Groping in the Dark

It is dawning on a few Fed governors that they have loosed too much of a 'good thing' (the quote marks are meant to indicate that it's mainly a good thing from their point of view), so we now frequently hear voices from within the Fed worrying about what to do with the tiger they have by the tail. Jeremy Stein's March missive in which he articulated worries about overheating credit markets was an example.

A few days ago, Jon Hilsenrath, the Fed's media mouthpiece penned an article that conveys the degree of confusion. Here are a few excerpts:


“Fed officials have been struggling of late managing expectations about its plans for the $85-billion-a-month bond-buying program, known as “quantitative easing.”

At their policy meeting in May, Federal Reserve officials expressed anxiety about shifting market expectations for the Fed’s $85 billion-per-month bond buying program. “A few members expressed concerns that investor expectations of the cumulative size of the asset purchase program appeared to have increased somewhat since it was launched last September despite a notable decline in the unemployment rate and other improvements in the labor market since then,” according to the minutes of the meeting released last week.


One bit of evidence before the Fed at its last meeting was a survey, conducted by the Federal Reserve Bank of New York before each meeting, that asks big banks that serve as its main counter parties in the bond market a wide range of questions about their expectations for Fed policy. The survey, released to the pubic last week, warrants attention.

The latest survey showed that as of late April, most market participants expected the Fed to still be purchasing $85 billion per month of bonds by the fourth quarter. Most didn’t expect the program to end until the second quarter of 2014. (See question #5) In similar surveys in January and March, market participants expected the Fed to begin winding down the program by the fourth quarter and to have completed it by the first quarter of 2014.

Our own survey of private sector economists shows a similar shift in expectations. In March, 71% of economists surveyed by the Wall Street Journal expected the Fed to begin reducing the bond buying program before year end and 61% expected it to be completed before year-end. By our May survey, 55% expected the program to be slowed by year-end and only 17% expected it to be completed by then.


Last week marked a potential course correction in the expectations game. Fed chairman Ben Bernanke’s reset market expectations when he told the Joint Economic Committee that the Fed might start winding down the program within the next fed policy meetings. The Fed’s hawkish meeting minutes amplified the point.

The challenge is especially hard now, because the Fed doesn’t have handy tools to measure market expectations. Before the financial crisis, the Fed’s main tool was a short-term interest rates – the one at which banks lend to each other overnight, the federal fund rates. It could look to the futures market to gauge what markets expected the Fed to do and when. But futures markets don’t track expectations for bond buying, leaving the Fed in a guessing game. That’s why surveys like the New York Fed primary dealer survey are now so important.”


(emphasis added)

We have long argued that the activities of central banks are essentially a special case of the socialist calculation problem. They are socialist islands in a capitalist ocean, and as such can observe 'prices' (in this case, not really prices, but interest rates) that form in the private sector. Although these are in a feedback loop with the central bank's actions and expectations about its actions, the Fed usually 'follows' market rates. However, what Hilsenrath tells us above is that they can no longer play that game under current conditions – conditions they themselves have created. Let us repeat the relevant passage:


Before the financial crisis, the Fed’s main tool was a short-term interest rates – the one at which banks lend to each other overnight, the federal fund rates. It could look to the futures market to gauge what markets expected the Fed to do and when. But futures markets don’t track expectations for bond buying, leaving the Fed in a guessing game.”


In other words, the Fed has now  finally arrived at the situation socialist central planners in the former Eastern Bloc command economies would have found themselves in if they had not been able to observe prices in capitalist economies:

They are completely groping in the dark.


This vastly increases the chance that the current echo bubble will end in another huge crash, because they will commit even more errors than they are usually prone to do.


Rosengren – Fed Needs to 'Do More'

A well known dove, Boston Fed president Eric Rosengren, recently added to market expectations that 'QE' will not only continue, but may even be expanded. According to him, the current  unemployment rate and current 'inflation' rates are still too far away from reaching the Fed's goals.


“Federal Reserve Bank of Boston President Eric Rosengren said the Fed should press on with record stimulus to speed economic growth, reduce 7.5 percent unemployment and boost inflation running below 2 percent.

