It's a Good Bet the Fed Doesn't Know What It's Doing

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I often find myself rereading both the minutes and the transcript for the June 24 & 25, 2003, Federal Open Market Committee (FOMC) meeting. So much of that two-day meeting contained heavy discussion about the very conditions that we now find ourselves trying to overcome. The economic recovery in the middle of 2003 was still in its infancy since the housing bubble had not yet fully impacted the real economy. There were indications that it was beginning to move the real economy in both the direction and manner monetary policy intended, but the FOMC participants were unsure of whether any additional monetary "stimulus" would need to be offered to remove any doubt.

Ominously, Federal Reserve Governor Mark Olson noted that:

"Asset quality has improved, but the interest rate margin declined 12 basis points from the fourth quarter to the first quarter. Moreover, there is an explosion on the liability side in short-term deposits while the only growth opportunity at the moment is in mortgage products."

In the middle of 2003, the Federal Reserve noted that all the monetary stimulation of the past two-plus years was "exploding" into the only area "markets" found suitable in terms of risk and spreads: mortgage products, i.e., structured finance. But that was not enough for the FOMC. They were far more concerned about deflation, having just begun to use that word as justification for continuing then-record low interest rates.

At that time, nearly two years after the official end of the 2001 recession, the committee debated not only whether interest rates should go lower, but what might happen if they went all the way to zero. Over the course of the 211-page transcript, there were numerous points made about the Japanese experience at the "zero bound", the condition where short-term interest rates are pinned right at or near zero percent by central bank policy. Almost like the myths and fears about what lay beyond the sound barrier before it was breached by Chuck Yeager in 1947, the FOMC was not at all sure that there were not intractable problems once that monetary barrier was in sight.

Just as Governor Olson was unknowingly alluding to in his note of mortgage products vis-à-vis the housing bubble that was fomenting under their extreme measures of that age, monetary policymakers really did not have a good grasp of policy under any non-"normal" conditions. They felt completely confident that what they were doing was well within the bounds of acceptable economic doctrine, but there were some considerable apprehensions about following Japan.

Among those expressing the most uncertainty was, ironically given his reputation, Alan Greenspan. In noting that the Japanese experience with Quantitative Easing (QE) and the zero bound was fraught with mistakes and, more importantly, miscalculations, he addressed the unknowns with surprising candor (perhaps because he knew the transcript would be kept secret for years):

"One is that I don't think we know enough about how the private financial system works under these conditions. It's really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments - which is what we have essentially been talking about - are independent of the level of the riskless rates themselves. The answer, I'm certain, is that they are not independent. But how their dependency functions and how those spreads behaved in earlier periods is something I think we'll need to know more about. The reason is that I don't believe, as I said before, that we can construct an effective preemption strategy. Well, we can construct a strategy, but I'm fearful that it would not be very useful."

Because there was no established track record for the FOMC to model, they really had no idea how the "private financial system works" when outside of normal operating parameters (that was true of his tenure as well as after, but the ultimate disposition would wait for his successor). His observation here includes a sort of hardened dichotomy between his strict orthodox, dogmatic approach to economic theory and the very small opening to the idea that his own understanding and history is, in this all important sense, very limited. The doctrinaire aspect of his comment was that he was absolutely sure that yield spreads were not independent of riskless instruments. In other words, control the risk-free rate, control the entire yield curve of the entire credit market. The benchmark is all that matters because the whole of credit intermediation begins at that risk-free benchmark.

