Money for Nothing

The persistence of low inflation across advanced economies has led central banks into the realm of zero and even negative policy rates, with the result that government borrowing (and thus spending) is now free. Populist politicians find themselves right at home, while those warning that there is no free lunch will be ignored – until it is too late.

Harold James




MUNICH – A monetary-policy regime centered on quantitative easing (QE) and zero or even negative interest rates has created an extraordinarily permissive environment for politicians of a certain disposition. Those who are willing to exploit current conditions to boost their own popularity can expect clear sailing ahead – at least for now.

Throughout almost all of the advanced economies, monetary and fiscal policymaking are interacting in a new and unique way. Consider, for example, that the German government just issued 30-year bonds with a negative yield. That means it can borrow for free, and, in theory, do anything it wants – at no cost. And Germany is hardly alone, which is why it is not surprising to hear a growing chorus of voices calling for greater fiscal activism at the first sign of a growth slowdown.

Obviously, the current situation could have far-reaching monetary and distributive consequences, given that governments are gradually expropriating from the traditional rentiers. But that is just the start. Politics itself has always been about managing tradeoffs.

Money spent in one area cannot be spent somewhere else. If nurses and doctors are paid more, teachers, police, or firefighters will be paid relatively less. Governments must choose between cutting taxes and building new high-speed rail links, aircraft carriers, or roads and bridges.

But now, unconventional monetary policy has given rise to an unconventional politics. In Europe, populist governments in Central and Eastern Europe have been especially good at playing the new game. They can buy off different political factions, raise child benefits, increase pensions, reduce the retirement age, build infrastructure, and cut taxes all at the same time. If the opposition pushes new spending proposals, the government can simply adopt those ideas as its own, ensuring its hold on power.

This new blurring of monetary economics and fiscal policy will inevitably lead to dysfunction.

In the 1990s, when Europeans were considering whether to adopt the euro, the single currency was sold both as a disciplining instrument and as a means of sugarcoating the bitter tradeoffs of conventional politics. Joining the eurozone meant sacrificing some degree of sovereignty over fiscal policy; but membership would bring lower interest rates, thereby reducing the costs of government debt and freeing up resources for other uses.

Under the new dispensation, the increased temptation to spend is still there. But it comes with a new, peculiar limitation: the sugar fairy only sprinkles her magic dust on countries that pledge to remain within the circle. The moment the prospect of leaving is raised, the spell is broken, which is why even Euroskeptic politicians in Italy and France no longer entertain that option.

Of course, the euro does not magically turn member-state governments into models of economic rectitude. On the contrary, they are now effectively rewarded for acting irresponsibly and unpredictably, while forcing monetary authorities into a more accommodating position.

The most obvious example of this gambit is in the United States, where President Donald Trump’s trade war and Twitter threats are fueling economic uncertainty and putting wind in the sails of doves on the Federal Open Market Committee. The Fed is now cutting interest rates to head off a growth slowdown. It is only a matter of time before European populists – British Prime Minister Boris Johnson, Hungarian Prime Minister Viktor Orbán, and Matteo Salvini (whose ambition remains to become the Italian prime minister) double down on the same strategy.

Compounding the dysfunction, populists have latched onto new intellectual arguments, and are increasingly presenting themselves as serious, innovative thinkers. Their first task is to persuade voters that what they are doing is not dangerous. But this hasn’t been too difficult, given that voices celebrating the demise of the old liberal order are now heard across the political spectrum. Throughout the advanced economies, there is a widespread perception that since the 2008 financial crisis, the old rules have no longer applied.

The new narrative that has emerged is ideal for populists. It holds that the financial crisis discredited traditional economics, and that “neoliberalism” was a dangerous illusion. The neoliberal insight that came in for the greatest criticism after the crisis was that fiscal restraint is a virtue and rewards adherents with lower interest rates, cheaper credit, and enhanced consumer spending. According to the critics, government spending is not only free, but also an unalloyed good.

In this brave new economy, no one seems to be able to say authoritatively how much debt is dangerous. But that doesn’t mean there isn’t some level of debt that could trigger a dramatic reversal. If depositors and investors become nervous, debt could become expensive again, making the existing debt stock unsustainable. Only then will the populist magic stop working.