While the labor market has improved, “significant accommodation remains appropriate at this time,” Rosengren said today in a speech in Minneapolis. “If the incoming economic data do not reflect improvements consistent with both elements of our dual mandate, I believe the Fed should be willing to increase asset purchases,” he said, referring to the central bank’s goal to achieve stable prices and full employment.

The Boston Fed chief is among policy makers warning that inflation — which slowed to 1 percent in March as measured by the personal consumption expenditures index — could impair growth should it decline further. A voter this year on monetary policy, Rosengren echoed testimony last week by Chairman Ben S. Bernanke, who said “premature tightening” could reduce inflation and jeopardize the economic expansion.

Rosengren has consistently backed the Fed’s record stimulus. He dissented at a December 2007 Federal Open Market Committee meeting because he favored more accommodative policy.”


(emphasis added)

Obviously we have yet another believer in the myth that inflation causes 'growth' here. Has the whole world gone crazy? Actually, the answer is yes, as you will see further below.



Boston Fed chief Rosengren: yet another 'inflation is not high enough' apostle

(Photo via FoxNews)



Peter Atwater on Kuroda – The Coming Loss of Faith in Central Banks

In the context of the above and as an addendum to what we have previously written about Japan, we want to direct readers to an excellent article by Peter Atwater on the Kuroda gambit.  We wish we had thought of the title ourselves: “What If Abenomics Is to Policy-Making What Subprime Lending Was to Housing?

Atwater discusses a topic that we have frequently mentioned in these pages and the importance of which we believe cannot be stressed enough. Namely the fact that faith in the omnipotence of central banks is eventually going to erode and when it goes, we will see market upheaval like never before. Our own theory on this point is that both the 2008 crisis and the subsequent euro area debt crisis have shown that central banks were really the last bastion able to restore investor confidence. It follows from this that in the event that confidence in central banks wanes, the mother of all financial accidents is likely to follow.

Here are a few pertinent excerpts from Atwater's article, which is well worth reading in its entirety:


“To succeed, Mr. Kuroda would need complete capitulation. To whip deflation, Mr. Kuroda required an immediate and profound shift in the market’s belief system. He had to reset expectations and convince businesses, consumers, and other policymakers that “everything from wages and corporate profits to the price of stocks” would be on the rise. There was no room for even the slightest hesitation or doubt; no time for questionable “green shoots.” Everyone had to immediately buy into the certainty of a mature bamboo forest watered to perfection by central bank liquidity.

For investors already primed by the Fed’s Buzz Lightyear and the ECB’s “whatever it takes” extreme monetary policy actions, the message was clear: Go long the Nikkei and Japanese Government Bond and short the yen, and do it with the maximum amount of leverage as possible.  This wasn’t just a TINA (“Theirs Is No Alternative”) trade, this was the TINA trade, where it paid to immediately capitulate and in size. Investors met Mr. Kuroda's craziness and immediately raised him.


What fascinates me most, though, about the situation in Japan, was not the action of the BOJ, but the behavior of investors: They completely capitulated. Having been well-primed by prior experience, they didn’t wait to be painted into a corner by policymakers; they eagerly took out their own brushes and painted themselves into a corner. TINA became TOA – “The Only Alternative.”

While on the surface this would appear to be a major victory for central bankers, I am afraid that Mr. Kuroda’s success may represent a peak in investor confidence in central bank policymakers. After capitulation – particularly saturating capitulation in which everyone is all in – what does a central banker do for an encore?


I would pay extremely close attention to what now happens in Japan. Bubble bursts have a LIFO (last in / first out) quality to them.  The most extreme case, which occurs at the very peak of confidence, always turns first. Given the yield move in JGBs over the past six weeks and last week’s move in the Nikkei, it feels like a major turn is now afoot. While this doesn’t prevent other global markets from going on to new highs, I would be very careful to assume that what has taken place in Japan this week is at all contained. Like subprime mortgages in 2007, “contained” is more likely to mean "just the beginning."

Even more, when it comes to confidence in global central banking, investors can’t be half-pregnant. One either believes or doesn’t. The decision is binary. One is either painted into a corner or isn’t. Admittedly, there is an enormous irony for policymakers in all of this. Like every other market Big Truth, when everyone is certain it is true, the top is in. For central bankers, I am afraid that once everyone believes in their omnipotence, it is lost.”


