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Entries in Federal Reserve (8)


Over and out for Forward Guidance

I'll try anything once, twice if I like it, three times to make sure."

So said Mae West, the late American actress and entertainer, whose upbeat line is often used to denote a positive and openminded approach to life.  Yet, just because you try it once does not mean that you have to like it. For example, I recently travelled from London to New York only to stay for 18 hours. Spending 12 hours in airplane over the course of a full day is decidedly not something I intend to do again if I can help it. 

I wonder whether Yellen would heed Mrs West's dictum in the context of trying to define what "a considerable time" really means or perhaps when it comes to putting a number on the elusive NAIRU? Unfortunately for Yellen she does not, unlike me, have to luxury of only trying once. She will be forced to try over and over again until she gets it right and it might be a bumpy ride.  

The problem is simple yet vexing for the Fed (and quite possibly the BOE too). It is steadily becoming impossible for the Fed to maintain the illusion of forward guidance and this poses problems. Forward guidance always worked incredibly well in theory for an economy stuck at the zero bound with a gaping negative output gap. It even worked in practice, but with the US economy starting to show signs of returning to steady positive growth (albeit that such growth might be weak overall) time horizons are getting increasingly squeezed. 

This was obviously highlighted with last week’s FOMC where short rates rose sharply and Eurodollar futures sold off. As we saw in the market for risk asset, such bear flattening is not something investors like too much. All the commotion arguably came as the Fed revised up its interest rate projections for 2015 and 2016. This won't really surprise any investors who tend to keep a close eye on fixed income markets in the US. However the key problem is that this renders forward guidance impotent. In short, rate hikes are now being priced in on a substantial level within a, for market participants, relevant and important time horizon. In a normal world where interest rates are price along a continuous spectrum this is normal but in a world of forward guidance which denotes a binary world where the central bank pre-commits to a specific interest rate regime (ZIRP) it renders such policy very difficult to sustain. 

One reason for last week's change in communication could be that Fed is genuinely turning more hawkish (in anticipation of a tighter labour market and wage pressures). After all, markets cannot expect interest rates to stay at zero forever. However, Yellen’ comments at the beginning of this week suggest otherwise, and herein also lies the problem. The communication of forward guidance is now almost impossible for the Fed; as investors know all too well, it is impossible to put the proverbial toothpaste back in the tube. 

Still, this seems exactly what Yellen attempted to do on Monday. Here is Macro Man [1]with a relevant observation in this regard.

(...) Yellen took pains to point out reasons why much of the current unemployment is cyclical rather than structural.   Among the arguments employed were the low level of wage growth.  While it is certainly true that wage growth is below long-term norms, it is somewhat disingenuous to suggest that it has been stagnant.  Indeed, private sector wage growth (the only type she has any power whatsoever to impact) has accelerated smartly over the past eighteen months, and now rests above the average level that prevailed when the past two Fed tightening cycles commenced.

So, the doves are back in charge it seems, but investors are not stupid. Whatever the Fed decides to do forward guidance is now a dead policy. It is time to find a new recipe regardless of whether Yellen and the rest of the FOMC agree with Mae West's morale or not. 


[1] - Readers should note that this is the original Macro Man wielding the pen here. To the extent that you can get excited over anything in the blogosphere, it is genuinely uplifting to have the good ol' MM back (with or without his knee caps!). 


The Fed and QE - (Dis)united we stand

I have put up a post over at Variant Perception's blog about how Fed members clearly do not agree on the effectiveness and merit of QE. 

A nice series of articles from Bloomberg news alerts us to the fact that the Fed is anything but united when it comes to QE. There is consequently ongoing confusion, disagreement and general apprehension surrounding whether and how the Fed is supposed to end QE . Quite simply; the powers that be do not see eye to eye on this one and this is slightly worrying (if completely understandable).

I think such debate is crucial within central banks, but the Fed should be careful. If QE is debunked too strongly as a policy tool and the next recession comes at a time when interest rates are still zero and the US economy faces the same structural challenges, what will the Fed do? 


Should the Fed move further down the rabbit hole?

Taper mania remains high as ever with the market trying to figure out when, how fast and indeed in what direction the Fed will choose to adjust its asset purchase programme. In particular, the possible combination of an extension of forward guidance coupled with tapering in 1Q13 is slowly emerging as the consensus, but there are a lot of US data points to contend with from here to there. 

Meanwhile, a note last week by Morgan Stanley points to the increasingly market distorting effect the Fed is having on the MBS market.

In the first instance, it is interesting to note MS's interpretation of the Fed's view on MBS purchases as a key instrument in the monetary transmission mechanism from QE to the real economy. 

The FOMC has made clear that while purchases of Treasuries are not an academic “best practice,” it does believe that MBS purchases directly support the housing recovery. In her hearing, Yellen stressed that lower mortgage rates have been the “positive factor in generating the recovery of the housing sector.” She also reiterated that the sharp increase in mortgage rates over the summer played a role in the Committee's decision not to taper at its September meeting.