Those who want to restore conventional politics and the old rules find themselves in an unenviable position. Although they do not wish for an end to prosperity, they sound like they do when standing next to populists. Nobody wants to vote for Cassandra when Pollyanna is on the ballot. By the time Cassandra’s warnings are borne out, it is always already too late.


Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.

Central banks are locked in currency wars they cannot win

Lowering interest rates to support economies has created a domino effect

Seema Shah


Years of aggressive monetary easing by the ECB has hacked away at interest rates © AP


Negative-yielding bonds are taking on an ever-greater chunk of the global fixed income universe and are still failing to lift economic activity. But the market continues to call for monetary policy easing from the European Central Bank and the Federal Reserve. It is not clear why central banks continue to acquiesce.

In fairness, for the ECB, the requirement for policy action is clear, given that Germany is teetering on the brink of recession. But with Bund yields already negative across the entire curve, pushing them even lower is unlikely to forestall deflation, encourage lending or nurture an economic recovery.

Years of aggressive monetary easing by the ECB has hacked away at interest rates. Negative deposit rates, rather than supporting bank lending, have instead hindered it, rendering the central bank less able to respond effectively to negative economic events with traditional monetary policy tools. Monetary policy has reached the limits of its effectiveness.

Of course, the ECB knows all this. So why does it continue to ease?

The simple answer is that easier monetary policy tends to cheapen a country’s currency and the foreign exchange channel has become one of the few ways the ECB can juice up the eurozone economy. When central banks turned to unconventional monetary policies a decade ago, driving in

terest rates to record lows, and with fiscal policy constrained by politics, it left them with little choice but to use interest rates surreptitiously to target currencies in the next downturn. This is the logical next chapter to follow quantitative easing.

A weaker euro acts as a shock absorber to cushion the blow of weak internal eurozone economics by improving external dynamics. However, it initiates a domino effect whereby other central banks must also lower their interest rates in an attempt to match the efforts of their neighbours and prevent their currencies from appreciating.

The US-China trade conflict has created more complications. China’s decision to permit renminbi depreciation as an automatic stabiliser creates friction for other Asian central banks, pressuring them to engage in competitive depreciation — a kind of beggar-thy-neighbour policy. Over the past few months, a succession of central banks has eased policy. So much for solidarity in global monetary synchronisation.

For its part, the Fed is understandably reluctant to indulge in aggressive monetary stimulus.

The US consumer has remained resilient in the face of slowing economic activity, suggesting that the problem is not that interest rates are too high.

If the Fed allows interest rates to deviate too far from the ECB’s, the US dollar will strengthen. President Trump, ever alert to the risks of other countries wanting to “take advantage” of the US, is becoming increasingly irate.

Unfortunately for him, the global economic slump creates the perfect conditions for a currency war. The US will try to participate in this race to the bottom, but it will probably be the slowest competitor.

Weakening global growth is not conducive to a downtrend in a cyclical currency such as the US dollar, and safe haven flows in these times of market turbulence have clearly amplified the upward forces on the greenback.

President Trump should look in the mirror — it is the homegrown trade war that is prompting investors to seek safety. What is more, with almost $16tn bonds trading at negative yields, 10-year US Treasury yields at just 1.5 per cent are relatively high. The US cannot help but attract capital, driving the US dollar higher.

The dark side of falling interest rates is the prospect of riskier investor behaviour. With negative rates in Europe and Japan, investors are searching for any kind of yield. As a result, they have little choice but to venture into the riskier corners of the bond market.

Given regulatory constraints limiting many investors to the investment grade space, US triple-B is the natural home. But if and when the US eventually hits recession, forced sellers will find that the house has a narrow and shrinking exit door.

Fiscal stimulus is an obvious circuit breaker in this race to the bottom in currencies and yields. The market is making it easy for countries to borrow more, yet governments remain strangely reluctant.

Companies are also failing to take advantage of negative yields. To date, only a handful have locked them in the primary market. Businesses appear to be worried about the economic environment and the risks they face in taking on more leverage.

Yet, if the domination of negative yields is sustained, companies will surely focus on bond markets rather than equity markets. Why, when you can be paid to borrow, would you look to public offerings instead?

This would create a unrecognisable environment: the pipeline of investible public companies could essentially dry up. Unviable companies would be granted extended lifelines, propped up by high valuations solely based on record low debt rates.