Not surprisingly, Governor Ben Bernanke was far less uncertain with the potential efficacy of monetary policy near any bound or extreme condition. While Regional Fed President Bill Poole expressed his desire or the Fed's need "to be vague regarding the things about which we can't be confident. We don't want to make statements that we really can't be confident about", Governor Bernanke indirectly retorted that:

"Ambiguity has its uses but mostly in noncooperative games like poker. Monetary policy is a cooperative game. The whole point is to get financial markets on our side and for them to do some of our work for us. In an environment of low inflation and low interest rates, we need to seek ever greater clarity of communication to the markets and to the public." [emphasis added]

For Bernanke, there was no vagueness or ambiguity to be had in extreme monetary policy, there was only manipulation that begins with the forceful projection of confidence and assurance. This was validated in no small part by the FOMC's explanation for why the Bank of Japan's monetary extremism had been such a miserable failure. First, they blamed the Bank of Japan for not responding forcefully at the start of the crisis, so much so that some of the committee members compared the Japanese central bank's actions to the Federal Reserve in 1930 and 1931. But a significant aspect to the Japanese failure, in their estimation, was a lack of confidence in their extreme measures that was communicated directly to market participants. That meant that these measures were doomed to failure before they were ever launched because Japanese policymakers were inadvertently negatively biasing expectations.

Monetary policy in the modern sense has morphed from printing dollar bills to psychological manipulation. As Governor Bernanke noted, moral suasion is the better part of modern monetary valor - get markets to do what you want without ever having to do anything directly. That requires a forceful announcement of intention that plays into the assumed "rational expectations" of economic and market agents. And it also means outright manipulation if needed.

Governor Bernanke expanded on that thought:

"There are many different ways to approach expectations management. One is communications of the type we've been doing through our statements. There are various targeting procedures for inflation or price level targeting. Eggertson and Woodford talk about some reasons for price level targeting, which is their favorite approach. There is also signaling through various kinds of market interventions of the kind Dino has talked about-options, purchases of bonds, discount window lending, and so on.

"I don't have much sympathy or forbearance necessarily for protecting small segments of the financial markets [money market funds that would likely suffer at the zero bound]. I believe our first approach should be the continuation of our current policy of working on the management of expectations. And then I think we should consider packages of policies that support each other to try to manage expectations in the market and thereby affect longer-term interest rates." [emphasis added]

If the primary approach to monetary intervention is expectations management, and it certainly has been for at least three decades, then there exists no room for Governor Poole's concerns about being careful about what policymakers don't know. That is also true of Chairman Greenspan's doctrine of benchmark risk-free rates and yield spreads. A Federal Reserve committed to expectations management cannot cede ground on any of its rigid dogmas.

It must have been somewhat disquieting for the Federal Reserve in October 2008 to, among other processes that had been failing and disproving a great many things about what the FOMC knows about monetary policy and the intersection of the real economy, see that the 30-year swap spread had fallen below zero (the difference between the 30-year fixed payment on an interest rate swap and the current yield on the 30-year US treasury bond). This was a direct violation of Greenspan's benchmark doctrine that yield spreads start and end with the risk-free security. A swap rate below its co-existent US treasury bond rate flips that dynamic into something far different than intended by monetarism.

When that happened initially, nobody quite knew what to make of it. Worse, the 30-year negative swap spread never disappeared, and remains to this day almost four years on. By March 2010, the 10-year swap spread also fell into the negative, and the 7-year not long after. While the 10 and 7 spreads have been mostly positive after December 2010, we have seen a re-occurrence of negative spreads recently. In the 34 trading days prior to November 7, 2012, there were five instances of negative spreads in the 10-year product.

Before October 2008 and the first appearance of the negative 30-year swap spread, market participants were equally inflexible about how interest rates are structured. Negative spreads were believed to be mathematic impossibilities, largely due to blind faith in the Greenspan view of interest rate structure. The implications of a negative spread run directly into the ability of central bankers to carry out expectations management. If markets pierce the defined interest rate framework that sustained Greenspan's doctrinaire confidence in his assessment for how monetarism actually works, the house of cards might fall.

In that same June 2003, FOMC meeting, Fed Governor Donald Kohn mentioned, "Another problem in Japan was that the authorities were overly optimistic about the economy. They kept saying things were getting better, but they didn't." Getting markets to do your work for you requires that markets actually believe you know what you are doing. Managing expectations is predicated on credibility more than anything else.

