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The Fed Has Boxed Itself Into A Corner
Via Scotiabank's Guy Haselmann,
Perfectly Imperfect
Following the ECB meeting last week, news headlines summarized the initial market response with titles such as, ‘Markets rally as ECB bond buying plan exceeds all expectations’. Such characterization judged the plan only on its size and schedule and failed to fully appreciate the deeper flaws buried in the details. My judgment is that Mr. Draghi secured the best compromise he could, yet it is one that is far from “whatever it takes”. It is a plan that cleverly masks shortcomings in its complexities.
For the Eurozone to truly maintain a currency union, it needs to have political, fiscal, and banking unions. All of these have been elusive and slow to develop. The ECB QE plan now exposes the cracks of their monetary union. If the EU truly possessed a monetary union then the ECB should have guaranteed or assumed the potential losses from the purchases of those assets. Forcing the national central banks to assume the risks, recognizes the non-zero possibility of default or EU break up.
Choosing to purchase assets through the national central banks is anti-integration. Unlike other ‘bail-outs’, this structure is a step backwards. It is anti-union.
- As I wrote in my Jan 16th note: “Movement towards, or away from, being a union is what has driven the binary aspects of EU sovereign debt spreads for many years. In other words, debt spreads are binary in that they will either converge (union) of diverge (anti-union). Therefore the structure of ECB QE will ultimately prove much more important than the size of the program.”
Since individual countries no longer have the ability to print money themselves, various types of credit risk exists. Hung Tran of the IIF argues that the debt structure is more similar to that of a US municipality than that of a sovereign nation. A municipality’s ability to honor its liabilities is limited to its taxing authority, or ability to legally implement revenue-generating reforms. Could, or should, the debt of, say, the State of Georgia trade through the debt of the US government?
I point this out since BBB rated Spanish 10-year bonds traded 55 basis points below AAA-rated US 10-year Treasuries (after the ECB announcement). I believe this spread will move during the year from the ‘negative 50 area’ to a spread that is positive by hundreds of basis points. I believe this will be one of the best trades of 2015. (The Spain/Bund spread fell below 100 bps; I obviously expect it to widen significantly as well)
ECB debt purchases will be made in line with the individual countries’ share of ECB equity, so the benefit to the EU periphery’s debt is restricted. About one-third of all purchases will be in German and French debt. Spain’s equity contribution is only 8%.
The ECB’s single mandate is to maintain price stability (not to spur economic growth or employment). The plan’s mechanism that helps to achieve such a goal is a weakening of the Euro. The ECB has had great success in this regard over the past 7 months simply by promising a QE program (i.e., Euro from 1.35 to 1.15). The announced program is designed to weaken it further and ‘buy more time’ by hinting at the open-ended nature of the QE program should it not reach its inflation objectives by the end date of September ’16.
Adding such conditionality is a powerful tool today that maximizes ECB flexibility, while limiting the market’s desire to fight its resolve. However, in reality there are two reasons why it is highly unlikely the program is ever extended beyond the announced end-date of September 2016. If the ECB’s inflation goal has not worked by September of 2016, then it is likely to be viewed as being ineffective, increasing the likelihood that those who were reluctant supporters in the first place will want to abandon it. On the other hand, if the inflation rate begins to creep back up in the ‘preferred direction’, then the ECB would want to end the program and may even wish to do so early.
The ECB has cleverly set the timetable in a way to almost ensure that it will be successful in terms of improvement on the inflation front by September 2016. The reason is due to the year-over-year effects that the price of oil will have on inflation indicators. The price elasticity of oil makes it likely that oil may bottom near current levels between $40-$50 dollars. Should that occur, oil will stop being a drag on inflation indicators beginning in twelve months’ time.
The market rate for EUR 5-year inflation beginning in 5 years, initially rose from around 1.55% to 1.80% on the ECB announcement, but quickly reversed back to 1.55%.
The 10 year German Bund fell in yield from above 0.50% to below 0.35% and has stayed there. This shows me that fixed income markets remain skeptical of the ability of central banks to lift growth or inflation.
Demand for money to invest in the real economy does not pick up when unusually low rates are lowered modestly lower, particularly when debt levels are already quite elevated. The plummeting velocity of money is a symptom of extreme indebtedness. Imposing a negative yield of 0.20% on the excess reserves of EU banks is a tax intended to boost lending, but there are many consequences to imposing such financial repression with little evidence that the intended goal will come to fruition.
Lowering rates from already low levels hurts the lender because margins usually fall as well. Lenders have a disincentive to lend when they believe that their compensation for the loan is inadequate. Moreover, promises that rates will remain low for a period of time damages confidence that economic activity is improving.