Is this the world central banks were hoping to create when they started out on the long road of unconventional monetary policy all those years ago?


Seema Shah is chief strategist at Principal Global Investors.

Trump’s Effect on US Foreign Policy

Donald Trump's long-term impact on US foreign policy is uncertain. But the debate about it has revived a longstanding question: Are major historical outcomes the product of human choices or are they largely the result of overwhelming structural factors produced by economic and political forces beyond our control?

Joseph S. Nye, Jr.




CAMBRIDGE – US President Donald Trump’s behavior at the recent G7 meeting in Biarritz was criticized as careless and disruptive by many observers. Others argued that the press and pundits pay too much attention to Trump’s personal antics, tweets, and political games. In the long run, they argue, historians will consider them mere peccadilloes. The larger question is whether the Trump presidency proves to be a major turning point in American foreign policy, or a minor historical blip.

The current debate over Trump revives a longstanding question: Are major historical outcomes the product of human choices or are they largely the result of overwhelming structural factors produced by economic and political forces beyond our control?

Some analysts liken the flow of history to a rushing river, whose course is shaped by the climate, rainfall, geology, and topography, not by whatever the river carries. But even if this were so, human agents are not simply ants clinging to a log swept along by the current. They are more like white-water rafters trying to steer and fend off rocks, occasionally overturning and sometimes succeeding in steering to a desired destination.

Understanding leaders’ choices and failures in American foreign policy over the past century can better equip us to cope with the questions we face today about the Trump presidency. Leaders in every age think they are dealing with unique forces of change, but human nature remains. Choices can matter; acts of omission can be as consequential as acts of commission. Failure by American leaders to act in the 1930s contributed to hell on Earth; so did refusal by American presidents to use nuclear weapons when the United States held a monopoly on them.

Were such major choices determined by the situation or the person? Looking back a century, Woodrow Wilson broke with tradition and sent US forces to fight in Europe, but that might have occurred anyway under another leader (say, Theodore Roosevelt). Where Wilson made a big difference was in the moralistic tone of his justification, and, counterproductively, in his stubborn insistence on all or nothing for involvement in the League of Nations. Some blame Wilson’s moralism for the severity of the America’s return to isolationism in the 1930s.

Franklin D. Roosevelt was unable to bring the US into World War II until Pearl Harbor, and that might have occurred even under a conservative isolationist. Nonetheless, Roosevelt’s framing of the threat posed by Hitler, and his preparations to confront that threat, were crucial for American participation in the war in Europe.

After World War II, the structure of bipolarity of two superpowers set the framework for the Cold War. But the style and timing of the American response might have been different had Henry Wallace (whom FDR ditched as vice president in 1944), instead of Harry Truman, become president. After the 1952 election, an isolationist Robert Taft or an assertive Douglas MacArthur presidency might have disrupted the relatively smooth consolidation of Truman’s containment strategy, over which the latter’s successor, Dwight D. Eisenhower, presided.

John F. Kennedy was crucial in averting nuclear war during the Cuban Missile Crisis, and then signing the first nuclear arms control agreement. But he and Lyndon B. Johnson mired the country in the unnecessary and costly fiasco of the Vietnam War. At the end of the century, structural forces caused the erosion of the Soviet Union, and Mikhail Gorbachev speeded up the timing of Soviet collapse. But Ronald Reagan’s defense buildup and negotiating skill, and George H.W. Bush’s skill in managing crises, played a significant role in bringing about a peaceful end to the Cold War.

In other words, leaders and their skills matter. In a sense, this is bad news, because it means that Trump’s behavior cannot be easily dismissed. More important than his tweets are his weakening of institutions, alliances, and America’s soft power of attraction, which polls show as having declined under Trump. He is the first president in 70 years to turn away from the liberal international order that the US created after WWII. General James Mattis, who resigned after serving as Trump’s first secretary of defense, recently lamented the president’s neglect of alliances.

Presidents need to use both hard and soft power, combining them in ways that are complementary rather than contradictory. Machiavellian and organizational skills are essential, but so is emotional intelligence, which produces the skills of self-awareness and self-control, and contextual intelligence, which enables leaders to understand an evolving environment, capitalize on trends, and apply their other skills accordingly. Emotional and contextual intelligence are not Trump’s strong suit.