A negative swap spread can be interpreted in many different ways and the truth of the matter is that we really don't know exactly what causes them to occur. The interest rate swap space is dominated by big money banks and big money players that have interests far beyond economics, but that is really true of all economic and market agents. Derivatives traders make bets on the Greeks (delta, gamma, theta) so there could very well be technical reasons for the occurrence of negative spreads. There is also the demand for hedging among corporate debt issuers - the more corporate debt, the higher the demand for IR hedging from derivatives dealers that then have to lay off risk somewhere.

There was precedent for a negative swap spread, however, right in the very place that the FOMC was focused in June 2003. Negative swap spreads had appeared in Japan in early to mid-2001. The primary catalyst had been quantitative easing from the Bank of Japan soaking up Japanese Government Bonds (JGB). The lack of liquid supply (the on-the-runs) led Japanese banks to increase their appetite to receive the fixed side of an IR swap. As the demand to receive fixed (and pay floating) increases relative to the demand to pay fixed and receive floating, swap rates decline regardless of some perceived structure starting at the sovereign risk-free rate. In other words, IR swaps acted as synthetic JGB's (including mimicking the short-term borrowing through something like repo) where the big Japanese banks refused to follow the intentions of the Bank of Japan to be pushed into lending to somebody other than the Japanese government. Absent an available supply of government bonds, banks simply synthesized them with derivative contracts.

Among the primary intentions of QE in any instance is to get money flowing into riskier assets. If one of the primary problems in Japan, like the United States of the 1930's, was the banking system's unending preferences for liquidity and safety far above risk/reward, QE was supposed to be the answer since it was believed there wouldn't be any substitutes for JGB's. As it is, IR swaps actually offer some benefits that are perceived as superior to actually holding a real security (leverage and the fact that there is no upfront capital required to purchase the full par value of government bond or even fund the haircut in a repo).

In fact, that was one of the prime arguments Governor Bernanke advanced in confident support of theoretically moving to the zero bound in that very 2003 FOMC meeting. He said, " [zero bound interest] works through mechanisms that depend on the imperfect substitutability of different assets". If central banks give banks no choice for a suitable alternative to liquidity preference assets, they will theoretically be forced to carry out the blunt end of monetary initiatives - assuming financial risk in the real economy through lending to risky obligors rather than governments. Yet here the banking system found itself with a synthetic alternative that not only confounded monetary designs and intentions, it upended Greenspan's interest rate doctrine.

The reappearance of negative spreads, even briefly in the 10-year tenor after the announcement of QE 3, suggests that liquidity preferences remain stubbornly in place despite more than four years of emergency liquidity measures implemented specifically to thwart them. Without movement of bank preferences out of that condition, there is no monetary transmission mechanism to carry out any amount of quantitative easing. Greenspan, in this one instance anyway, was likely correct. Despite the best and brightest economists and PhD's at the Fed, nobody really knows how markets will behave under duress.

One thing is known, that market participants that cling to liquidity preferences, even to the point of violating the risk-free benchmark and turning increasingly to synthetic/derivative spread products, do not seem to be buying the overly-optimistic economic case that is a prerequisite for Chairman Bernanke's attempts at expectations management - thus the unending duress. There is one other important aspect to negative swap spreads as well, it speaks directly to the view that interest rates are likely not finished moving lower. In other words, it is both a play on central bank ineptitude in the real economy and a bet on the future direction of the economy itself in the "wrong" direction.

Governor Kohn's warning about predictions containing too much optimism due entirely to unearned confidence in monetary intervention seems to have leaked out of the Japanese monetary model and into the US. Confidence and doctrine matter less than actual results. Some markets will simply refuse to surrender to ineffectual monetary policy, preferring instead to wait for a real recovery, but simultaneously betting massive sums that one is further and further away. They are wagering, in the end, that central banks really don't know what they are doing. So far that has been a good bet.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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