When In Doubt, Create More Choices
Nowadays, the FOMC minutes never cease to amaze and amuse.
"The first key issue was the extent to which the Committee would want to tighten policy, at the appropriate time, by increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both. Because the two policies would restrain economic activity by tightening financial conditions, they could be combined in various ways to achieve similar outcomes. For example, in principle, the Committee could accomplish essentially the same degree of monetary tightening by selling assets sooner and faster but raising the target for the federal funds rate later and more slowly, or by selling assets later and more slowly but increasing the federal funds rate target sooner and faster. The SOMA portfolio could be reduced by selling securities outright, by ceasing the reinvestment of principal payments on its securities holdings, or both. A second key issue was the extent to which the Committee might choose to vary the pace of any asset sales it undertakes in response to economic and financial conditions. If it chose to make the pace of sales quite responsive to conditions, the FOMC would be able to actively use two policy instruments--asset sales and the federal funds rate target--to pursue its economic objectives, which could increase the scope and flexibility for adjusting financial conditions..."
My initial reaction to reading this passage in the minutes, which focused on some of the questions associated with the eventual shrinkage of the Fed's balance sheet and rate increase, was "oh great, more levers?"
Here is a hypothetical question: If a trainee pilot is unable to keep his Piper straight and level using only the stick, does it improve outcomes to put him in a jumbo jet's cockpit with 500 gauges, dials, and switches? Or would you prefer he practice on a simple system instead?
The nature of the problem the FOMC confronts, when it goes to figure out how to reduce its balance sheet without sending the bond market reeling, isn't simple of course. There is no simple lever for monetary policy, and there will not be until and unless the Fed is able to get the SOMA account back to being just Treasuries and quite a bit fewer of them at that. So, don't interpret what I am saying here as an indication that I think the Fed should ignore the problem. My point is that the market seems to have a robust confidence that the ultimate outcome will be decent growth with contained inflation and low rates, and when one reads passages like this it ought to lower one's confidence in the ultimate outcome to the same degree that it raises one's understanding of the difficulty of the problem. Because let's face it, our pilots haven't shown a high amount of skill over the last twenty years.
In my view, the Fed is underestimating the difficulty of unwinding its asset purchases. If the federal budget was moving into balance, so that there were fewer Treasuries splashing into the market every day, then it would be more feasible, but I suspect it will be many years before the balance sheet is meaningfully shrunk unless the Committee grows comfortable with the idea of much higher interest rates.
All of this remains academic at this point. The Fed took pains to point out in the minutes that discussion of how they would exit should not be taken to mean that tightening is "imminent." Or as my friend Andy Fately succinctly and artistically puts it:
Debate at the FOMC
Revolved around ending QE
Should rates go up first?
Assets be dispersed?
Whichever, it's months 'ere we see!
That's the news on this side of the pond, but the crisis in Europe continues to develop new wrinkles. I really don't understand why policymakers, at least non-elected ones like Bernanke and Klaus Regling, the head of the European Financial Stability Facility (EFSF), feel they need to be quoted in the news all the time. It's destructive far more often than it is constructive, and as I am fond of pointing out it is a short options position: very little upside if everything goes right, but tremendous downside if there is a gaffe. While Regling's comments don't constitute a gaffe per se, they are still words better left unsaid. In a Bloomberg story entitled "Regling Says ESM to Be Senior to Private Bonds, But Below IMF," he said:
"The ESM will claim seniority just below the level of IMF seniority, but above everybody else. That's a political statement which is there. It's not questioned by anybody in the policy world. The question is how to implement it. We will probably do it like the IMF, which does not write this anywhere down in its lending contracts."
Well, that's just wonderful. Political statements trump contracts! Here's a little thing about bondholders. They really like, one might even say they insist on, knowing where they stand in the payment waterfall. In well-written private bond indentures, it will state very clearly whether the debt is senior or junior (and to what other specific debt), and in what circumstances if any the creditor's claim can be subordinated.
Sovereign issuers don't usually have bond indentures (which might otherwise include covenants they'd regularly fail, like debt-to-income tests and so on). Probably that is because everyone knows that there is no recourse if they violate the indenture - you can't sue the government into Chapter 11. But if third-party creditors can cavalierly insert themselves into the waterfall by "claiming seniority," as Regling puts it, then it adds a new layer of risk. A friend of mine who is a widely-read and sage observer of (and has been ahead of the curve in forecasting) events in Europe noted in his comment this morning, "It is then, in my view, the risks of owning European debt that is driving capital into American debt and driving yields down in the process."
That is a very insightful thought. Whatever the credit circumstance of the U.S., Japan, Germany, and the UK, they're unlikely to see their debt subordinated if only because there's no one big enough to bail them out and claim a senior position!
That's all the news, but most of the interesting market action happened long before the Minutes were released. Commodities staged a rollicking reversal today, with NYMEX Crude +2.7% (remember the surprising inventory build last week? It turned into a surprising draw today, as these things do), Grains +4.1% (using the DJ UBS Grains index), Softs +2.8%, Precious Metals +2.0%, and Industrial Metals +2.7%. All of that is with the dollar unchanged. The S&P was +0.9%, messing up the clear chart I showed yesterday (this is why there are few billionaire technicians). Bonds actually sold off, with the 10y note up 7bps to 3.19%. Incredibly, TIPS only sold off 1bp and the 10y TIPS that is being reopened tomorrow (in $11bln) is still yielding only 0.78%.
Speaking of that auction, I am more concerned with this one than I have been in a while. For the last few months, the fact that the Fed was scarfing up all of the new paper at the same time that investors were wanting more inflation protection created a shortage of TIPS. In that environment, they were never going to sell off very much. But now we're approaching the end of that buying, and I sense that the Street has learned that you're not supposed to be too short into TIPS auctions. This may be the wrong time to rely on that lesson. While I still think the auction will clean up well, I would not be surprised to see it tail a bit.
Tomorrow also brings Initial Claims (Consensus: 420k) as well as Existing Home Sales data (Consensus: 5.20mm from 5.10mm), Leading Indicators (Consensus: +0.1%) and Philly Fed (Consensus: 20.0 from 18.5). Watch for the 'homes available for sale' part of the home sales report. The last number was a disappointing 3mm units. The low from the end of 2009 was 2.76mm units.
The markets have now backed off, at least for a day or two, from the critical levels beyond which we would have been at crisis pricing. This is probably appropriate, since the Greek/Portuguese/Irish crises don't appear to be coming to a head imminently. It may be time for a zag now that we've survived the zig.