Zervos. It's a doozy. There is some sarcasm in there. I get the impression he's not a big fan of the Fed.
State of Louisiana
Department of the Treasury
From: DAVID ZERVOS (JEFFERIES LLC)
Sent: Thursday, August 22, 2013 9:13 AM
To: John Broussard
Subject: Guidance Schmidance ... Show Me the Money
"Actions speak louder than words."
"Talk is cheap."
"Speak softly and carry a big stick."
These are common aphorisms which have been used historically to admonish those with loquacious tendencies to pipe down. They are words of wisdom-and something our central bankers should think about long and hard. The release of the minutes yesterday confirms that there is a campaign within the core of the Committee to wean our economy off of an ever-increasing central bank balance sheet and to rely instead on "words" for the necessary accommodation. The recent work from the SF Fed, along with some tortured paragraphs on forward guidance in the minutes, indicates that "the power of mental persuasion" is fast becoming the central monetary policy tool for the FOMC. To make the concept simple, they are replacing the big stick of money printing with the cheap talk of forward guidance.
Why are they doing this? Well, reading between the lines, it appears that many on the Committee are nervous about the size of the USD 4 trillion balance sheet. It is a BIG stick-and frankly it has worked pretty darn well at creating a reflationary recovery. But as we in the market and those on the Committee know all too well, there are some nasty long term negative side effects from excessive QE usage - the difficulty in draining excess reserves effectively down the road, the potential for creating politically sensitive mark-to-market losses, and of course the big kahuna: the systemic risks arising from excessive leveraged risk taking in fixed-income markets. On this last point I found this passage in the minutes quite revealing:
"Some participants also stated that financial developments during the intermeeting period might have helped put the financial system on a more sustainable footing, insofar as those developments were associated with an unwinding of unsustainable speculative positions or an increase in term premiums from extraordinarily low levels."
There is no doubt these folks are trying to delicately pop a fixed-income leverage bubble. They are deathly afraid of a souped-up version of the 1994 rout! They know that balance sheet expansion comes with the parasitic side effect of excessive private sector leverage. And as of now they feel the potential costs of further expansion are beginning to outweigh the benefits. The economy is recovering; QE has been working like a charm; but it's time to nip the side effects in the bud. That's the current Committee view!
As a consequence, there is a campaign underway by the FOMC to somehow convince us all that "soothing language" will be better than QE injections. That, of course, is like trying to tell Charlie Sheen that a warm cozy snuggle by the fireplace with a good book will be better than an eight ball. The market is not stupid, and neither is Charlie - both will freak out when u try to take their drugs away! And to be sure, we are 130bps into this freak-out session on 10yr rates. The bubble has been popped. And the question we should all be asking ourselves is, will the Fed lose control of the situation? My answer to that (for now) is NO! But I must say, there is quite a bit more room for a policy mistake than at any other time in the past few years.
Why? Because the idea that forward guidance is somehow going to ease the pain of exiting from QE is a pipe dream. In fact, it takes enormous hubris on the part of our central bankers to believe their words are so powerful. I thought we had rid the central banking community of such ridiculous delusions of grandeur in 2008/09 - but no such luck, they are back to their old ways. The really sad part about all of this is that the Fed is trying to convince us forward guidance will work precisely when the Board of Governors is going to lose between three and five of its voting members. Ben, Betsy, and Susan are all gone next year. And Jerome and Janet could easily leave as well. Oh yeah, and the Cleveland Fed will get a new president in 2014. Honestly, it's hard to remember a time in the past when the POTUS had so much potential control of the FOMC. So the idea that time-consistent forward guidance has any value at this stage is basically insane.