The leadership theorist Gautam Mukunda has pointed out that leaders who are carefully filtered through established political processes tend to be predictable. George H.W. Bush is a good example. Others are unfiltered, and how they perform in power varies widely. Abraham Lincoln was a relatively unfiltered candidate and was one of the best American presidents.

Trump, who never served in office before winning the presidency and entered politics from a background of New York real estate and reality television, has proven to be extraordinarily skilled in mastering modern media, defying conventional wisdom, and disruptive innovation.

While some believe this may produce positive results, for example with China, others remain skeptical.

Trump’s role in history may depend on whether he is re-elected. Institutions, trust, and soft power are more likely to erode if he is in office for eight years rather than four. But in either event, his successor will confront a changed world, partly because of the effects of Trump’s policies, but also because of major structural power shifts in world politics, both from West to East (the rise of Asia), and from government to non-state actors (empowered by cyber and artificial intelligence).

As Karl Marx observed, we make history, but not under conditions of our own choosing.

American foreign policy after Trump remains an open question.


Joseph S. Nye, Jr. is a professor at Harvard University and author of Is the American Century Over? and the forthcoming Do Morals Matter? Presidents and Foreign Policy from FDR to Trump.

George Friedman’s Thoughts: Passion and Aristotle’s Four Virtues

Aristotle’s virtues, like passion, have a complex and important relationship to geopolitics.

By George Friedman


Of late I have been writing on issues like passion, and some have asked what this has to do with geopolitics. Geopolitics is the dynamic between nations, but it also defines internal dynamics, where ethnicity, wealth and religion all matter. And this, in turn, relates to the family and the individual. It is not that individuals are decisive, but rather that they both shape and are shaped by the foundation of the nation. The question of passion and its basis in civilization is therefore connected to, for example, Sino-American relations in complex yet important ways.

In response to my view on passion, some argued that passion is necessary for success. But passion is a poorly defined concept. Passion can be used to describe Christ on the cross, a wealthy man’s desire for more money, or Churchill’s definition of a fanatic as someone who can’t change his mind and can’t change the subject. Passion is a form of anger that hides itself under the cloak of civility. The fanatic shows his hand; the passion that frightens me is the rage of certainty masquerading as calm.

Aquinas, Maimonides and al-Farabi all regarded Aristotle as the greatest thinker of all time, as do I. He had a simple but powerful matrix of the virtues a man must have. Aristotle never embraced passion. He spoke of passion but regarded it as far below the virtues; as he said in his work on ethics, any beast can possess passion, and men who are passionate and nothing else are beasts.

Aristotle identified four virtues and the one that was both lowest and the foundation of all others was courage. When we think of courage, we think of war. But courage went beyond that.

For Aristotle, courage was also the ability to stand alone regardless of the opinions of the many.

The need to be well-regarded would lead men to betray themselves. That is what Socrates refused to do.

But courage was also for him a necessity of everyday life. We have all lived through nights when we dreaded the coming of morning. The courage to confront the dawn and face the day is perhaps the most fundamental and necessary part of courage. Life is difficult, and death is terrifying. We live between the two and without courage could not go on. I think this is why Aristotle treated it as the most fundamental of the virtues.

But courage is also a form of madness. I remember a night in Islip on Long Island in New York. I was driving a well-seasoned Plymouth Belvedere, against a knight astride a Chevy Impala. Dying was better than flinching as we engaged in the ancient game of chicken. In the end, I swerved. We were both drunk on courage, but the prize was not a substitute for the abyss.

Aristotle despised this sort of impassioned bravery.

Aristotle’s second virtue was prudence. Prudence was intended to moderate courage; it is the scale on which courage is measured and tempered. The willingness to die is not an eagerness to die. Risking your life might be too high a price to pay for the prize. Other means might be found to satisfy the need.

Prudence alone devolves into a careful calculation that neglects the soul. Courage is indispensable to life, and prudence without courage knows the price of everything and the value of nothing. Courage without prudence is recklessness, which risks all for nothing. For the crazy brave, the risk of everything is an end in itself, and it leaves his flank uncovered. Prudence without courage is Shakespeare’s Shylock wailing over his daughter and then his money, knowing the price of each but knowing nothing of their value.

