Upcoming FOMC Meeting

With the next FOMC meeting almost upon us (Oct. 31st), a review of the dollar LIBOR money market yield curve(s) is in order. See chart below, click to enlarge.

A week before the Fed's last 50 bp cut the curve was ugly (red line), with a huge 60 bp spread between o/n and 1m rates. The market thus pushed the Fed into doing a rather embarrassing full monty, discussed in a previous post. The curve immediately normalized (blue line), saving speculators tens of billions in losses. As we learned a bit later, the decision was not exactly reached in splendid academic and institutional isolation.

Data: BBA

What do the curves tell us about the current situation?

There is presently no immediate short-term funding abnormality in the interbank market (yellow line) and from this perspective alone the Fed could sit tight, particularly with inflationary pressures increasing daily (oil is at $93/bbl today). However, the very same curve tells us that this is not how the market perceives things: it is steeply inverted past the 3m period, meaning the market is betting more rate cuts will be forthcoming soon. The 12m rate is a full 40 bp below the 3m rate and, even more significantly, 20 bp below o/n, which is Wall Street's rather unsubtle way of trying to force the Fed's hand once more.

Should the Fed oblige? The answer is a matter of opinion, depending on how one views the role of the central bank. During the Greenspan years the Fed established a pattern of paying close attention to market signals and acting in close co-operation with Treasury Secretaries, who also came mostly from Wall Street. That modus replaced the prior, slightly antagonistic ''push me - pull you" balance that existed between the Fed and the executive branch. The friendship and professional esteem between Mr. Greenspan and the Secretaries/Wall Street played a decisive role in generating mutual trust, so that monetary policy decisions could somewhat objectively rely on market signals. For the most part the scheme worked well.

But the playing field is entirely different today. First of all, markets are no longer acting as signals for the economy; instead they have largely become the economy, wholly dependent as it is on asset prices. And while real estate prices may not be readily manipulated, financial markets have increasingly become prone to institutionalized "steering". Some say that markets are too large for this to happen, but size is not the decisive factor today. While markets are certainly larger than ever before, their control has also become highly concentrated. M&A activity has created financial titans in banking and fund management and the spread of structured and derivative products has allowed for increased operating leverage.

In the past, "cash" markets (i.e. plain stocks and bonds) directly affected and controlled their thinner and more volatile derivatives; today the reverse is true: derivatives markets can be larger, deeper and in many cases more cost efficient to do business in than their referenced primary instruments. The tail can easily wag the dog and, from all appearances, it frequently does. Furthermore, it is not just the "pure" derivatives that matter; there is a whole slew of engineered products like index trackers, contracts for difference, financial betting, ETFs and structured bonds that act, or can be forced to act, as derivatives.

For example, unlike a plain vanilla index mutual fund that buys or sells shares depending on investor inflows and redemptions (i.e. tangible money flows), a tracker is forced to buy or sell shares depending on the performance of its benchmark alone. There are now literally thousands of such obligatory correlation trades that happen daily, throughout all asset classes. What is more, derivative trading is concentrated amongst just a handful of sophisticated investment banks and their leveraged customers, i.e. hedge and private equity funds. In other words, the game is being gamed to a greater extent than in the past.

I am thus of the opinion that the Fed - and all other central banks - should be cautious; they should carefully analyse and question the provenance and validity of all market signals, as they may no longer be as impartial as in the past. To draw an analogy, the cries of "wolf" may now be originating from within the wolf pack itself, waiting in ambush for the rescue party.

It is all too easy for a new Fed chairman to get sandbagged by Wall Street, particularly at a time when its leaders reign supreme over the economic and political affairs of the nation. However, I honestly hope that Mr. Bernanke appreciates that his authority ultimately derives from a much broader base of citizens. As a public servant, his primary duty is to ensure their continuing economic welfare and not to shelter special interests from their own avarice.