Looks like Tom Hoenig's dissension at the recent FOMC vote is starting to generate some serious traction. A paper just released by V.V. Chari of the Minneapolis Fed, "Thoughts on the Federal Reserve's exit strategy" goes so far as blasting the Fed for demonstrating Goldman Sachs-like "hubris" courtesy of the persistent lowest common denominator resolution to every crisis, namely Bernanke's redux of MLK "I have a dream" speech for the 21st century, in the Chairman's "we have a printing press" thesis.
The money line from the paper, which Chairman Shalom would be all too wise to re-re-re-read over and over until his delusion of grandeur curve flattens by at least by 1 basis point.
"...The Fed differs from private firms and emerging markets in that it can “create” money to finance its debts. And indeed, that ability may well lead to hubris on the part of policymakers—similar to that seen among financial managers in the current crisis who were clearly overconfident in their ability to obtain financing. Regardless of such self-assurance on the part of policymakers, if market participants lose confidence in the Fed’s ability to obtain funds from lenders, the Fed would have to pay very high interest rates to obtain short-term debt. A self-fulfilling, high-inflation equilibrium in which expectations that the Fed will pursue lax monetary policy because banks demand a high-inflation premium will lead banks to demand that high-inflation premium."
This is, in a nutshell, the encapsulation of the downside risk to the entire recovery: the entire ephemeral bear market rally is based on confidence in the Fed, which in turn is based on confidence that there will be no "paradigm shift" (yes, we hate the phrase as much as you do) in perceptions vis-a-vis the Fed's ability to print without any inherent checks and balances. Downside analysis must always start (and end) with precisely a view on how and why this concept should be taken for granted. Because if even the Fed is starting to question its soundness, the capital markets can not be far behind.
As to the paper itself, Chari performs a very relevant analysis of the three alternatives to Fed liquidity reduction (in the absence of an actual Fed Fund rate hike), which are as follows: Strategy 1: Raising interest rates on overnight reserves, Strategy 2: Offering banks higher interest rates on short-term deposits, and Strategy 3: Gradual sales of financial assets. In surprisingly lucid fashion Chari demonstrates just what the key weaknesses of Strategy 1 and 2 are, which in a nutshell boils down to Interest Rate and Rollover Risk associated with the ambiguity of Fed actions as pertains to the general interest rate environment.
And while Chari describes the asset sale alternative as the most feasible one (this is true, and hammered home previously by other Fed presidents), his logic as to why concerns about the spike in Mortgage rates (and a depression of all other asset classes) are overblown, is flawed. He says:
The extent to which asset prices would be depressed depends on how segmented financial markets are—that is, how difficult it would be for investors to shift assets from one market to another over a reasonable time frame. Bear in mind that the volume of traded financial assets of all kinds in world markets is on the order of $200 trillion. Given this extremely large financial market, if the Fed were to sell $1 trillion in assets over a period of time, the odds are small that such sales would have a big effect on global financial markets, assuming assets can be shifted among markets with relative ease.
Chari tries to neutralize the impact of asset transfer by saying that in the long run, portfolio shifts will normalize. Well, on a long enough timeline...
How much segmentation truly exists among such markets? If you look at them minute by minute, it’s clear that markets are highly segmented; but over longer time horizons, such as two or three years, people clearly have time to shift their portfolios. The question ultimately is, where is that break point where market segmentation ceases to be quantitatively and materially important? While there is little empirical research on this question with regard to mortgage-backed securities, for instance, it is my judgment that over a reasonable time frame, market participants would be able to absorb the sale of the Fed’s security holdings without significant price impact.
This is patently flawed. Assuming that asset flows and yields will normalize on a long-enough timeline, is of course correct in a Chicago-esque perfectly efficient market. Yet the author himself earlier ridicules Chicago economics when he says "Because markets are not complete and since frictions do exist, each strategy can have a significant effect on both the economy and the conduct of future policy." So while the withdrawal of liquidity in 2050 will certainly have been priced in, what happens in the near-term, courtesy of a market which is jaggedly volatile on materially declining liquidity, not just in equities, but in cash bonds and certainly in CDS will be a massive (over)reaction the second selling overtures are initiated.
Furthermore, using BIS data about total financial asset traded annually and comparing that to Fed MBS holdings is extremely juvenile from an actual trading perspective. It is like saying that the entire capital structure of various risk assets is one homogeneous pool, with equal liquidity and in which returns up- and down-shift gradually and gracefully, without regard for "speculators" (oh wait, just ask Greece about that one). Having the very bottom of the balance sheet propped up provide massive leverage to dabble in higher yielding (and risky) assets as it removes the risk to the sub-5% yielding asset class, and allows material leveraging of positions in assets in the IG (6-7%), HY (8-10%) and equities (12%+) return classes. If the MBS bid is gone, the bottom of the market would literally fall out. Which is why we believe that while Chari is implicitly correct in principle about the Fed's options, he is extremely wrong about the ramifications to not downward price pressure on not just MBS, but all asset classes.
Then again, the Fed can merely continue on its path of unmitigated hubris until “some ‘kids’ in New York and elsewhere sitting in front of a computer" decide it is time to put an end to the Fed's stupidity. Which is why the Fed and Europe must put an end to all CDS and naked (or any other kind) of equity shorting optionality, and also make outright selling of securities illegal, coupled with mandatory participation by every US citizen in UST retirement accounts, before such time as these "kids" finally wake up and smell the manipulated market coffee.
Full Minneapolis Fed paper.