The
Fed Awakens
John Mauldin
I
got the following from a friend at J.P. Morgan just a few minutes ago. You
might have had something like it hit your inbox as well.
WASHINGTON – Federal Reserve officials said
Wednesday they expect a more gradual pace of short-term interest rate increases
in coming years than they did three months ago.
They also tweaked very modestly their views on the
outlook for the economy, according to forecasts released after the conclusion
of the Fed's two-day policy meeting. Officials made small changes in their views
of future economic activity, and they still don't expect to achieve their 2%
inflation rise target until 2018.
Clearly
not a surprise and in line with what I’ve recently been saying. I think the Fed
is going to be raising rates a lot more slowly than even they project. When you
look at the “dots,” the median projection for the Fed funds rate is 3.75% in
the much longer run.
Side
bet? I think we see 0% again before we see 2%. I’ll take the overs on that bet,
thank you very much. If you make the number 3%, I’ll even give you odds.
Today’s
Outside the Box is
from my friend Danielle DiMartino Booth, who used to work at the Dallas
Fed for Richard Fisher. She has gone out on her own and has begun to write
occasional pieces that seem hit my inbox at least weekly. The cover a wide
range of topics, but many of them deal with the Fed.
This
morning she wrote:
What if it really is all about reinvestment and
not one teensy quarter-point rate hike? Over the next three years, some $1.1
trillion in Treasurys could roll off the Fed’s balance sheet if reinvestments
were to cease. Tack on the potential for mortgage backed securities (MBS) to
prepay and/or mature and you’re contemplating a figure that approaches $2
trillion.
Make no mistake, shrinkage of the Fed’s balance
sheet to half its current size is much more feared by market participants than
a slight tick-up in interest rates. Taking the step to not reinvest would
increase the supply of Treasurys and MBS available to investors and reduce the
Fed’s support of the economy. The higher the supply on the market, the lower
the price and hence, higher the yield, which moves opposite price.
I
should note that she predicted the Fed would expand its overnight reverse repo
program to the tune of $2 trillion, and the Fed has done just that. That should
be enough to cover most contingencies for the next few weeks; and, as Danielle
explains, that move has a great deal more impact on the markets and your
returns than an itsy-bitsy 25-basis-point increase in short-term rates.
Danielle
weaves a story about what will really happen over the coming year, based on her
knowledge of what Fed members are likely to do and what the markets may force
them to do. If you are not much interested in Federal Reserve policy and how it
is created, her writings might seem to take you deep into the weeds; but given
the importance of Fed policy to the markets, maybe this one time you should pay
attention to what goes on behind the curtain. I think this makes a great and
timely Outside the Box.
My
schedule is usually busy, but it has become hectic. I have over 120 people
helping me as research associates for the book I’m writing, Investing in an Age of Transformation.
I’ve outlined some 27 chapters, 24 of which have teams working on the research
and writing. Each team needs its own regular 30- to 45-minute conference call.
Plus, there are calls with individual researchers on some of the minutiae.
I
am really impressed with the knowledge level and skill and enthusiasm this
intrepid group of volunteers brings to the table. This is going to be so much
more than the book I would have written all by my lonesome.
Have
a great week. It seems that most of us in America (from the calls I’ve been
making) have seen unseasonably warm weather so far this winter. I can’t
remember a December this nice in Texas. The long-range forecast says Christmas
Day is going to be 72° and sunny. I was talking to friends in Detroit yesterday
and they were marveling that there would be no snow for Christmas. Not that
they were complaining. It’s fabulous to be able to walk to local restaurants
and entertainment venues in a light jacket in the middle of December. However,
this being Texas, I know the weather can change on a dime, so we just enjoy the
good times as they come along. Kind of like oil booms.
Your
enjoying his month of global warming analyst,
John Mauldin, Editor
Outside the Box
The
Fed Awakens
By Danielle DiMartino Booth
What if Mario
Draghi really did whip out a bazooka?
