Clean-up role
Weekly Comment – February 23, 2020
You all recall (or perhaps it’s just another anachronism) seeing kids in school who would use fat yellow highlighting markers on their textbooks. I would buy used textbooks whenever I could, and sometimes huge swaths of text would be completely yellowed out. It often occurred to me that if you’re highlighting the entire book you’re not possibly distilling the material down to core concepts.
This weekend I read the FOMC minutes, Brainard’s speech and Clarida’s speech from Friday. I found myself excerpting large amounts of text from each source (now using copy/paste instead of a yellow marker). For my purposes, how the Fed considers data and the economic environment and its reaction to those inputs is extremely important. From my reading, I would say these factors are most important in the interplay between financial CONDITIONS, financial STABILITY and inflation. Clarida and Brainard are likely the two most influential board members. However, there are a lot of conflicting thoughts between these speeches and the minutes.
My conclusion is that the Fed still has a credible voice, but that its message has been muddled and markets have now relegated the Fed to a much more reactive ‘clean-up’ role. That conclusion has been reinforced by September’s repo squeeze, by the Fed’s $60B/month t-bill buying program, and by current market action. So that’s my distillation.
The minutes reveal the Fed’s current concerns in one sentence:
At this meeting, the discussion focused on two topics: the potential interactions between monetary policy and financial stability and the potential use of inflation ranges around the Committee’s 2 percent inflation objective.
The first question is why the Fed is so obsessed with a small shortfall in inflation measures. In my opinion, another excerpt later in the minutes obliquely provides the answer.
…several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances—including overvaluation and excessive indebtedness— could amplify an adverse shock to the economy, that the current conditions of low interest rates and labor market tightness could increase risks to financial stability
Overvaluation and excessive indebtedness can be “cured” by higher inflation levels. The implication is that firms will have more pricing power and can more easily service debt levels because of greater cash flow, therefore asset values can come into more justifiable ranges with respect to other macroeconomic variables. Additionally, nominal wages increase which can support buying power. Interest rates will naturally rise, pulling the Fed away from the zero-bound issue. Disinflation puts the whole process into reverse and makes high nominal debt levels unserviceable.
Now let’s consider a couple of comments by Clarida. First he talks about monetary lags and says that policy decisions today have no effect on today’s inflation or unemployment rates. Clearly, that makes some sense. He continues:
Thus, central banks and financial markets are looking at the same data on macro fundamentals to make inferences about the future path of the economy, and, of course, any decisions on the policy path made by the central bank will influence asset prices through the discount factor. So optimal monetary policy will (almost) always be correlated with asset prices. Correlation is not evidence of causation, and the hall of mirrors problem at its essence is about inferring causation from correlation.
I would argue that the outsized importance of financial markets, in large part spurred by the Fed’s post-crisis expansion of the balance sheet has, in many ways, put the Fed in a box with respect to policy decisions; the only question now is when are we forced to do MORE. As the long bond has plunged in yield I have heard a lot of people talking about refinancing mortgages. Clearly this happens on the corporate side as well. The market has lowered rates, influencing all asset prices, without as much of a lag as we might have had previously. The Fed might be trying to hold off on rate cuts because it doesn’t want to contribute to what might become larger indebtedness and future financial instability, but the market has taken the lead and forced the issue. Furthermore, the policy change spurred by markets probably has less of a lag than actual Fed decisions. The markets drag the Fed into trying to endorse stretched valuations, and indeed many Fed officials have done just that. What appear to be supportive financial CONDITIONS presently can lead to financial INSTABILITY later.
Often, Fed officials talk about communication policy and credibility in outlining a course of action to the public. A lot of this discussion has centered around inflation averaging, that is, letting inflation overshoot for a time to “make-up” for past shortfalls. The problem here is addressed in all sources. Clarida mentions data-dependence, and notes that estimates of inflation and rates in SEP dots have come down for years. My interpretation: how can the Fed promise a course of action with respect to inflation averaging if its own estimates of conditions are continuously evolving? The Fed has fallen short of its inflation target for years.
Brainard’s speech mainly concerns discussion of a paper written by Cecchitti et al.
The report assesses how unconventional tools—including forward guidance, balance sheet policies, negative nominal interest rates, yield curve control, and exchange rate policies—have performed over the past few decades.
The authors conclude that unconventional monetary policies worked during the crisis but did not fully offset a significant tightening in financial conditions. This finding leads the authors to conclude that these policies should be deployed quickly and aggressively in the future through a plan that is communicated in advance. This point is very important, so it will be the focus of my discussion.
To the extent that the public is uncertain about the conditions that might trigger asset purchases, the scale of purchases, and how long the purchases might be sustained, it could undercut the efficacy of the policy. Furthermore, the cessation of asset purchases and subsequent balance sheet normalization can present challenges in communications and implementation.