(emphasis added)

Obviously we believe Mr. Atwater is on to something here. It may still be too early to sound the death-knell on the Kuroda reflation experiment, but there is a reason why we have recently spilled so much ink on Japan and tried to familiarize readers with every possible angle of the Kuroda gambit. We always stress that one must keep an eye on the JGB market, as that is the market in which control will most likely be lost. However, there are other possibilities as well, and it is even likely that eventually, several markets are going to haywire at the same time. Anyway, Atwater's point that “once everybody believes in the omnipotence of central banks, it is lost”, strikes us as extremely important.

Now think about what we noted about the Fed and its 'QE' program above: the Fed is now 'groping in the dark' – similar to a socialist central planning organization that can no longer observe the outside market signals that are most relevant to its plans. We conclude that the times are sooner or later going to get very 'interesting', in the Chinese curse sense.



kurodaBoJ chief Haruhiko Kuroda: trust me, I'm crazy.

(Photo credit: AP Photo/Pat Roque)




5 year CDS on the sovereign debt of France, Belgium, Ireland and Japan (the white line) – while CDS spreads on Japan's debt are still down quite a bit from the levels reached at the height of the euro area crisis, the gap between them and their European counterparts continues to increase – via Bloomberg – click to enlarge.



Japanese Margin Traders

The losses and gains of Japanese margin traders, the ultimate contrary indicators, via Sentimentrader. They have never made as much money as now – click to enlarge.





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4 Responses to “Taper Dance”

  • No6:

    Kuroda, another financial terrorist.

  • 6 years ago $800 billion and change was enough and now $3 trillion isn’t? I have to believe some of these Fed characters and guys like Krugman need to be examined at a psychiatric ward?

  • zerobs:

    What fascinates me most, though, about the situation in Japan, was not the action of the BOJ, but the behavior of investors: They completely capitulated.

    Can someone help me out here? WHO EXACTLY are these investors? The reason I ask is that public pension funds are such a large percentage of the market that they will just as easily “invest” based on political winds as they will on actuarial risk calculations.

    Lumping all investors into one bucket isn’t helping me understand any better. I’m wondering if we really have Western-style markets at all anymore or if we have nothing but central planning activity sliced and diced and dressed up in the costumes of a bygone market era along with a minority of players/suckers who don’t realize it’s actually a costume party.

    • mc:

      The graph shows it well, and the article discusses it – margin trading. Whatever tiny capital could be leveraged, speculators and trading desks piled in the same exact trade with the near-hyperbolic price movement as a result. The enormous carry trade of borrowing low-interest yen and loaning in higher interest rate markets like Australia should have large paper gains at the moment that could be borrowed against to fund this trade. That is why this action from so many is so stunning, as this is going to be a zero-sum game when the positions are exited. And exit they have to, as the collateral for such margin is Japan is JGBs that can only be invincible for so long. The very goal of Abenomics, real sustained price inflation, will be successful when it destroys the JGB market.

      In the end, it is the triple paradox (aka Impossible Trinity), where a country cannot have all three:
      Control the exchange rate
      Free capital movement (absence of capital controls).
      An independent monetary policy.

      And it appears Japan will break the free movement of capital with exchange controls. Pretty quickly after the free movement of capital is impaired, the enormous amount of foreign investment into and out of Japan will be disrupted. Attempts to keep the interest rates low with purchases of JGBs will fail eventually when local inflation finally increases and interests rates rise. Having the lowest interest rates in history for decades has distorted all capital flows in Japan, and even a slight disturbance of 10-year rates at even 1+% will have large ripple effects.

      The JCB is literally trying to defy economic law and have it all, breaking the triple paradox, saying the impossible trinity can be made reality. Weak yen, low rates, yet happy savers keeping their money in Japan with 0.34% 5yr JGBs, despite the yen now falling vs major currencies?

      0.3% yield on 5 yr JGB + 2.4% (annual increase of yen vs dollar 1996-2012) – inflation of -0.5%/yr (minor price deflation over time period) = 3.2% real yield, thus a stable return for the average japanese JGB investor then.

      0.3% yield – 2% annualized loss of yen vs major currencies (assuming the 30% loss in 6 mo tapers to just a small relative weakness, and the JCB continues policy of extolling weak yen) – inflation of 2% (goal) = -3.7% real yield now for domestic savers.

      Pop goes the central banking faith bubble.

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