On Sub-Zero and Decoupling

Bruce Krasting's picture


On the IOER and Hilsenrath


Bernanke has to do something this week. Most pundits are suggesting it will be more LSAPs (QE). I have trouble with this scenario. To be of any benefit, a new QE would have to be for $600Bn. If QE3 were to be only a paltry $200Bn, it would be received very poorly. I don't see Ben shooting off a pop-gun this week. He would be better off doing nothing, than something that will fall flat. I think he knows that.

There is also the issue that there is no justification for more QE right now. We are not in an emergency, stocks are at four year highs and there really are negatives to a policy of perpetual ZIRP. Also, a big splashy QE would be perceived as being very Pro-Obama. Taking sides in a national election is not something the Fed really wants to do. Republicans tend to have very long memories.

Extending the ZIRP language for another few years is idiotic. It is a promise that can't and won't be met. It also has zero value to the current economy. Extending the language is a ho-hummer that will accomplish nothing other than to demonstrate that the Fed is out of arrows.

That gets us to changes in the overnight deposit rate (IOER). Currently at a 1/4%, it could be cut in half to 1/8. This seemingly insignificant change would actually have profound effects. I wrote about this recently (Link), but much more importantly, so did Jon Hilsenrath of the Wall Street Journal. His thoughts from Friday night on the IOER (Link):

Another possibility, which is more controversial internally and might not happen, is a small reduction in the 0.25% interest rate that the Fed pays banks for reserves held at the central bank.

If you believe (as I do) that Jon's words are scripted by Bernanke, you could read through this sentence and conclude:

A) Ben has told Jon that a cut in the IOER will be discussed and voted on next week.

B) The words "small reduction" is new to me in this context. The discussions to date have been that the IOER might be cut to "0", rather than something in the middle.

C) There is opposition to this step from at least two voting members. While Bernanke has the votes to do as he pleases, he wants there to be a consensus of opinion that includes only one dissenter. (This about the "Optics")

D) Ben is pushing for this. He wants to prove he has more arrows. He does not want to confront Republicans with a major QE at this time. But he has to do "something", the IOER might be it.

E) The words, "might not happen", could also be read as "might happen". A cut in the IOER is (at least) 50-50 if you read through Jon's words.

Three and six month T-Bills are now .10 and .13 respectively. Post an 1/8th cut in the IOER they would be -.03bp and 0.00bp. Does that matter? I think it would be a very big deal indeed.




On FX, Equities and Bonds


My most recent efforts in FX have led to a loss. I had a bear spread on the EURUSD with the near leg at 1.2350. That went off the sheets last week, option premium went out the door.

I don't dwell on losses. They are part of the game. But I do try to evaluate why I am wrong in an effort to avoid the same mistake again. In this particular trade I completely missed the market sentiment that Draghi's plan has created.

I didn't believe that Draghi could ever say the words, "Unlimited Intervention". But he did, and I'm the poorer for it. I'm as certain that I can be that Draghi has made a promise that he can't deliver on, but for the time being, he seems to have the upper hand.

Don't shed too many tears for me, the past month has been one of my best in the equity market for years. The hedge funds I invest with have done very well. But of course that is all paper, and the future is uncertain.

I spoke with a guy who runs a fund (with a couple of bucks of mine) this weekend. He was happy as can be. His fund's performance has past the upside mark, so he's getting a free 20% of any additional gains. Like all equity guys, he's bullish for the rest of the year. His thinking is that common stocks of companies with good balance sheets, positive cash flow, and buying back stock have much more upside to them. Google at 800+ is in the cards, according to him.

He made one interesting observation. He believes that equity prices have decoupled from the business cycle. Stocks can do well when the broad economy is struggling and government financing is in ruin.

That sounds crazy to me. But it is exactly the status quo today. Stocks are at four year highs, while government financing (globally) is in the toilet, and about to be flushed. His justification for the optimistic outlook for equities was:

Who in their right mind would buy any government bonds today?

We shall see if the decoupling of stocks and the broad economy/public sector financing continues, but you can't ague with what the guy says. Bernanke and the other central banks have converted the debt market into a very unlovable asset class. There is no return on the bonds; there is credit and yield risk. Bonds are a total downside story at this point.