The Fed has boxed itself into a corner as it has attempted to prepare the markets for a rate hike around June. If it does not raise rates in June, or thereabouts, then it must have an exceptionally good reason. The reason would have to be a significant and material deterioration in the economy or a highly troubling worsening of the geopolitical environment.
Regardless, risk assets are likely to suffer mightily in the near future under either scenario. Risk assets will either have to endure a Fed hike or worsening conditions. The high for the year for the S&P could already be in place. Either way, the biggest beneficiary will remain the back end of the Treasury curve. I remain a bond bull.
Extreme central bank policies over the past 5 years have ballooned asset prices, fueled speculation and moral hazard, and exhausted interest rate tools of central banks. The Swiss National Bank reminded markets just how fleeting promises can be. And now, central bank’s under-delivering on growth and inflation promises are now further concerning risked-up markets; such could not come at a worse time.
It appears markets are on the verge of learning just how damaging the unintended consequences will be from multiple years of extreme central bank promises now that the Fed has run out of the ammunition to keep the utopian market façade alive. The structure of the ECB QE and the Greek situation make the backdrop considerably more troubling and difficult.
“Can you tell a green field from a cold steel rail? / A smile from a veil? / Do you think you can tell?” – Pink Floyd
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I disagree... I doubt Mr. Yellen's box has been used in a very long time, nor will ever be used again...
thanks for that image. i bet that old bag wears depends so she doesnt have to push away from the buffet when she is in the middle of her 3PM snack.
I'm from the government & I'm here to help!
http://finance.yahoo.com/news/us-cut-building-real-economy-231004061.html
I disagree. I think Corzine is hiding in there with Mozillo.
Yeah, she may be a 'ghost from another time', but she's not yet 'obsolete', Mr. WORDSWORTH...!!!
"If it does not raise rates in June, or thereabouts, then it must have an exceptionally good reason."
Or what?
The Yuan gets a seat at the IMF.
Hong Kong dollar fer sure.
Maybe the New Taiwan Dollar as well....
Or..., there will simply be more newer vague words in the fed statement by which to string the charade along for, a lot longer!
The fed has only been bluffing the market now for what....8 years now?
The "fed is gonna raise rates any second" mantra has been going on now ever since they went zirp, and it still continues.
The recovery is nothing more than containing the paper price advancements of the real physical money gold & silver.
Thats the recovery! Everything else is bullshit, and the bullshit spewing fed can keep this charade going until the physical disappears.
I don't know. Seems like the Fed has a pretty good scapegoat now.
the CB's have manipulated things so badly that the world markets are going to shed energy one way or another and the banks are making sure its the worst possible way....
Are we figuring out we can't afford to put anybody back to work yet??
If not, this will come as a bit of a shock...
why is the Fed in a corner? they can always just turn on the printers again. we need a "shock to the system" first, but i'm sure that is already planned by TPTB......
The fed put themselves in a corner years ago. Turning on the printers only delays the inevitable less and less and makes the coming crash worse. They will deflect blame though, and the sheeple will believe whatever they say.
Following the ECB meeting last week, news headlines summarized the initial market response with titles such as, ‘Markets rally as ECB bond buying plan exceeds all expectations’.
i bet these headlines have been sitting on the shelf for years- prefabricated. reminds me when they accidentally released george soros obituary LMFAO yea that about sums up modern journalism
http://www.wsj.com/articles/mike-newton-beware-the-currency-wars-of-2015-1420760225
It will be very difficult to avoid deflation and promote growth in 2015 and beyond without major changes to the global monetary system, some of which are unthinkable right now. Policy makers in Asia and Europe are already devaluing their currencies, apparently driven by the failure of low interest rates to stimulate investment and by the recognition that the U.S. is the only place that is showing real growth. Making their exports cheaper, they believe, will help their economies grow.
The problem is that if every country devalues its currency, no one wins. And if devaluations become more aggressive and disorderly, it could create great systemic risks world-wide. Dollar borrowers would struggle to find liquidity. U.S. corporations would see their export markets evaporate. And emerging markets would be forced to raise their interest rates dramatically to prevent their currencies from collapsing.
The dollar is already at a nine-year high against other major currencies. In Asia, the yen, thanks to the Bank of Japan’s unprecedented and ongoing quantitative easing, is now seriously undervalued versus the yuan and other regional currencies. China in turn has begun to allow the yuan to weaken. Beijing is in a bind as it seeks to grow the economy. It needs to deflate the wild lending boom of recent years, which rules out traditional monetary easing, and fiscal policy runs up against a lack of suitable projects and ruinous local government finances. For China, devaluation is the only show in town.