Morgan Stanley, November 15th, p. 2

Personally, I am skeptical that it was really the back-up in long rates which delayed tapering in September; I think was the fact that short rates were also starting to move. This then represented a direct attack on forward guidance which was effectively an attack on the Fed's ability to set short term rates. There was no way that the Fed could let this happen and also one of the reasons I think that Yellen intends to implement an even more aggressive forward guidance. My guess is that she is playing with fire here boxing herself in to conduct a dog fight with the market on the course of short term interest rates as far ahead as 2-3 years.

For those who are calling for the Fed to extend forward guidance under the guise of Yellen's optimal control framework, consider the following question. Could the yield curve invert under forward guidance?

I will leave that question to simmer a bit. 

Another point is that the notion of MBS purchases as strong support for the housing recovery. This is an increasingly difficult argument to make in my view. There are two reasons for this. First of all, new mortgage origination in the US has not made a rebound after the crisis with consumers essentially suggesting that the Fed is pushing on a string with its MBS purchases. This is to say that while it may help to keep long rates lower it has done little to increase new mortgage borrowing. 

Secondly as MS shows, the Fed's involvement in the MBS market is becoming systemic just at a time when the Federal government is trying to rid itself of mortgage market involvement through GSE (government sponsored entities). 

(...) there are stock-based and flow-based constraints the Fed will have to bear in mind. Since the beginning of MBS purchases under “QE3”, Fed holdings as a percent of total MBS outstanding have increased rapidly to about 26 percent. Every month of $40 billion (net basis) in MBS purchases increases the Fed holdings as a percentage of total MBS outstanding by about 0.8 percentage points. Even if the Fed were to taper MBS beginning in March and complete purchases by the end of 2014, Fed holdings of MBS would rise to 34% of the total MBS market.

A key question, then, is how much of total outstanding MBS does the Fed want to hold; at what point is it too high? Flow-based constraints have also become more of a risk following the drop-off in refinancing over the summer. Agency MBS production has now fallen to $70-$80 billion per month with the Fed buying $53 billion per month ($40 billion in QE and $13 bn in reinvestment). A compelling argument can be made that this would be considered a market-distorting share.

Morgan Stanley, November 15th, p. 3

I think MS is being diplomatic here. It is now abundantly clear that the Fed is having a market distorting effect on the MBS market. This would favour, contrary to what currently appears to be the Fed's preference, tapering MBS purchases quicker than treasury purchases.

Instead, let me venture an altogether more outrageous "suggestion" even if I am not sure this would work at all. 

Another proposition is then simply that the Fed is buying the wrong thing. Quantitative easing can principally be targeted at all kinds of assets and with the Fed effectively hoovering up the entire MBS market, maybe it is time to look farther afield. One opportunity would be to realise that consumers' demand for homes is not only a function of low long term rates. Betting on a steady increase in homeownership and thus positive response from households to the ability to lever up their balance sheet may not work post 2008. 

Specifically, we should note the decision by Blackrock to start marketing bonds backed by the rental income of the thousands of properties the investment company has spent the past 4 years accumulating

Quote FT; 

Now they are beginning to package the rental proceeds from those homes into the kind of “sliced and diced” securitisations that proliferated before the bursting of the housing bubble in late 2007. This week Blackstone sold the first of these bonds – a $479m deal that bundled the cash flows from more than 3,000 single-family rental properties scattered across Arizona, California and Florida. 

Quote Bloomberg; 

The market for rental-home securities may grow as large as $900 billion, assuming 15 percent of annual home purchases are conducted by investors and 35 percent of those and existing rental-home owners turn to the market for financing, according to Keefe Bruyette & Woods Inc. Banks have been the main source of financing for new property landlords such as Colony Capital LLC and Blackstone, which has spent $7.5 billion on about 40,000 houses.

Of course, at $900 billion (even with positive expectations on the market size), this market is obviously currently too small for the Fed to step in, but it also means that the Fed could support this obvious channel of the US housing market revival by deploying much less financial firepower. Alternatively, the Fed could start buying straight corporate bonds of which there are now more outstanding than MBS in the US.

Now, if you can sense the irony here at the end of the post then you wouldn't be entirely mistaken, but we should understand that it is perfectly within an aggressive Fed's mandate to seek out new avenues to transmit their policies to the real economy. 

Central banks are becoming increasingly certain and secure in the position that their activist policies are not only effective, but also that they can orchestrate orderly exits. I am personally highly skeptical that this is the case.  

Regardless of whether you agree with this or not, we should understand that the notion of an increasingly activist Fed supports the idea of tweaking not only the size but also composition of its asset purchases. Just like Alice, Yellen could be about to take one step further into the rabbit hole with painful consequences for investors further down the line.