Monday, October 29, 2007

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.


  1. I agree and I think the Fed thinks it may be time to "teach the markets a lesson".

    At this time it appears the Fed does not want to cut rates and feels pressured to do so. Like feeding a heroin addict constantly expecting more. Where does that get you?

    This may be the opportunity they need to put a floor under the dollar. They may even be able to do that by yielding to a 25 bps cut and stating that they are done, cutting the perception of an easing campaign. The earlier 50 bps cut was their way to assure the markets that they were not behind the curve. They didn't expect the markets to demsnd so much more so quickly, but in that regard they were totally naive. Shame on them.

  2. Great insights as usual

    What is your guess not your hope about the upcoming rate decision

    Do you thinks they could resist Paulson and friends at wallstreet
    and capitol hill

  3. We don't have enough data to adequately assess Bernanke's character yet. It all really depends on his spinal fortitude vs. "the Market", because he can't be so blind as to think that oil and food prices are rising simply due to one-off events.

    If he is a straight shooter he will cut 25 bp (so as not to totally upset the apple cart) but also include language that stresses the inflationary threats ahead, i.e. that's all for now.

    If not...50 bp.

  4. I don't know what to make of the spike in the High of the Fed Funds rate to 15% on 10/25/07. Any ideas? Relevant? Irrelevant?

    Somebody in trouble?

    Federal Funds Data


  5. I believe we have a willing accomplice in the FED. Remember that the FED is owned by private banks, and we pay them to buy our sovereign paper. Hell of a deal if ya can get it. Look at $BKX and $XBD for the clues.

  6. Ben Bittrolff said...
    I don't know what to make of the spike in the High of the Fed Funds rate to 15% on 10/25/07. Any ideas? Relevant? Irrelevant?

    Somebody in trouble?

    Federal Funds Data


    I read $75 million was the number on the 15 handle with lots of action in the 7 to 7.5 area as well. Someone is in deep shit! Don't ask for an official link because there ain't one.

  7. Re: Fed Funds

    For o/n transactions $75 million is small. And for 1 day, the difference between 15% and 5% on that amount is about $20.000. There are all sorts of technical reasons why this would have happened. You may have noticed that it was not repeated the day after.

    And there couldn't have been too many trades around the 7% handle because the effective rate (weighted average) was 4.86%.


  8. hellasious,

    don't you think the 'tail wagging the dog' argument also holds for crude oil and various other futures' determined commodity prices?

  9. As a public servant, his primary duty is to ensure their continuing economic welfare and not to shelter special interests from their own avarice.

    You are not serious, are you? How many public servants do you see around in the top arena, who are dying to serve American public? I can count only a handful - (i) Bush, (ii) Cheney, (iii) Paulson....

  10. 20K overnight is lot of money. What does it cost to hire a callgirl in NY lately?

  11. Great post, Hellasious...and I happen to be an avid reader of blogs.

  12. There was a Peter Drucker book. From the 80s I think - I'll have to go back and find out which one (hey - maybe I can use

    Anyway he stood what was conventional wisdom on its head. To wit: trade had always driven finance. Not any more according to Drucker: now finance will drive trade.

    Which doesn't exactly apply here. More obviously it applies to China's industrial rise.

    However if for the word 'trade' you substitute 'the so-called real economy' then it applies quite well.

    I had a vivid demonstration of that when I arrived in Japan in Oct of 89 as part of the Am half of a joint venture. And a finance firm. When I arrived the Nikkei was at 40,000. 6 mths later it was at 20,000. And don't think it's ever risen back above 20,000 in the intervening 17 yrs.

    But that's only the first half of my point. For some # of yrs in the early 90s the Japanese repeatedly told themselves - our industrial economy is a world-beater. Finance doesn't matter. And indeed, all through their post-WWII development they'd treated finance as a captive handmaiden (if you will). Much to their later peril.

    That finance should drive trade or even the whole of the economy is non-intuitive perhaps, but then I would guess many observers are sensing this change even if they can't quite yet put it to words (that's excluding hellasious of course).

  13. >Much to their later peril.

    Give it another ten years, and you will sing a different tune. It is just that cyclically Japan has always been 10 years ahead of US. Check their history in 1920s. They had their crash in 1920, while we had in 1929.

  14. "As a public servant, his primary duty is to ensure their continuing economic welfare and not to shelter special interests from their own avarice."

    Are you kidding me? Do you think dovish Fed JumboJet Ben will do such honorable thing. Ok ok, let hope he cut by 100bp and give a hawkish statement? But how many times have we fooled by hawkish statement?

  15. Oil rising, dollar tanking, only a fool would lower the rate. He should raise it 50 bp to where it was before.
    All he does it to create the next bubble in stocks & commodities. Once the rate reaches zero the game is over anyway, see Japan.

  16. The U.S. had a deflationary crash in 1921-22'..Read about Warren G. Harding...Now there was a President who understand what is a free market economic system...

  17. The Federal Reserve should raise by 100-200 BPS....And that should be just the beginning...

  18. If he is a straight shooter he will cut 25 bp (so as not to totally upset the apple cart) but also include language that stresses the inflationary threats ahead, i.e. that's all for now.
    Sorry, but that's just not gonna be enuf. 50bps or you're gonna see a lot of folks in deep severe, pronto.


    The Fed is between a rock and a hard place, as usual. If they raise rates by oh, say .50 bp, they will only temporarily bouy the dollar BECAUSE the overall effect of raising rates will shake the financial realm and the general economy such that they collectively begin to swirl the bowl in earnest. A tottering economy ultimately means a falling greenback.

    If the Fed doesn't raise rates, but opts to lower them, the dollar continues its sickening slide and the price of all that we import raw and otherwise continue to rise thereby straining the already strained consumer. Oops, a weakening consumer is the death knell for the economy.

    Having said all that, I believe that Hellasious is probably on target as to what the Fed will do, namely lower rates by a measly quarter point and issue a statement to the effect that the quarter point is all they have in mind for the forseeable future.

    Of course such a statement is ultimately meaningless piffle since we all know The Fed can and will drop rates in a nanosecond. But such statements generally provide them cover with the clueless lamestream media if nothing else.

    Technically, shares look ripe for a slide in here. so such a move from The Fed meeting as described by Hellascious fits perfectly with what is setting up chartswise as a November slide.

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