Wednesday, September 21, 2011

Don't expect miracles from the Fed

Many years ago and in a simpler time, we believed in Santa Claus and the Easter Bunny, also that Dad would fix things when he got home.

Today, we believe in the FOMC.

In anticipation of the results of the two-day FOMC meeting, let's review what the likely actions the Fed are going to take:
  1. Operation Twist: Extend the maturity of the Fed balance sheet buy selling short-term Treasury paper to buy longer-dated ones.
  2. Reduce or eliminate the interest paid on interest on excess reserves (IOER) in order to encourage banks to lend.
  3. A better and more transparent communication strategy in order to better explain Fed objectives and intentions.
All these actions were signaled in advance in the WSJ's Fedwire:
Fed officials are likely to consider other steps they might take to boost the ailing economy in the short-run when they meet Tuesday and Wednesday, including altering the composition of the Fed’s portfolio of securities so that it holds more long-term debt. The idea would be to push down long-term interest rates to stimulate more investment and spending. They also could try to encourage lending by cutting the 0.25% interest rate currently paid to private banks when they park money at the central bank.
The better communication policy came in the second paragraph of the article (and these articles in Fedwire are undoubtedly part of that communications strategy):
Fed Chairman Ben Bernanke has asked Philadelphia Fed President Charles Plosser and Chicago Fed President Charles Evans, two intellectual adversaries, to work with Vice Chairwoman Janet Yellen on how the Fed can better explain its economic goals to the public. One issue high on the agenda: Detail what changes in unemployment and inflation it would take to make the central bank veer from its low interest-rate policy, according to people familiar with the matter.

What twists are there to Twist?
Let's explore each of these one by one. First of all, Operation Twist has been widely anticipated and would not be a surprise to the market. It is unclear what the net benefits are. In the last FOMC meeting, the Fed stated that it would keep rates low for another two years, which signaled to the banking system that it was ok to put on the carry trade of borrowing short and lending long. Don't worry about rates in the short end, they said. If the Fed were to sell short-dated Treasury paper in order to buy longer dated ones without expanding its balance sheet, it could hurt the banks that went long that carry trade based on the FOMC's signal.

Is that what the Fed wants?

A possible deflationary spiral?
The idea of cutting or eliminating interest rates on excess reserves appears to be a good idea on the surface, but as Izabella Kaminska of FT Alphaville explains, it could be disastrous because it can lead to negative interest rates because the current IOER 0.25% rate acts as a floor on rates:
Which means in effect a lower IOER would put more balance sheet pressure on banks (overload them with more reserves) and make it increasingly difficult to make competitively priced loans, meaning net interest income would come under pressure. The only solution would be to pass those costs along to customers through things like negative interest rates on certain deposits.

To think of it another way, it would introduce a cost on money.

Which of course is possibly what the Fed wants to do to encourage the money to flow into the real economy — but it also runs the risk of kicking off a deflationary spiral that will be impossible to stop, especially if market expectations catch up with Fed thinking as regards deflation risks.
Would that have the perverse effect of driving people towards holding physical currency instead? Or a deflationary spiral?

In addition, Jerome Schneider of PIMCO believes that a cut IOER could boomerang and wind up hurting the banks and GSEs:
Schneider, who is head of the short-term and funding desk at Pimco in Newport Beach, California, notes that the GSEs are a main market participant in the fed funds market. He believes they may choose to park cash earning zero interest at the central bank rather than earning a few basis points by taking “incremental risks” in the markets.

“The result could lead to changing liquidity dynamics in [the] fed funds [market] and may eventually even push up fed funds rates,” said Schneider in an interview Tuesday. Pimco is one of the world’s biggest asset management firms with over $1.3 trillion in assets.
For banks, a cut on the IOER will likely put additional pressure on earnings margins as the spread between the cost of deposits and borrowing funds with reinvestment opportunities, including IOER, will be compressed. Additionally, domestic depository banks have to contend with additional fees charged by the Federal Deposit Insurance Corp. to insure deposits in their pursuit of income.

Unlike banks, the GSEs aren’t eligible to tap the central bank’s interest-paying excess reserve policy, so they have used the fed funds market to lend out idle cash.
Are those the risks that the FOMC wants to take?

I operate on the basis that the Federal Reserve is not just one person but an institution, with economists on staff. Many of the former staff members, as well as former governors, have gone on to careers on Wall Street and I have met a number of them. Most of them are smart and aware of these technical issues relating to the effects of such proposed changes and their effects on the banking system. Surely the members of the Committee will be aware of these issues if they spent were two days considering their options.

What can the Fed do?
If eliminating IOER is off the table, then what's left? Operation Twist (meh) and a better (gasp) communication strategy?

The market would likely be disappointed with those two steps.

There is the off chance that David Rosenberg is right and Bernanke goes nuclear with the option of buying foreign securities as he stated in his famous helicopter speech [emphasis added]:
The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
The USD swap lines established with the ECB can be a backdoor way of flooding Europe with USD liquidity. Expanding the swap lines does expand the Fed balance sheet. He already has significant political opposition to the expansion of the Fed balance sheet. To expand in order to rescue Europe might be one political bridge too far. Even if Bernanke had the votes to go down that road, it would risk a rupture within the FOMC, serious damage to his own credibility and the credibility of the institution of the Federal Reserve. In all likelihood, any course outside the three already telegraphed is a low probability event.

In short, I believe that anyone who thinks that the FOMC announcement will be a huge positive surprise to the market is akin to believing in Santa Claus. While Christmas does come once a year, but don't count on Santa bringing you all the presents you asked for.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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