Lordie, the market upset we’ve had over the past week plus over Bernanke using the T, as in “tapering” word, is escalating into a full-blown hissy fit. We now have the Wall Street Journal and other finance-oriented venues telling us how unbelievably important today’s job report is. Huh? One jobs report is just another in a long series of data points.
So why has this one been assigned earth-shaking importance? Let’s look at what is going on in the economy:
1. PMI has slipped into negative territory
2. Refis (a boost to consumer ability to spend) are falling fast
5. Unemployment is over the Fed’s target and we still have a ton of discouraged workers and underemployment
6. The sequester will only make 1-5 worse.
This reading is corroborated by reader responses to our latest query on local conditions. The bottom line from geographically wide ranging reports seemed to be that while certain areas were hot (and the biggest seems to be Washington, DC), the rest of the country is at best mixed, with a lot of erosion beneath the surface.
Before the markets’ “loose lips sink ships” freakout, we did have a frothy-looking stock market, rising home prices (but at a far lower level of activity than previous housing recoveries) and rising (but still not all that good) consumer confidence as offsets.
So what was Bernanke thinking with even mentioning tapering? The savvy economists I know are uniformly of the view that there is no way the economy will be strong enough for the Fed to let up on QE any time soon (not that I believe that QE does all that much for the real economy, but it does help the confidence fairy).
Possible motivators are:
1. Perversely, because the Fed believes in QE, it has to believe the economy is getting better, ergo not to believe it will need to take its foot of the gas would be an admission of central bank impotence. Horrors!
2. As discussed in earlier posts, the Fed under Greenspan took to signaling interest rate increases way way in advance to give the big boys the opportunity to reorganize their affairs accordingly. But since the Fed has targeted quantities, and not yields or bond prices, it can’t assure a slow and steady exit. And the fact that no one has confidence in how the exit might work (and on top of that, there’s a lot of misunderstanding, for instance, some believing that the Fed needs to sell bonds when MBS amortize in 5-ish years), which is not exactly helpful
3. The Fed may be feeling political pressure and/or rebellion in its ranks (see here for instance). Many investors are uncomfortable with the size of the Fed’s balance sheet. Given that it took a pitched battle for the Fed to escape full-blown, ongoing Audit the Fed, some members of the Board of Governors might lean to getting out of QE on the early side simply to reduce the noise level. Since Alan Grayson sent a letter to Bernanke asking some pointed questions about the Fed’s exit strategy, political worries might not be completely unfounded. The body of his letter to Bernanke dated June 5:
Over the past two months, the prices of agency mortgage-backed securities – including those on the balance sheet of the Federal Reserve – have declined. This decline is consistent with broader interest rate increases. It is possible that interest rates could continue to increase, causing a further decline in the value of assets held by the Federal Reserve.
With this is in mind, I have the following questions:
1) How have rising rates over the past two months affected the value of the mortgage-backed assets on the Federal Reserve’s balance sheet?
2) What has the Federal Reserve done, if anything, to mitigate possible losses?
3) Considering the significant possible losses implied by a $3 trillion balance sheet, will the Federal Reserve be marking its assets to market?
4) What effect, if any, will the Federal Reserve’s shrinking to negative capital base have on the economy?
5) Will rising interest rates and associated balance sheet losses mean the Federal Reserve will reduce or end its contributions to the Treasury?
6) Is it possible that the Federal Reserve could require a fiscal infusion from the Treasury should the central bank capital base become technically insolvent? If not, what is the legal basis for the Federal Reserve operating with negative capital?
7) Considering that major losses to the Federal Reserve would be, at the very least, an embarrassment for the central bank, is there an institutional bias towards continuing quantitative easing so as to prevent or delay such an embarrassment? Have you taken any steps to mitigate this institutional conflict of interest?
8) What is your internal policy regarding remittances to the Treasury?
What I find odd about the period after the markets started getting upset about the taper talk isn’t that there was a negative reaction. It’s that no one from the central bank has gone out to reassure rattled nerves. Damage containment has been the response every time there’s been an official pronouncement that has landed with a splat. Calm everyone down and consider whether to soft-sell later.
So investors and bankers have escalated their hissy fit. For instance, the Financial Times blares, Doubts over Fed’s QE3 spark dollar fall. Huh? We had Abe make his Abenomics Part 3 dud announcement, which led to a yen rally, and the ECB stand pat, which helped the Euro. But the dollar fall is all the Fed’s fault. Really?
Similarly, William Pesek in Bloomberg argues that the “bond crash” of 1994 visited all sorts of horrors on investors, including the Asian crisis of 1997. Erm, the reason for the big losses in 1994 were due not so much to tightening as to the fact that Greenspan surprised everyone (the consensus was overwhelmingly for further interest rate reductions) AND unbeknownst to the central bank, there were a ton of derivative bets on further interest rate declines. The derivatives losses were bigger than the 1987 crash and prompted a host of Congressional investigation but squat in the way of reforms. And hot money was messing up emerging markets before the Fed increased rates; I was in Indonesia in early 1995 (the rate move was late 1994, too soon to affect the real economy in emerging markets) and you could see it was bubbly even then. Way way too much new construction. Similarly, the Asian Tigers could have choked off the hot money but chose not to. So this is a long winded way of saying there is some truth to Pesek’s charges, the financiers are playing it up because they’ve come to believe they have an imperial right to profit and to be protected from risk. So tell me again why you deserve the big bucks, if it isn’t for your risk management and investing acumen?
So it still isn’t clear what the Fed was thinking in bringing up tapering now, and continued oracular silence hasn’t helped matters. The central bank may figure the jobs release today will allow it to maintain its pose of mystery, and if not, it can take to the squawkbox later in the day. But will they? Stay tuned.