Diary of a Financier

The Fed Won’t Do It, Not Yet

In Politics on Wed 21 Sep 2011 at 08:57

T minus five. The Federal Reserve will conduct a press conference this afternoon at 2:15pm EST. At least for the US, the event is a much-anticipated culmination to a summer calendar riddled with political checkpoints. As of this week, I do not expect material action from today’s announcement. I do, however, expect more of a plan for action.

Yesterday, Goldman Sachs printed a client note, which neatly framed consensus expectations for the outcome of this Fed meeting:

Recent press reports have signaled Fed officials are considering three specific easing options:

  1. Change in balance sheet composition… It has been dubbed a new “Operation Twist” after a similar Fed program in the 1960s. We believe the Fed will announce outright sales of short-term Treasuries coupled with purchases of longer-term Treasuries in order to lengthen the average maturity of its securities portfolio.
  2. Cut in interest on excess reserves (IOER) rate. Although it is a much closer call, we also believe the FOMC will announce a cut in the IOER rate—the rate the Fed pays banks for their excess reserve deposits.
  3. Change communication about policy objectives. Another policy option that has received increased attention lately would tie the FOMC’s rate commitment language more closely to economic conditions, in order to bring greater clarity to the central bank’s goals and intentions.

I discussed all of these scenarios as early as this Spring. They’re sheepish solutions, mostly window dressing. I’m balking now, in the 11th hour, regarding expectations for any large developments out of the Fed. I do not think the Fed will launch any [re]new[ed] programs today. (More on this later.) Specifically, I doubt any insinuations from Mr. Bernanke will stoke capital markets today. I think the Fed will withhold any “shock-and-awe” programs for upcoming [European] crises. “Operation Twist” is not one such program. A twist is merely a shuffling of the deck. It guts the belly of the yield curve, sending capital scurrying up Exter’s Pyramid like maggots from a corpse. I do expect Mr. Bernanke will launch Operation Twist today. However, nothing sustainable is wrought from a twist, hence I maintain my insistence that sustainable solutions must arrive from the fiscal realm and monetary policy can only build bridges over troubled waters.

Part of my low expectations for imminent Fed [in]action derives from US Dollar swap lines having redoubled in Europe. The ECB has weekly released information about a few banks’ tapping the liquidity pool. I’ll concede that this is somewhat necessary due to the surge in USD funding costs for European institutions, as evident in LIBOR:

LIBOR 12M- surge in USD funding costs

European banks are having trouble funding USD obligations, whether via traditional debt market offerings or overnight borrowing. China announced yesterday that they were shutting European banks out of their FX markets. These aforementioned Fed/ECB swap lines allow the US to infuse the foreign system with USD, aiding Mr. Bernanke’s QE intentions that are so politically painful to implement domestically.*

We’ll frankly never know what the economic outcome would had been void of QEs 1 & 2. I shudder at the thought though. Just consider the onslaught of natural disasters (Japan) and socioeconomic hindrances (MENA & Europe) that historically plunge capital markets ahead of economics. I must echo the recent comments from Market Anthropology and my own Diary entries, which celebrate the underperformance of Financials as a steady “workout” phase. Aided by an accommodative Fed, bank writedowns are a step in the right direction–away from a zombie nation–as long as markets don’t shut these institutions out of liquidity access. I’d prefer to see the toxic assets quarantined, but what’s transpiring is another man’s approach–albeit dovish and prolonged.

With bonds having rallied so epically, the Fed’s biggest risk in deferring material action would lay in fixed income carnage a la 1994. The monthly chart of Treasury 10-year bond futures (TY/) shows how extended the rally is:

TY monthly (1981-2011)

That’s why I expect Mr. Bernanke to drop a pricetag today, perhaps signaling that ‘the Fed governors agreed to standby with $500B in fresh capital for further easing in the Treasury & MBS markets, if warranted by crisis conditions.’

This guidance of expectations could save a brutal unwind in the bond market, although some air will likely leak from longer maturities, which are almost at the top of their historical ranges anyway.