My conclusion here is that 1) the Fed has to identify and agree that a problem is occurring which requires unconventional policy. 2) if it’s unconventional, almost by definition you will have a hard time communicating intentions to the public in a credible way, especially in advance. Again, how will the public know that temporarily offsetting tightened financial conditions won’t lead to future financial instability? Brainard, or perhaps more appropriately the authors of the paper, are placing the Fed squarely in a reactive role. Technical details about inflation averaging and yield curve targeting are almost irrelevant. This final line is almost a joke:
It is important to emphasize that for monetary policy to be effective, it will be key for policymakers to communicate their strategy clearly in advance to the public, to act early and decisively, and to commit to providing the requisite accommodation until full employment and target inflation are sustainably achieved. This was one of the important conclusions of this year’s U.S. Monetary Policy Forum report.
Finally, from the minutes:
The staff noted that clear communications of the Committee’s ongoing assessments of the interactions between monetary policy and financial stability could help avoid large interest rate surprises that could otherwise contribute to financial vulnerabilities.
Some participants remarked, however, that keeping policy rates low to achieve both of the Committee’s dual-mandate objectives may contribute to a buildup of financial vulnerabilities, especially at times when the economy is at or above full employment, a development that could pose future risks to the economy and to the ability of the Committee to achieve its dual mandate.
And here’s the kicker:
…the possible use of financial instability escape clauses to help explain the rationale for policy actions when a buildup of financial vulnerabilities poses risks to the achievement of the Committee’s goals.
You had a cute kitten and now it’s a man-eating tiger. So now the Fed wants to use “OUT” clauses to change policy when it realizes it has gotten behind the curve and perhaps communicated an incorrect message. POP! Now we have to clean up with whatever tools we can find.
So let’s relate the Fed’s recent communications to current markets. Stocks made all-time highs early in the week, but at the first signal of a pull-back implied vols in treasuries and VIX jumped. Eurodollar futures and option markets have signaled that the Fed is going to have to ease, perhaps aggressively. Spreads between corporate bonds and treasuries remain extremely tight, even though some high-profile downgrades to junk are occurring, for example Kraft-Heinz. The long bond yield ended at 1.917%, an all-time low in spite of 50 year lows in unemployment. We have what seem to be very accommodative financial CONDITIONS, but the markets are indicating that VULNERBILITIES are lurking just around the corner. The Fed will be forced into a clean-up role.
OTHER MARKET/TRADE THOUGHTS
The most notable changes week over week are the long bond yield, down 12.6 bps to a new low of 1.917% and the action in the front end of the curve. EDM0 settled Friday at 9853.5 from 9845.0 the previous Friday. EDU0 at 9862.5 from 9854.0 so both up 8.5 bps vs a change in the two year treasury yield of just 7.6 bps. There has been an astonishing amount of activity in EDM0 calls, clearly betting on a forced Fed ease.
Here are open interest changes in selected EDM0 calls, along with Friday’s settlements and deltas.
| EDM0 | 2/14/20 OI | 2/21/2020 OI | CHANGE | STL | DELTA | |
| 9850C | 400k | 468k | +68k | 12.75 | 0.55 | |
| 9862C | 376k | 567k | +191k | 8.50 | 0.38 | |
| 9875C | 539k | 600k | +41k | 5.00 | 0.26 | |
| 9887C | 402k | 717k | +315k | 3.25 | 0.17 | |
| 9900C | 299k | 341k | +42k | 2.25 | 0.12 |
Friday’s settle of the atm 9850 straddle was 22.0, the previous Friday it settled 20 vs 9845. These open int changes seem like whopping numbers and they are. But in the grand scheme of things, an increase of 191000 EDM0 9862 calls, even at the settlement price of 8.5 is only $40.5 million. A drop in the bucket for some large funds. Should the Fed be influenced by such a paltry sum? The full 717k of 9887 calls at 3.25 is only $58.25m of premium in total. It almost seems as if a few large funds could use this fairly inexpensive signaling mechanism to help push the Fed along in its reactive function.
FFG0/FFG1 settled at a new low of -52.25. I.e. the market has two eases priced for the year. April FF vs EDH0 settled 7.0, FFN0 to EDM0 (9861.5/9853.5) settled 8.0, and January 21 FF (FFF1) vs EDZ0 settled 9890.0 vs 9866.5 or 23.5. Nearer, lib/ois proxy has collapsed, while more deferred has remained bid. Partially due to technical factors relating to near term bill supply. Obviously many markets had wild moves this week, and are at or near the point when positions are forced.
| 2/14/2020 | 2/21/2020 | chg | |
| UST 2Y | 142.2 | 134.6 | -7.6 |
| UST 5Y | 141.1 | 131.6 | -9.5 |
| UST 10Y | 158.7 | 147.0 | -11.7 |
| UST 30Y | 204.3 | 191.7 | -12.6 |
| GERM 2Y | -65.5 | -63.8 | 1.7 |
| GERM 10Y | -40.1 | -43.1 | -3.0 |
| JPN 30Y | 38.7 | 34.5 | -4.2 |
| EURO$ H0/H1 | -33.0 | -41.5 | -8.5 |
| EURO$ H1/H2 | -3.0 | -4.0 | -1.0 |
| EUR | 108.31 | 108.47 | 0.16 |
| CRUDE (1st cont) | 52.32 | 53.38 | 1.06 |
| SPX | 3380.16 | 3337.75 | -42.41 |
| VIX | 13.68 | 17.08 | 3.40 |
