Only time for one post tonight. I had a late meeting with some men from my church. Away from that, my oldest son goes to college for the first time tomorrow, to St. John’s in Annapolis. I will miss him, even though I will see him most weekends; he is a joy of a child to be around, and a really sharp thinker. As an intern, he has impressed two investment firms with his acumen. But what I will miss most is his good character.
Into the fray, then. It’s the WSJ’s word, but is the Fed genuinely hopeful? If so, it’s on scant evidence. Away from that, you have Governor Lacker, who tends to be a hawk, saying that it is the effect of the financial markets on the economy will drive Fed policy, not any volatility in the credit markets themselves. Well, the present dislocation is worse than LTCM in many ways already. LTCM did not gum up the mortgage repo market, or money market funds. As it is, Central banks are still showing themselves willing (minus the Bank of England) to engage in a series of short term injections of liquidity.
Why are money markets doing badly? Asset-backed commercial paper [ABCP] makes up 50% of all money market fund assets, and those claims will have to be rolled over the next 1-3 months. At a time like like this, the lack of alternatives is driving money market funds to grab T-bills and highly rated CP, even as those with higher ABCP exposure wonder what will happen if the ABCP conduits extend the obligation, and at the end of the extension period, are still inverted? What will those that have to provide liquidity or credit support do? This problem is not limited to the US; there have also been problems in Canada and Britain, but banks operating there have stepped up and taken the hit themselves. Altruistic in the short run, but regulators and business partners have long memories, even when it is only implied promises getting broken. (Hey, maybe the Fed can open up the discount window to non-bank ABCP conduits. Please don’t… 🙁 )
At a time like this, is it any surprise that the guy who created the money market fund is saying that the concept has been abused? It was not meant to fund speculators in risky asset classes. Not all ABCP does that, but that is what some of them are proving to be now. But, perhaps it is fitting in its own warped way. The introduction of money market funds (and the elimination of regulation Q, a ceiling on credited interest rates) helped prolong the inflation of the 70s, because the Fed couldn’t control liquidity the way that it used to; money market funds just kept supplying liquidity at interest rates investors found attractive.
So, how tight is US monetary policy? If you gauge it by T-bills, pretty tight. At every percentage rise in the Treasury less fed funds spread like this, the Fed has loosened. It could be different this time, but if so, the markets will be jolted, and by markets, I mean the debt markets, the money markets, etc. The stock market will be down too, but that will be the least of our worries. Even now, other types of consumer lending are starting to tighten. With the markets already discounting a 50 basis point decrease in September, those markets will be tighter still if the Fed sounds like Governor Lacker.
So things are bad in the US. How about elsewhere? WestLB CEO Alexander Stuhlmann says that he sees an increasing reluctance to lend to German banks. The Bank of England lent to Barclays plc at a penalty rate at their discount window, and supposedly for no big reason. (I hope the reason is innocent incompetence… I’m a shareholder. Oops, there’s the h-word again, and it’s me.)
The carry trade is getting squeezed, partly because currency option volatilities are rising. How does this work? Think of it this way. The carry trade works by borrowing in a low interest currency, and investing in a high interest currency. Assume for a moment that I approximately matched the maturities of the two trades (risk control!), but that I wanted downside protection from the trade going wrong, so I would buy an option that would stop me out at a certain level of loss (again, attempting to match trade maturity). The higher the option volatility goes, the more costly it is to limit the risk on my trade, so as option volatility rises, the willingness to do the carry trade falls.
Chinese Inflation? As I’ve said before, that is a threat to the recycling of the US current account deficit, and also a threat to US inflation levels. Could that keep the FOMC from loosening? Not yet. We need to see more pain here.
Finally, from the “don’t bite the hand that feeds you file,” the Bush Administration is worrying about the impact of sovereign wealth funds exerting undue influence on the US. Oh, please, you worry about this now, after expanding our current account deficit like mad?! At this point, the US has few options but to sell assets to all but dedicated enemies of the US; if we are not willing to cut back our current account deficit in other ways, and our debt becomes unattractive, there are two choices, let the dollar fall until US goods become compelling (with rising interest rates and inflation), or let them buy our assets. We can’t freeload on the rest of the world forever (though we did sell much of the toxic CDO waste to unsuspecting naifs, we just don’t know who yet), eventually we will have to be willing to sell away large stakes in major US corporations. (Or maybe all the surplus homes! 😀 )
Full disclosure: long BCS