Thursday, January 25, 2007

Who's Flying the Plane?

Central banks are finally getting concerned about the rapidly escalating systemic risk posed by credit derivatives. Just the sheer notional amount outstanding (est. at $35 trillion) and the very nature of the beast - it is nothing but naked put writing - is certainly reason enough for alarm. Speaking at the World Economic Forum in Davos yesterday Zhu Min, the Vice President of Bank of China, said: “You can easily get liquidity from the market every second for anything…We really don’t know what the risks are”. The ECB President Jean-Claude Trichet has previously said that investors may not be accurately assessing risk and so has ex-Fed Chairman Alan Greenspan.

But before discussing risk, let’s first concentrate on another aspect - that of interest rate control. Central banks consider interest rate control one of the few tools they have to regulate monetary policy. If rates are totally hijacked by the market central banks may end up having to use blunt instruments to achieve policy goals: open market purchases and sales of government bonds, banks’ reserve requirements, margin regulations, etc. Now, a determined central bank will always ultimately win – “you can’t fight the Fed” – because it can raise short rates to such an extent that even the most obdurate trader will eventually stand up and salute smartly. No central bank can long afford to be accused of pushing on a string, as the Fed was in 1999-2000 in the face of the dotcom IPO mania that had supposedly made interest rates irrelevant.

In previous posts we saw how demand for “free” money from writing credit default insurance is lowering CDS premiums, thus lowering overall market-driven interest rates. Of course this money is not really “free”, it is just that its price has ceased to be expressed in interest rate terms and has been replaced by the assumption of ever more risk. At some point, however, the course will reverse, risk premiums will rise and so will the cost of money.

Therein lies the Fed’s and other central banks’ quandary: long rates stayed flat even as the economy strengthened and credit demand soared, despite repeated hikes in short interest rates. I believe this has happened due to the CDS effect explained above (more detail in previous posts).

If the economy weakens and the Fed needs to stimulate by cutting rates, will market rates fall too? If my explanation is correct, they won’t – they may even rise substantially as the weakening economy heightens credit risk and raises CDS premiums from all time lows. In short, the central banks’ traditional role as the economy’s “punch bowl” provider and taker-away may no longer be relevant to the “real” economy. This is certain to give pause to central bankers: they can’t have the inebriated partying passengers flying the plane. Pretty soon the Fed and other central banks will have to wrest the controls back for themselves or face unintended financial aviation terrorism.

Back to discussing risk: central bankers have a language all of their own. Alan Greenspan was the Triple O Master (Obfuscation, Obscurantism and Opaqueness), having famously said that if you thought you understood him, you understood wrong. Thus, when they speak openly of risk we better listen and listen carefully. These are not people that are paid to provide opinions but to judge conditions and act accordingly. If they publicly say things are getting too risky it's because they are warning markets. If they pay attention and self-correct, fine: that's called moral suasion. If they don't, next comes intervention. Because no central banker ever wants to be accused of talking big but carrying a limp rope.

P.S. From our reverse indicator dept.: PriceWaterhouse reports that 92% of 1,084 corporate executives polled said that they are either "confident" or "very confident" about their prospects this year, the highest reading since the survey began ten years ago. And the market keeps selling naked puts; but then again there is that extra bit of "juice" - we could perhaps go to 99% confidence? As in "Stocks have reached what looks like a permanently high plateau". Need I remind anyone who and when made this memorable pronouncement?

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