..................
The Fed could theoretically keep interest rates at or near historic lows far beyond 2015, hoping that this would reduce the attraction of owning dollars. But this is problematic if the recent spurt of U.S. growth continues or accelerates. The Federal Open Market Committee is committed to bringing interest rates up to a historically more normal level. Aside from the dollar legally being a Treasury Department responsibility, the Fed’s primary concern is the systemic risks from domestic asset bubbles if policy is not tightened as growth picks up, not baby-sitting countries that are devaluing.
The situation demands policy coordination. Seismic shifts are coming in exchange rates in 2015 whether Washington likes it or not, and policy makers need to get ahead of the curve. The U.S. can show global leadership by opening up a process to coordinate Asian and European devaluation—a dynamic that will also lend badly needed stability to emerging markets.
There is historical precedent for this. In 1985 the U.S., France, West Germany, Japan and U.K. signed the Plaza Accord to manage the devaluation of the dollar. Two years later the Louvre Accord reversed this process. While big international agreements are never easy, the major positive is that everyone’s interests would be aligned if a “New Louvre” agreement was drawn up among the U.S., the eurozone, Japan and China.
The world may ultimately be heading toward a global managed exchange rate regime. This may sound far-fetched, but policy makers have already fixed the price of government bonds in the aftermath of the 2008 global financial crisis. Why should they stop there? And if they don’t do something, then the disorder that potentially lies ahead in foreign-exchange markets could spark major systemic problems and undo much of the healing that has taken place since 2008.
Funny, the only growth that I see in the US is cancerous.
Take what ya can get, I guess.
cognitive dissonance in the last sentence....
Why should they stop there? And if they don’t do something, then the disorder that potentially lies ahead in foreign-exchange markets could spark major systemic problems and undo much of the healing that has taken place since 2008.
the healing that took place?!?!?!? their "HEALING" they refer to was essentially printing dollars- the whole reason other countries are printing like crazy!!!
Exactly. They have added trillions in debt, thus enslaving everyone more. It's not simply printing. It's bonds (as in bondage, in this case) issued against the labor/property of citizen/slaves. Only Iceland (pop. around 300,000) and, maybe, Greece (pop. 11m), have balked.
@polo007:
You are suggesting that solving the problems caused by too much centralized control (i.e. "financial repression") will be done with further centralized control. Seems like a !REF to me...
when the fed runs out of tools, it will create new financial tools. this goes on for quite some time.
remember they are in charge of monetary policy until they fuck it up but good, but we are getting closer to the brink, ha...
The only reason the Fed got on this 'don't worry we're getting ready to raise rates any minute now' bullshit was because the mantra was 'the Fed is in danger of losing all credibility if they don't raise rates'....it's all just a fan dance the Fed is doing, no rate raise ever. Or if they do, it will be some 1/4 point bullshit.
just a bluff, is my thought.
go to finviz and slide your mouse over all the futures and look at the charts.
almost every commod is down, pork bellies, you name it. charts are all similar.
deflation, so fucking obvious. yea, they have a problemo brewing...
Uh, the Fed has boxed us into a corner is what I think you mean.
The problem appears to me to be the dollar...specifically the dollar is moving the Fed and not the other way around.
In the sense that the "Fed must normalize (raise rates) anyways" then yes, the Fed is "boxed in" in that no monetary policy tool can do anything to improve "financialization."
And I mean ABSOLUTELY NOTHING.
The Fed can't even get commodity prices to stop collapsing!
Sorry but I still see nothing but Detroits "for as far as the eye can see" here.
The entire Government workforce will have to be privatized if it is to exist at all.
The one ans only exception appears to be the war fighter.
Everything else will be run by computer.
"The Fed can't even get commodity prices to stop collapsing!"
What make you think they are trying?
The western banking cartel are the bad guys. The Fed must fail. Hopefully, the Chinese will help US citizens restore our Constitution as it was originally written. Maybe they wont help.
More likely, they buy the US, one bankruptcy sale at a time. I don't know how to say that in Chinese, yet.
Well yeah, this is only what everyone has feared since 2008.
Raise rates? Even nominal, while real rates plummet? Really want to refinance $19,000,000,000,000 at higher rates? Raise rates and print faster, is that it?
Or will the Fed do a turnaround and go NIRP?
As soon as the interest rate hits 0% ( and w are CLOSE ), the NPV of debt becomes infinite. Why? Simple, borrow a quadrillion or 5 and no interest to be paid, no principal will ever be repaid and debt skyrockets nor any actualisation ( the rate = 0 ). The most idiotic project or investment is now "feasible". End game.