Beyond that, I have to note precious metals like Gold (GC/) and Silver (SI/) at the bottom of their short-term fractals’ trading ranges. An even greater anomaly, a major decoupling of Copper (HG/) and S&P 500 futures (ES/) presents a convergence opportunity for the short-term:

ES v HG daily- indicators exhibit major decoupling that

ES v HG daily- illustration of Copper’s dip below support

Last week, I had mentioned HG bottoming in alarming advance of ES. It’s a short-term mispricing in the relationship–a fact supported by the overlay of more deterministic, monthly fractals of the pair. ES:HG high correlation set in after 2000, whence financialization & monetization seized markets:

ES v HG monthly- both look like they’re heading lower.

I’d outright buy the Copper ETF (JJC) if the Fed were to announce liquidity measures this afternoon. Otherwise, I’m compelled to pair a short SPY with that long JJC to capture the compression.


*A very important & interesting caution about these Fed/ECB swap lines: the Fed does not require specific interest or collateral from borrowing institutions. Instead, it leaves such terms in the hands of the ECB, with which the Fed merely settles for the central bank’s guarantee and a no-cost FX forward to unwind the arrangement. This exposes the Fed to significant counterparty risk, and in the event of material bankruptcies or defaults in the Eurozone, a return of capital could come to question. Further, if the EMU were to disintegrate, the ECB would likely cease to exist as an institution. This makes me think of Merrill Lynch, which had hedged its CDO exposure with monolines, yet in Merrill’s hour of need, the monolines themselves were insolvent, rendering Merrill’s protection worthless.

  1. I wouldn’t bet Copper will outperform the SPX.
    Troubles in China haven’t even started yet.

    If global trade gets crushed again, as I believe it will, China has much smaller room for the massive credit expansion they did in late 2008/early 2009 to fund fixed-asset investments while their exports collapsed…

    • Theoretically, I agree. In fact, HG Copper has vastly outperformed Shanghai (SSE) since the bottom, which would suggest HG has a long way down to go.
      I consider the Sino-American relationship mutually symbiotic at best–to be polite and apolitical. Regardless, SPX/SSE fates are intertwine, with SPX components heavily investing in China since 2008. There’s more leverage in China, much greater downside, and Copper seems to have been used as collateral for some of that leverage. Wrought with caveats, you’re right.
      If you’ve followed this diary, you’ll know I’m a big China bear. The HG/SPX pair trade was set-up to capitalize on a potential short-term pricing anomaly. I almost never open a trade with a chart pattern like HG’s, thus I haven’t acted. There’s been no lift off these lows yet, and Copper is down ~6% today–leading the way down. If I got my signal for an entry point, the story would have perhaps been different: Copper mispricing (convergence trade) rather than Copper leading indicator.

  2. The way the world is looking like right now, with policy makers empty handed to end this crisis I find it very, very difficult to do relative trades.

    And in bear markets, when banks are suffering, it seems that the smaller the market the toughest it is to outperform.

    In up-swings, yes, but I am structurally very, very bearish.
    Positions I liked before and now I like even more are long German CDS, long USDCNY calls, long XAUXAG, and long JPY Swaption payers.

    Short EURBRL and receiving BRL rates Jul12.

    Let’s hope for the best. 🙂

  3. […] mentioned (and predicted) the Fed’s renewed swap lines with the ECB. The Eurocrisis has caused a […]

  4. […] mentioned (and predicted) the Fed’s renewed swap lines with the ECB. The Eurocrisis has caused a […]

  5. […] Bernanke (or maybe Tim Geithner) has the clout to move markets with rumor.  To wit, I reiterate my expectation that Mr. Bernanke will defer action until after Eurocrisis Event Horizon; why waste resources before […]

  6. […] (or maybe Tim Geithner) has the clout to move markets with rumor.  To wit, I reiterate my expectation that Mr. Bernanke will defer action until after Eurocrisis Event Horizon; why waste resources before […]


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