On December 3rd, the stock market
pitched a fit reacting to what it perceived to be insufficient stimulus on the
part of the European Central Bank (ECB). The market had wanted “Super
Mario,” as investors have lovingly nick-named the ECB president, to take two
measures.
The first would have expanded the quantitative
easing (QE) program, increasing the amount of securities the ECB is committed
to purchase. The second would have cut already negative deposit rates by
-0.15%; Draghi only delivered -0.1% (negative rates penalize banks for holding
excess cash at the EBC when they could lend it out to spur economic growth.)
Borrowing a page out of New York Federal Reserve President Bill Dudley’s battle
plan, Draghi did manage to push through a much more forward-looking program –
reinvestment of any proceeds that result from securities maturing on its
balance sheet. Bratty fast-money, instant gratification investors dismissed the
move.
Draghi, though, never looked more the cat that ate
the canary than he did the next day in New York. He vociferously reiterated his
commitment to do whatever it takes to get inflation to the ECB target, as long
as that might take. If QE wars need be fought long into the future,
reinvestment will strategically position Draghi on the central banking
battlefield.
Back at home, many market watchers are scratching
their heads as to why the Fed would be raising rates at this juncture.
Financial conditions have tightened, not eased, since the Fed pushed the hold
button at its September meeting. And yet, the markets and economist community
remain unanimous that the Fed will pull the trigger.
What if it really is all about reinvestment and
not one teensy quarter-point rate hike? Over the next three years, some $1.1
trillion in Treasurys could roll off the Fed’s balance sheet if reinvestments
were to cease. Tack on the potential for mortgage backed securities (MBS) to
prepay and/or mature and you’re contemplating a figure that approaches $2
trillion.
Make no mistake, shrinkage of the Fed’s balance
sheet to half its current size is much more feared by market participants than
a slight tick-up in interest rates. Taking the step to not reinvest would increase
the supply of Treasurys and MBS available to investors and reduce the Fed’s
support of the economy. The higher the supply on the market, the lower the
price and hence, higher the yield, which moves opposite price.
“It seems to me you’d like to have a little room
before you start ending the reinvestment… (which) is a tightening of monetary
policy.”
So said Dudley on June 5th to a group of reporters. He went on to
define how big the ‘room’ needs to be a “reasonable
level.”
“By how far that is – you know, if it’s 1 percent
or 1.5 percent – I haven’t reached any definitive conclusion.”
At the risk of allowing the appearance of
decision-making to occur in unilateral fashion on Liberty Street, Fed Chair
Janet Yellen made clear to reporters that the entire Federal Open Market
Committee (FOMC) was tasked with determining the future size of the balance
sheet.
In a June 17 Q&A session that followed the
FOMC meeting, Yellen assured the public that, “President
Dudley was expressing his own personal point of view, but this is a matter that
the committee has not yet decided and I cannot provide any further detail.”
But what if there’s more than one way to skin the
reinvestment cat?
The interest rate markets that determine the cost
at which banks lend to one another is notoriously illiquid at the end of
calendar quarters and years. The Fed knows this. That makes the insistence on
raising interest rates this month all the more intriguing given the pressures
emanating from the corporate bond market.
As watching-paint-dry boring as the mechanics
surrounding the actual rate hike are, a rudimentary understanding is crucial to
grasping the tumultuous nature of the deliberations among FOMC voting members.
(That was a preamble to implore the reading of the next few paragraphs.)
The overnight fed funds rate market, which the Fed
employed to embark on its last rate-hiking cycle, is a shadow of its former
self in terms of trading volumes. We’re talking about $50 billion a day
compared to today’s theoretical $2 trillion in institutional cash dehydrating
on bank balance sheets parched for safe positive yields.
It’s a complete unknown what portion of this $2
trillion would rush off bank balance sheets into money market funds. That said,
it’s a slam-dunk assumption that the demand for higher yields is ubiquitous
among those making south of nothing on their cash.
