money at the Fed because they are not banks.]
Accordingly, were the Fed to lower the IOER to say 0.10%, several investment options would immediately become more attractive to banks and a material amount would likely leave the custody of the Fed. How much and in which directions cannot be known, but the implications should not be ignored simply because the spread is seemingly small. We’re talking over $1 trillion of leveragable cash held by banks.
One of the worst case scenarios for the Fed would be to engage in a new large scale asset purchase scheme, only to see the Fed Funds rate creep (much less jump) above the IOER threshold of 0.25%. This came close to occurring in mid-June, 2009, but was averted by fears that the nascent equities rally had come to an end. If the Fed Funds rate were to trade up to say, 0.30% or 0.40%, the effect would be similar to that if the Fed had lowered the IOER–banks would start looking for places other than the Fed to put their money, and money multipliers would start taking over. The Fed could either allow the consequences of serious inflation to take hold, or it could raise the IOER. Neither would be attractive, as it would look either negligent or pusillanimous.
The bottom line? The “recovery” is ubiquitously recognized as a statistically-manipulated sham (at least, in a universe that excludes CNBC hosts). The Fed, when faced with signs of both deflation and inflation, will always resolve such dilemma in the direction that theprintosine bases embedded in their phosphate-deoxyribose backbones direct. Ad hoc interventionist measures beget only more of the same, and thus, what seemed a binary central banking world a mere two years ago–to print, or not to print–is a unary one. The “decision” is only the magnitude, with the margin for error exceedingly small.