Not many of my posts generate a large number of quality responses.  Rather than respond in the comments area, I thought I would make this a separate post.  My views on the Fed are eclectic, and a little quirky, because I am a skeptic about the power of central banking generally, on both the upside and the downside.  I’ve done fairly well as a bond manager using my views of the Fed to add some value.  (I’m not a bond manager now, though I would like to run a bond fund again at some point.)

First let’s clear the decks.  I am not short.  I am not underinvested in stocks, or private equity.  I am also a “lone wolf.”  I don’t work for anyone.  When I worked for my prior employer, what I posted here and at RealMoney often disagreed with the view of the owner/founder (a genuinely good fellow, and a bright guy).  What I said, I said on two levels.  First, what should be: maintain a tight-ish monetary  policy, because the crisis is nothing the the Fed should be concerned about.  I care about public policy.  I don’t like inflation, which is very understated by the PCE, and understated by the CPI, for reasons that I have stated previously.  I also don’t agree with the concept of core inflation.  If you want to remove volatility, trim the mean, or use a median.  But excluding whole classes of goods is bogus, particularly when their removal lowers the CPI by a lot.

My view is that the temporary injections of liquidity will fail.  There will be enough demand for additional short term liquidity that the Fed will have to begin making permanent injections of liquidity into the system, and eventually cut the Fed funds rate.  Once you cross the intellectual barrier of providing enough incremental liquidity to keep the system afloat, you have committed to an uncertain course of action that will likely lead to rate cuts eventually.  If the goal of monetary policy shifts, so will the direction of policy, usually.

Has the Fed lost control of monetary policy?  Yes and no.  Yes, if they continue to do business the way they do now.  No, if they want to get ugly, and restrict the ways the banks do business, either through regulation or through a modification of the risk-based capital rules.  Even so, what can they do about stimulus via foreign purchases of US debts?  Not much, and even the US Treasury would have a hard time there.

Why have the markets been so good for 25 years? I have five reasons:

• Demographics — the Baby Boomers entered their most productive years.
• Easy Federal Reserve — after the overshoot of policy in the early 80s, the Fed was far more activist and willing (particularly under Greenspan) to throw liquidity at problems that should be liquidated by the free markets.
• Capitalism — Almost every nation is Capitalist now, even if it is crony Capitalism.
• Deregulation — business benefited from deregulation under Reagan (and no one else).
• Free-ish Trade — Trade isn’t really free, but many nations are more willing to compete globally, and the deflationary effects of that competition have been a real benefit.

Finally, I am still thinking about what will benefit from a shift in Fed policy.  I mentioned high quality financials.  To me, that means companies like Hartford (or maybe PRU), which I don’t own at present.  Maybe Wells Fargo?  I’m not sure, but it would have to be institutions that have suffered a real price setback, where a permanent impairment of capital is unlikely.  But what other industries will benefit from lower financing rates?  That is the $64 billion question, and with that, I bid you good night.

I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.

Central Banking in the Forefront 

Let’s start with the state of monetary policy.  Is it easy or tight?  It’s in-between.  The monetary base is growing at maybe a 3% rate yoy.  The Fed has not done a permanent injection of liquidity in over 3 months.  MZM and M2 are around 5%, and my M3 proxy is around 8%.  But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too.  The increase in foreign holdings of US debt is roughly equal to the increase in M2.  That provides a lot of additional stimulus that the Fed can’t undo.

So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets.  So why did short-term lending rates to banks spike?  My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity.  I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast.  Also, some banks needed quick liquidity from the unregulated eurodollar markets.  But who?  Inquiring minds want to know…

So, over at FT Alphaville they wonder, but in a different way.  What do central bankers know that we don’t?  My usual answer is not much, but I am wondering too.  Panicked calls from investment bank CEOs?  Timothy Geithner worrying about systemic risk?  Maybe, but not showing up in swap spreads, yet.  Calls from commercial bankers asking for a little help?  Maybe.  I don’t know.  I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut.  We haven’t even had a 10% correction in the market yet.  Obviously, But some think we’ve had enough pain.  But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here.  Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right?

Speculation Gone Awry, Models Gone Awry

We can start with a related topic: money market funds. Some hold paper backed by subprime mortgages.  With asset backed commercial paper, some conduits are extending the dates that they will repay their obligations.  Not good, though ABCP is only a small part of the money markets.  Ordinary CP should be okay, even with the current market upset, though I wonder about the hedge funds that were doing leveraged non-prime CP.

In an environment like this, there will be rumors.  And more rumors.  But many admit to losing a lot of money.  Tykhe. Renaissance Technologies. The DWS ABS fund.  There are some common threads here.  I believe that most hedged strategies (market-neutral) embed both a short volatility bet, and a short liquidity bet, which  add up to a short credit spreads bet.  In a situation like this, deal arbitrage underperforms.  The Merger Fund has lost most of its gains for the year.  Part of the reason for losses is deals blowing up, and the rest is a loss of confidence.  Could other deals blow up, like ABN Amro?  If you want to step up now, spreads are wider than at any point in the last four years, and you can put money to work in size.

More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here.  (Stock market-neutral does not mean credit market-neutral.)  Statistical arbitrage strategies were crowded trades.  Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar.  Academic research on anomalies is almost freely available to all.  Two good quants can bioth start fresh, but they will end up in about the same place.

Last week, I commented how my own stocks were bouncing all over the place.  Some up a lot, and some down a lot on no news.  Many blame an unwind in statistical arbitrage.  Was this a once in every 10,000 years event?  I think not.  The tails in investing are fat, and when a trade gets crowded, weird things happen.  It is possible to over-arbitrage, even as it is possible to overpay for risky debt.  As the trade depopulates, prices tend to over-adjust.  Are we near the end of the adjustment?  I don’t think so, but I can’t prove it.  There is too much implicit leverage, and it can’t be unwound in two weeks.

Odds and Ends

Two banking notes: S&P has some concerns about risk in the banking sector, despite risk transfer methods.  A problem yes, but limited in size.  Second, ARM resets are going to peak over the next year.  The pain will get worse in the real estate markets, regardless of what the Fed does.

Insider buying is growing in financial stocks, after the market declines.  I like it.  My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.

Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur?  I love nonlinear dynamics, i.e., “chaos theory.”  I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain.  It could be next month, it could be a decade at most.  The thing is, you can’t tell which straw will break the camel’s back.  I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high.  In those cases, I would rather give a weak signal, than one that could likely be wrong.

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were dying.”

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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”

PS —  Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.”  A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.
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And now to the present application:

My main point in posting this story is to point out the impotence of Fed policy in helping areas of the economy with compromised balance sheets.  When credit spreads are wide, cuts in the fed funds rate do not appreciably affect the funding costs of firms deep in junk grade.

Beyond that, temporary injections of liquidity are meaningless, and that is all the major central banks of the world have done, together with words saying they will support the markets.  Well, what happens after the market digests that, and the temporary injections of liquidity are gone.  They will expect the Fed to stand and deliver something more permanent.  Much as I have resisted this thought, and hate it in terms of public policy, the FOMC will cut rates at that point in time, and begin a loosening cycle.  It’s the wrong thing to do, and won’t achieve the goals intended, but my view of Fed policy is that I must focus on will they will do, not what they should do.

So you have my change of view here and now.  The central banks of our world have caved in to an unrealistic fear of what is going on in the fixed income markets.  The next move of the Fed is to loosen.  It will happen in 2007.  Look for the areas of the economy that are healthy, and will benefit from cheap financing, because they will get it.  The trade: buy high quality financial stocks.  Time to overweight.