At the same time, the perfect balance of prudence and courage leaves open the end toward which prudence will guide courage. Perfectly balanced, it is the sphere of the banal man who has courage but is constantly restrained by prudence to be far less than he can be. For Aristotle there is, therefore, a third virtue: justice.

Where prudence shapes and restrains, justice demands that men act in its name. It takes the mediocrity of prudence and courage and turns it into a moral imperative. With justice, we know what we owe and to whom. Prudence now becomes a servant of justice, making certain that courage is shaped properly in pursuit of justice.

Of course, the nature of justice is itself mysterious. Is it the interests of my nation? Is it the teachings of my God? Is it a vision of perfection that other men have conceived? Is it the right of the strong to rule the weak? Geopolitics teaches that between nations there is courage and prudence, and that justice is merely the expression of the interests of each nation. If that is all that justice is, then it is far from a binding power.

To give your life to that would please the crazy brave but repel all others. Humans have a need for something truer and nobler to which to commit their lives, fortunes and sacred honor. But where is it be found? Is it in the habits of my people or in the coming of a new age wrought by revolution?

The American founders sought to solve that problem by melding habits with revolution. It has worked, but the habits and the moral principles of the revolution have always been uneasy partners. And America was invented. Justice could be invented as well, but it has always required a seductive poem to be recited, diverting our eyes from its complexity.

In all of this, then, there is a fourth virtue: wisdom. Wisdom recognizes what matters and what does not. It’s what the philosopher is said to possess. Wisdom knows that justice is absolutely necessary, and it understands that just because it is necessary does not mean that it exists. The fact that it exists does not mean that it applies in this time and place. And the fact that it applies does not mean that men will believe in it.

Wisdom understands the needs and limits of humankind and the gorgeousness of the true and the beautiful. And it understands the tragedy of being human, which is that the true and the beautiful blind the eyes of the many, so that they can only have second best – a poem that is built on the truth but expressed as a lie intended to seduce, to give the needed justice rather than the true.

Wisdom is, therefore, the highest sort of prudence, just as justice is the highest moment of courage.

Plato spoke of the noble lie. The noble lie was built on the truth that men could not bear to know and was presented to them in the form they required. The rare wise man recognizes the true and beautiful and the fact that gazing upon it would drive ordinary people mad or blind.

So, a lie is invented that rests on truth, and that lie becomes the foundation for men to be courageous. Wisdom understands the limits of truth.

It is like the story of Moses, who, on seeing the promised land, was not permitted by God to enter it because he had struck against God in anger. God knew that Moses could lead a rebellion against Egypt and God himself. But he could not govern. So, he replaced Moses with a lesser man, Joshua, who had never spoken to God but believed that God had spoken.

Joshua was a warrior, a man of courage, who prudently sent spies into Jericho. He believed in the justice of his cause, dubious though it might have been. But he was never wise as Moses had been. And that made him suitable to serve the geopolitical needs of his people, without being troubled by things that were beyond him.

Here's The Real Takeaway From The Fed Meeting

by: The Heisenberg


Summary

- Thanks to a seizure in funding markets, many desks were forced to reassess their expectations for the September FOMC meeting at the last minute.

- The only thing that mattered on Wednesday was what Jerome Powell said about the squeeze and how the Fed planned to address it.

- He was characteristically unconvincing on that score, but did manage to stumble into the "correct" answer when prodded by CNBC's Steve Liesman.

- Forget any other Fed takes you might have read. This is the real story.

 

You may not know (or even care to know) the specifics, but most investors are probably aware of the fact that funding markets suffered something of a seizure earlier this week.

 

The squeeze, which saw GC repo surge (visual below), was attributable to the collision of structural/legacy issues (e.g., Fed balance sheet runoff, Treasury supply to finance the deficit and bloated dealer balance sheets), and idiosyncratic factors (e.g., corporate tax payments, coupon settlements and last week's bond rout, the worst since the election).

 

(Bloomberg)

 

 

The New York Fed was forced to intervene on Tuesday for the first time in a decade, after the effective funds rate was dragged through the upper end of the target range. The visual below, for those who still haven't come to terms with what happened, represents the Fed quite literally losing control of rates - albeit temporarily.

.

(Heisenberg)

 

 

On Thursday morning, the New York Fed injected liquidity for a third consecutive day.

 

As I was writing this post, they announced they'd conduct a fourth operation on Friday.

