The Ex Ante Factor: The Devil and Ben Bernanke
Members received this on Oct 28th.
In addition to the FOMC meeting, this Wednesday we celebrate Halloween. The most recognizable symbol of Halloween is no doubt the Jack O'Lantern and the legend of "Stingy Jack" tells a tale that resonates in today's battle between the capital markets and chairman Bernanke.
There are various accounts of the legend, but basically "Stingy Jack" was a miserable obnoxious drunken fool who played tricks on everyone in town including the Devil himself. One story recalls that Jack, in order to save his soul, tricked the Devil into climbing an apple tree and placed crosses around the trunk, trapping the Devil. Jack then made the Devil promise to not take his soul when he died. In order to escape, the Devil agreed. As expected, when Jack died he was damned to Hell, but the Devil, keeping his promise, did not allow him to enter and turned him away forcing him to live in solitary darkness. When Jack left, the Devil tossed him some fiery coals which Jack placed in a hollowed out turnip that he used as a lantern. Hence the "Jack O'Lantern". (I realize this is stupid but there is a point....)
Stingy Jack and Speculators
Speculators provide a vital function in capital markets. They make markets and provide liquidity for investors, savers and risk managers. The markets would not be able to operate as efficiently without their services and risk appetite, but there are consequences. Just as Jack took his mischievousness to an extreme where blackmailing the Devil was his last option, speculators can take their risk appetite to an extreme, pushing multiples and spreads to levels where blackmailing central bankers are their last option. What defines extreme is difficult to quantify at the time as many variables enter the equation and speculation always goes further than most expect. That being said, when we get there, often a showdown with the central bank arises as the instability can hold markets and the economy hostage forcing some reaction. The so called put option and subsequent moral hazard is often the result of this blackmail.
The Devil and Ben Bernanke
During the days surrounding the 8/7 meeting when the Fed left rates unchanged the S&P 500 had lost over 10% of its value and the bond market shut down the repo and commercial paper markets. A seizing up of the money markets was causing failures in some money market funds and fears of failures at banks which in turn drove runs on deposits in the US and UK. These two savings vehicles are in theory the most safe and liquid investments. Both the real and financial economy rely on the money markets to fund basic transactions. Companies that utilize the money markets to fund daily and weekly operations found themselves shut off from funds availability and thus accounts payable and payroll were at risk. Bond dealers could not finance trading of anything except pristine credit and banks were hoarding cash as evidenced by the LIBOR spreads blowing out. The ripple effect cut far and wide. Few wanted to admit it at the time, but the integrity of the whole system was at stake. The Fed had to ease. They couldn't allow the most basic function of capitalism, the money markets, to buckle. Like the Devil trapped in the tree, we had a hostage situation.
What are your demands?
The severity of the situation came to light when we learned that the day after the 8/7 meeting, Bernanke received a phone call from one of the hostages, current Citigroup chairman and former Treasury Secretary, Robert Rubin. The following days he consulted other hostages, such as industry veterans, ex-Salomon Brothers mortgage market founder Lewis Raneiri and macro hedge fund manager, Raymond Dalio, president of Bridgewater who manages $165b in assets. Just three days after they chose to do nothing, the Fed injected reserves through open market operations and when it was evident the problem persisted they resulted to lowering the discount rate by 50bps on 8/17 (option expiration day) sparking a huge short covering rally and marking the recent bottom in equity prices. They followed that intra-meeting ease with another 50bps ease in the discount and Fed target rate at the September meeting, citing "disruptions in the financial markets." I don't know what is worse: The idea the Fed was oblivious to the credit crunch or the idea that private market participants were influencing monetary policy. Regardless of the motivation, the result has been that markets now think they can in essence blackmail Bernanke into lowering interest rates when they require some stimulation. As it was for Greenspan, this "put" can be a slippery slope. Will Bernanke continue to pay the ransom?
Inflation is the Devil
At the previous 9/18 Fed meeting the committee mentioned, "Inflation risks could be heightened if the dollar were to continue to depreciate significantly." As argued by Milton Freidman, inflation is a monetary phenomenon and arguably the value of the dollar is the best indication of excessive monetary stimulus. The Fed's congressional mandate is to foster maximum employment consistent with price stability and moderate long-term interest rates. Price stability is a product of the inflation environment not inflation itself. While we obviously don't want to see money markets freeze, a general receding of credit is positive for lower inflation and price stability. The massive expansion of credit during Greenspan's easing campaign was the primary driver of the depreciating dollar and hence inflation. If the dollar wasn't tanking oil would not be at $90/brl. Moderate long-term interest rates are too a function of inflation as the term structure of interest rates reflects discounted inflation premiums for the individual maturities. A steep yield curve is discounting high inflation premiums while a flat curve discounts low inflation premiums. The recent steepening of the yield curve is evidence of how the bond market discounts easier monetary policy and the most effective method for keeping long-term interest rates relatively low is to run tight monetary policy.
Bernanke's Last Stand
The markets are discounting anywhere from a 25-50bps ease at Wednesday's FOMC meeting. The Fed discount rate and federal funds target rate are at 5.25% and 4.75% respectively. The 2YR note is yielding approximately 3.80%, 3 month bills are just under 4.00% and 3 month LIBOR is trading near 5.00%. At the 8/10 meeting when the Fed decided to keep both of their rates unchanged board members specifically noted, "the risk that inflation would fail to moderate as expected continued to outweigh other policy concerns." Since that meeting the price of crude is up 30%, on its way to $100/brl and the dollar is down 4.5% v euro and making new all time lows on the DXY. According to those metrics, inflation is failing to moderate. Why then have they been easing despite the fact that their main concern seems to be accelerating? They clearly had to deal with the crisis of a dysfunctional money market but with employment and economic growth in relatively good shape (though below trend) the Fed must keep inflation under control. Taking their target rate to 4.50% or 4.25%, which is already discounted by the capital markets, is appropriate given current nominal GDP. Taking rates much lower than that and they will be providing excess stimulus and reigniting the speculative fever that put them in this bind in the first place. We will concede one more ease by the Fed at Wednesday's meeting but expect Bernanke to send a hawkish message to the markets that they are taking a stand against inflation and the price instability that is a direct result of the deterioration in the purchasing power of the dollar. If the chairman fails this test, the markets will never let him regain control and the spirits of inflation will haunt him for the rest of his tenure.