Musing About Fed Policy and Credit Crunches

For the last six years, I’ve had a reasonably good call on Federal Reserve policy.  That partly stems from having been an institutional fixed income investor in one way shape or form for fifteen years.  This dates back to my days at Provident Mutual where the company at that point in time left hedging decisions in the hands of the line of business actuaries.  In 1994, I sold GICs (Guaranteed Investment Contracts) like mad after the first Fed tightening, and ran unhedged.  Smooth move at the time, but that was too much power to grant me.  In hindsight, I was a novice then, and it could have gone badly wrong.

But at the present time, my view on the FOMC is cloudy.  It’s cloudy for a few reasons:

  1. Bernanke is new, and we really don’t know his reaction function.
  2. He has granted more autonomy to the Board of Governors to speak their minds, unlike Greenspan.
  3. There are more inflation hawks with voting rights at present than over the past two years.
  4. Using the discount window adds another dimension to the puzzle.  Unless the gap between the discount window and Fed funds is narrowed further, I don’t see it becoming a major factor, unless they further liberalize collateral requirements, and who may use the window.

Now, Bernanke has committed to act to avoid damage to the economy from conditions in the credit markets.  To me, this is important, not because I think the Fed can help the dead and dying — they can’t.  They can help the walking wounded, and overstimulate the healthy.  In the former cases, credit spreads dominate, in the latter credit spreads are still low.  From my angle, the Fed will slowly be forced to recognize that problems developed from speculation in residential real estate, CDOs, overdone arbitrage strategies and private equity are either a) too big to solve through monetary policy, without causing a lot of inflation, or b) they will try to “solve” the problem anyway, and hope that inflation doesn’t rise too much.

There’s no panacea here, and personally, I am not expecting anything too great out of the US equity markets if the Fed starts loosening.  After all, during the tightening cycle, the market rallied, including financials.  That was weird.  Weird things come in bunches; “Don’t fight the Fed” didn’t work last time.  Will it work this time?  Many are assuming that Fed policy will make the markets go because it has done so in the past.  When too many think so, it may not work.

Now, a week ago, some could say that conditions were normalizing in the credit markets.  I didn’t think so, and still don’t think so.  As an example, consider what I wrote at RealMoney on Friday:

David Merkel
Systemic Risk Gives Way to Mortgage Hedging
9/7/2007 3:27 PM EDT

Treasury and Swap rates have fallen enough that we are finally getting mortgage refinancing/hedging activity. 10-year swap spreads are 12 basis points below where they peaked a month ago, and 10-year swap rates, which serve as a proxy for prime 30-year mortgage rates, are 35 basis points below their 18-month moving average. The 10-year swap rate has come down 90 bps since the peak three months ago. Remember the panic then over higher rates? I wish I had put on more then, but I didn’t panic, and my bond positions did well.At present the discount window action is doing little; I struggled to find any mention of it last night. But M2 is showing some life, and my M3 proxy as well… quietly, banks in the Federal Reserve System are expanding their balance sheets, making up for the loss of commercial paper (and mebbe absorbing some collapsing conduits…). But the monetary base is stuck in the mud, and Fed funds averages 5% since the crisis began. Lotsa talk, but not much action.

I would let the long bonds ride here, because mortgage hedging sometimes takes on a life of its own. That doesn’t mean that systemic risk has gone away, but some of it is being hidden by mortgage hedging; interest rate swaps have many uses. You can still see the systemic risk in the TED spread (over 160 bp), and other option implied volatility measures.

For more fun, look at the TIPS market, where inflation protected bonds are outrunning nominal bonds. The longest TIPS is up more than 2% today. Wow. Also, the carry trade currencies (yen/swiss franc) have been running as well.

So, fear is alive and well, and so are prime mortgage bonds. What a fascinating day to watch the bond market in action.

Position: none, my prior bond positions are with the firm that I no longer work for…

Not that I am calling for a recession in 2007, but when a hawk like William Poole says that the odds of a recession are rising, it tells me that the Fed is looking for a reason to cut rates.  With the jobs report on Friday (which I think is over-analyzed relative to its true value), the FOMC may have more reason to cut.  If nothing else, it gives them political cover to cut.

Now, there are bigger issues here, and it is possible to be too shortsighted about current policy.  Efforts to solve the immediate problem can complicate future problems.  Even the actions of the ECB, in doing nothing at their recent meeting, sends a signal that the credit markets are more important than inflation.

Financial crises will always happen, and if we use monetary policy and bank regulation to try to avoid them in entire, we only set ourselves up for larger crises in the future.  (Ask Japan how much it likes low interest rates — they are really stimulative.)  Financial crises eventually end when bad debts are liquidated, or when financing is adequate to make it through.  In this case, the Fed will have a hard time fighting the large increase in debt to GDP.  (Also here.)  Bad loans have been made.  Regulation can deal with future loans to some limited degree, but monetary policy is at best a crude tool to deal with past mistakes.

It is outside the Fed’s mandate from Congress to deal with asset bubbles unless they affect inflation or full employment of labor.  Yet the Fed gets criticism for that.  Maybe Congress should get the criticism.  As it is, most of the current problems are manifesting on the short end of the yield curve, and among non-regulated lenders.  There are some assets that Asset backed commercial paper conduits should never have financed, as the SEC is now probing.  No surprise, though; the BIS saw this coming, after a fashion, and much more clearly than US regulators.  In any case, the problems in short-term lending are difficult to deal with.  Clearly, credit losses need to be taken by lenders who made bad loans; I don’t think that Fed policy can do much about that.

The deeper problem is that financial systems that rely on short-term lending are inherently unstable.  From the end of Alan Abelson’s column this week:

But, Stephanie [Pomboy] sighs, the current credit bust is not confined to real-estate lending. In truth, there are interest rate “resets” galore across the entire economy. Borrowing short has become a raging epidemic. Floating-rate paper now accounts for 54% of total debt issuance, up from 26% as recently as 2002. That means a startling $540 billion in corporate bonds will need to be rolled over next year.

The serial abusers in this realm are — who else? — financial enterprises, who need to replace a tidy $428 billion in debt next year, a third more than this year. In 2008, too, some $160 billion worth of leverage loans mature.

To top off this orgy of borrowing short, there’s the $87 trillion interest-rate swaps market. Essentially, she explains, here’s where long-term fixed-rate obligations are converted into floating-rate short-term notes. Swaps, Stephanie reports, accounted for more than half the growth in the $145 trillion derivatives market in the past two years.

What she foresees is a kind of financial Armageddon as the credit crunch deepens and widens. “Scarcely will they finish putting the subprime situation under house arrest” before policymakers will be forced to address similar problems in “credit-card debt, commercial-real-estate loans, CLOs…and beyond.”

As the credit engine sputters, the repair crew will be forced to “print and spend.” That, she says, is what gold has figured out. And what equities, we might add, are only beginning to learn.

Now, ignore the derivatives to a degree, because for every long there is a short.  So long as the counterparty risk management of the investment banks works, there should be no reason to worry.  (I wonder about this, but know that the investment banks are trying to manage this.)  The increasing prevalence of floating rate finance should make the system more sensitive to Fed policy, but even more to LIBOR in the Eurodollar-markets, which the Fed can’t directly affect.  That doesn’t mean that they won’t try, though, and to me, it indicates that he Fed will cut rates significantly through 2008, assuming that inflation or a rapidly falling dollar doesn’t intervene.

We live in interesting times.  I think that there is an inflation bias here, and that investors should prepare for it.