The insanity (and it truly was chaotic, as detailed in Bloomberg's dramatic retelling) forced Wall Street to reassess their expectations for the September FOMC meeting at the last minute.

 

For the uninitiated, this can be an intimidating subject, but stick with me, because this is important - I'll keep it as brief as posible.

 

On Tuesday, some desks suggested the Fed might be compelled to announce its intention to expand the balance sheet imminently and/or launch a long-rumored standing repo facility.

 

Some high profile names got in on the act. Jeff Gundlach, for instance, said in a webcast (and also in an interview with Reuters) that the Fed would launch "QE-Lite" "pretty soon" to address the pressures that contributed to this week's funding squeeze.

 

The idiosyncratic factors cited above notwithstanding, the overarching issue is reserve scarcity.

 

BofA's Mark Cabana has been one of the most persistent voices in documenting this in near real-time over the past several months. There are people who will take you as far down into the "plumbing" as you want to go (with Zoltan Pozsar being perhaps the best example), but Cabana's cadence is relatively user-friendly as this discussion goes.

 

"The increase in funding pressure as reserves declined to ~$1.35tn likely suggests that the market is on the upward sloping part of the reserve demand curve, below the minimum amount of reserves needed for an ‘abundant reserve regime'," he wrote on Monday evening, as it became apparent that this week would be all about the funding squeeze. Here are two key visuals (note the X-axis is the FF-IOER spread, which you can put in the context of the second chart above):

 

(BofA)

 

 

Here is Goldman saying the same thing in a Wednesday note out prior to the Fed decision:

Until last week the relationship between FF-IOER and aggregate reserves largely seemed to track the curve imputed from the Fed’s Senior Financial Officer Survey, which suggested a substantial buffer (i.e., the “steep” part of the curve was probably at reserve levels below $1.2tn). However, at current levels of aggregate reserves (which we estimate had dropped to about $1.34tn this week), the realized FF-IOER spread, at 15bp on Monday and 20bp on Tuesday, is nearly 7bp to 12bp above where we would have anticipated it to be based on the survey.

That is what CNBC's Steve Liesman was referring to in the press conference on Wednesday when he asked Jerome Powell if the Fed might have "underestimated the amount of reserves necessary for the banking system." Powell's response was lengthy, but here's the abridged version:

We try to assess what that is. We’ve tried to combine that all together, we’ve put it out so the public can react to it. But yes, there’s real uncertainty and it’s certainly possible that we will need to resume the organic growth of the balance sheet earlier than we thought. That’s always been a possibility and it certainly is now. Again, we’ll be looking at this carefully in coming days and taking it up at the next meeting.

 

Powell's remarks amounted to an acknowledgement that the Fed will need to expand the balance sheet imminently, but the nuance (i.e., the "organic" bit) is crucial and I'll get to that below.

 

As far as the amount goes, BofA's Cabana on Tuesday estimated that the Fed probably needs to buy $250bn in assets in the secondary market in order to get back to an "abundant" reserve regime with a buffer. Going forward, the Fed would need to persist in outright purchases of around $150bn/year to maintain that level. That gives you an idea of the scope.

 

It's not a coincidence that stocks turned around as Powell discussed this during the press conference. And indeed, Nomura's Charlie McElligott suggested ahead of time that because the nuance around this isn't well understand, many market participants would rely on "muscle memory" conditioned over the post-crisis years to buy on any headlines around balance sheet expansion. "If we get a 'Fed balance sheet expansion' headline, the equities market risks an overly-bullish interpretation," he wrote, in a Wednesday morning note.

Although we did not, in fact, get an announcement of balance sheet expansion, Powell's discussion during the press conference was seen as confirmation that it's coming, and probably son.

 

And yet, it's crucial that investors understand that this isn't really "QE", per se. One commenter elsewhere claimed that Powell had left "QE Easter eggs" in his remarks at the presser. That is indicative of the general investing public not understanding the dynamic.

 

Here's McElligott again (from a Thursday note):

The danger near-term however is that so many in markets equate “balance sheet expansion” to a resumption of “outright QE” and LSAPs…despite a much more nuanced “organic growth” / “QE-Lite” message from Chair Powell at this juncture to “offset +” further Reserve depletion—thus a risk of a near-term bullish sentiment overshoot surrounding this misnomer of “balance sheet expansion = QE.