But that will not stop the Fed propaganda machine from trying. Remember, we have that excellent bit of research from some leading SF Fed economists to fall back upon. They have a "model" - yes, one of those wondrous Fed concoctions that were so effective at forecasting economic activity for the past few decades (insert more sarcasm). Let's take an excerpt on "model assumptions" from the Economic Letter authored by those SF Fed economists:
"We consider an economy with two types of investors. The first can invest in both short- and long-term assets. For them, a lower risk premium prompts them to reallocate their portfolios, but doesn't change their spending behavior. If all investors behaved this way, a change in the risk premium would not affect the economy. The second type of investor buys only long-term bonds, for example to match asset duration with life events, such as retirement date. If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation."
Really? A model with 2 types of investors in some highly stylized metaphor of an economic system is going detect that markets reacted more to guidance on rates than large scale purchases? Where are the mortgage REITS, where are the hedge funds, where are the dealers, where are the sovereign wealth funds??? PUUULLLEASE!! This might be an interesting exercise for some PhD students, but in the real world it has NO use! This reminds me of the joke about the three econometricians applying for a job on Wall Street - one from Harvard, one from Princeton, and one from Faber College. The joke goes something like this:
Three econometricians head in for an interview with a large investment bank on Wall Street. The first one is from Harvard - Dr Smith. He steps in to meet the head of trading and on the white board in the room are two jagged lines pointing upwards that look awfully similar. The head of trading says to Dr Smith - what do you think the correlation is between those two time series on the white board? Dr Smith answers - at least .95 maybe .99. The head of trading says thanks and sends him out. Dr Jones from Princeton then steps in and the same thing happens. Finally, Dr Blutarsky from Faber College (and a Delta house alum) strolls in looking hung over and a bit dazed. The head of trading asks the same question, and Dr Blutarsky responds - what would you like it to be? Instantly, the head of trading says - YOUR HIRED!
Seriously though, after seeing this paper and reading the minutes, I had an instant memory of being at a St Louis Fed conference in 2009. It was the 30th-anniversary celebration of the great money-targeting experiment of '79-'82. Oddly enough, Volcker wouldn't come. But in the audience was Steve Axilrod, who basically ran the entire staff at the Fed during that time. He told a story about Volcker calling him and a few of the other senior economists into a room in early 1979 to discuss raising rates aggressively. He needed "an academic rationale" for driving rates much higher and thereby squashing inflation. But he couldn't just say "I'm raising rates," as that would be too politically controversial. Et voila, the staff came up with a new study suggesting that targeting the money supply rather than interest rates was a more appropriate and effective way to stop inflation. In short order the funds rate target was abandoned, and the era of money supply targeting began. Oh yeah, and after the changeover, the first print on short rates in October 1979 was 300bps higher!
That would not be the first time the Fed manufactured research to support a policy stance, and it clearly was not the last. The reality is, they are trying to cleanly get out of a VERY tricky situation. The good times from QE are in the here and now (i.e. housing up, spoos up, u-rate down etc etc). The bad times are lurking on the horizon (i.e. difficult balance sheet unwinding, higher inflation, emerging market stress, systemic financial asset deleveraging, etc., etc.). That said, so far they have done a fabulous job of extinguishing a bunch of the excessive fixed-income leverage from the system. But they need to be careful. The markets and the economy are still fragile. They have made the mistake many times before of declaring victory too early. We needed the QE, and we may need it a lot longer. The last thing we need now is a bunch of sanctimonious central bankers telling us their words matter more than their actions. Their actions are what saved us, their words have been an annoyance! The only way words would really matter is if Ben (or Larry/Janet) followed Mario and said: "Our policy is to do whatever it takes to generate asset price reflation and an economic recovery." Now that's the kind of speaking softly and carrying a big stick that Teddy Roosevelt would be proud of!
I suspect, when all is said and done, the FOMC will actually follow that simple rule (as it largely has done up until now). But for the moment, they are trying to be cute and rid us of some nasty leverage based side effects of QE. So far so good, but if their strategy backfires and side effect management contaminates the seeds of recovery, the stick will come out VERY quickly just like it has in the past. And once again actions will speak louder than words! Good luck trading.