Planning for a complete unknown dictates that the
Fed be flexible in trying to minimize overnight rate market upheaval. Funny
thing – policymakers have a tool that can maximize a smooth transition called
the reverse repurchase ‘repo’ (RRP) facility.
In the post-zero interest rate world, which
celebrates its seven-year anniversary the day the Fed is expected to raise
rates, repo markets determine overnight rates. Banks and other financial
institutions swap collateral in the form of U.S. Treasurys, MBS and corporate
debt to other investors for cash. In that these are overnight trades to
facilitate the shortest-term funding needs, the bank buys back the securities
the next day.
A bank in the above example that’s selling
securities overnight, with the understanding they’ll buy them back the next
day, is entering into the repurchase agreement. The party on the other side of
the transaction, which buys the securities overnight agreeing to sell it back
the next day, has entered into a reverse repurchase agreement.
Mitigating any disruptions in this market is key
to a successful initial rise in interest rates. That’s saying something when
the size of the collateral market has already shrunk from $10 trillion in 2007
to $6 trillion today. A rate hike, in its simplest form, involves reducing the
liquidity in the system from this $6 trillion starting point. It follows that
the Fed can use its RRP to absorb liquidity using money market funds as the
conduit.
The problem is the RRP is currently capped at $300
billion per day, a fraction of the potential demand for the discernible yield
money market funds will presumably be able to offer in a positive rate
environment.
Of course, the Fed could satisfy the need to
provide the market with collateral by selling Treasurys, but again this shrinks
the balance sheet.
What of the elegant solution cleverly proposed by
Dudley, you ask? The answer: Temporarily
lift the cap off the RRP to act in the markets’ best interest. In the blink of
an eye, the money market fund industry will be completely dependent upon the
RRP as a one-stop shop for overnight collateral. In a world bereft of
collateral sourcing to begin with, how could such a dependency imply anything
“temporary”?
The short answer is it won’t. The long-term
devilishly detailed answer: Yes, the Fed uncapping the RRP would succeed in
tightening financial conditions by absorbing monies from the money market funds
that will be flooded with deposits. But
this maneuver will not release the collateral from the Fed’s balance sheet. The
size of the mammoth balance sheet would thus be largely held intact.
Perhaps this is why we’ve been hearing dissentious
grumblings from unusual suspects such as Fed Board governors Lael Brainard and
Daniel Tarullo.
Monetary policy is effectively being determined mechanistically
at an illiquid time of the year notorious for mechanical dysfunction.
Policymaking by proxy has to bristle even the loyalist of consensus builders.
Recall that there have been only four dissents on
the part of Fed governors over the past 20 years (Federal Reserve district
president dissents are relatively-speaking a common occurrence). If dissent
weren’t a clear and present danger, why would Yellen warn Congress she’s
prepared to push forward with a rate hike in spite of potential dissents? The
chair could easily have been referring to mutinous governors.
Since the creation of the RRP, policymakers have gone
to great pains to reassure the public they have the political will to shrink
the facility when the time comes. That would be quite the acrobatic act if the
money market fund industry becomes reliant on the RRP for daily functionality.
Conveniently, with markets pricing in all of two
additional rate hikes in 2016, we’ll never get to Dudley’s 1 to 1.5-percent
overnight rate that justifies shrinking the balance sheet.
Will policymakers have the luxury of time to raise
interest rates enough to combat the next recession? Looking 12 months out, it’s
much more likely that the business cycle will have turned. As the Wall Street
Journal has pointed out, at 78 months, the current expansion is longer than 29
of the 33 dating back to 1854.
There’s no doubt the Fed’s first rate hike in
nearly a decade is an awakening.
The open-ended question is the true motivating
factor. Perhaps investors should cue off Draghi’s recent success in securing
ECB balance sheet reinvestment and connect the dots from there.
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