 

So, again, you have to understand this in the context of this week's funding squeeze which itself has to be couched in terms of reserve scarcity and an apparent miscalculation of what level of reserves count as "ample."

 

The September FOMC statement and the dots betrayed a divided committee. Frankly, it doesn't even make sense to speak of "forward guidance" when it comes to the Powell Fed. One is lucky to be able to divine anything about what went into this meeting's decision, let alone what's coming next. The dissents (Rosengren and George in favor of staying on hold, Bullard in favor of a larger cut) don't help.

 

But really, that was beside the point on Wednesday. What mattered was that the Fed definitively address the funding squeeze or, barring the announcement of balance sheet expansion or a standing repo facility, that Powell demonstrate during the press conference that he takes the situation seriously.

 

Instead, we got another IOER tweak, the promise of ad hoc, "as needed" liquidity injections (i.e., the operations the New York Fed conducted on Tuesday, Wednesday, Thursday and will conduct on Friday) and remarks from Powell that were anything but forceful.

The IOER tweak and the overnight repo operations are Band-Aids, almost by definition. They buy time, that's all. To address the issue sustainably requires balance sheet expansion, one way or another.

 

As far as Powell goes, here is another excerpt from his response to Liesman (you can watch the exchange here):

Of course, we were well aware of the tax payments and also of the settlement of the large bond purchases. And we were very much waiting for that. But we didn’t expect … The response to that was stronger than we expected. And by the way, our sense is that it surprised market participants a lot too. I mean, people were writing about this and publishing stories about it weeks ago. It wasn’t a surprise, but it was a stronger response than, certainly than we expected. So, no, I’m not concerned about that, to answer your question.

He elaborated further, but his response was wholly insufficient in my judgement, and I'm hardly alone in that assessment.

 

Irrespective of whether you think Powell managed to come out unscathed thanks to the reference to balance sheet expansion (and, again, equities' response to that was likely a reflection of market participants not fully understanding the situation) please note that if you read any account of Wednesday's press conference that suggests the Fed chair threaded any needles or otherwise navigated these choppy waters deftly, those accounts are not accurate.

 

Here, for instance, is what TD rates strategist Priya Misra said as Powell spoke (this was carried on the Bloomberg terminal):

This is disappointing. He is not addressing the structural issues at all. He is not acknowledging the reserve scarcity point and in fact says that we are operating at an ample reserve regime. I expect repo vol to stay high and then rise again at quarter end and year end.

 

Not every account was as critical as that one, but the fact is, there were no needles threaded on Wednesday. There was just Powell stumbling his way through another somewhat painful press conference, dodging questions when the going got tough and coming across as insufficiently concerned about the only thing that really mattered this week - the funding squeeze.

All of that said, you should also be wary of accounts that suggest this week's turmoil in funding markets represents some kind of 2008-style freeze-up. That isn't the case for a variety of reasons.

 

Here's a simple assessment from a much longer Credit Suisse note:

What we have seen this week is not a crisis but a symptom that we have reentered an old regime for Fed policy operations. To answer the question, is the Fed losing control, we say no it isn’t, but it must now move to allowing its balance sheet to grow in order to maintain its interest rate target.

 

And therein lies the problem. What the market got on Wednesday was an IOER tweak and a promise of ad hoc liquidity injections in perpetuity. They're putting duct tape over an earthquake fissure.

 

That characterization isn't meant to suggest that temporary measures can't close the fissure for a spell, or that the fissure is going to widen out and swallow us all. Rather, it's just to say that the issue at the heart of this week's funding squeeze wasn't addressed in a sustainable way at the September Fed meeting.

 

Going forward, the important thing will be for the Fed to communicate effectively ahead of the inevitable announcement of balance sheet expansión.

 

This is a subject that is poorly understood by most, and understood down to the granular details by a relative handful of rates strategists and those active in money markets. That means the Fed is walking a (very) fine line between educating the 99% of people who don't understand (so as to avoid accidentally creating the impression that "QE 4" is about to be launched), and convincing the 1% of people who do understand that the Fed isn't asleep at the wheel and appreciates the urgency of addressing reserve scarcity.

 

I wish them the best of luck in that endeavor and I wish you the best of luck in re-reading this post from the beginning so that you can be sure you're a well-informed investor.