In 1964, the Supreme Court heard the obscenity case of
Jacobellis v. Ohio.
That decision became infamous for Justice Potter Stewart’s attempt to define obscenity:
"I
shall not today attempt further to define the kinds of material I understand to
be embraced . . . [b]ut I know it when I see it . . . "
That statement, while possibly true, had no salutary effect,
at least in terms of providing guidance to the legal community as to what is
obscene. When it comes to providing counsel, the “I know when I see it”
standard is a rather ambiguous one to apply. The now infamous pronouncement led
to decades of confusion amongst the courts.
Which brings us to the Fed, and their metronomic approach to
raising interest rates towards the so-called “neutral accommodation.” During
yesterday’s congressional Q&A, Fed Chairman Alan Greenspan was asked why
the 30-year interest rates have not risen with shorter-term rates. Greenspan
famously called it a “Conundrum.”
It was one of those rare instances where a bon mot enters
the lexicon almost immediately. To that short list, right next to “Irrational
Exuberance,” we shall now add the convoluted word “Conundrum.” We expect a book of the same title by a Yale economics professor to follow shortly.
But while everyone seems to be focused on the multi-syllabic
expression for riddle, they may have missed the Fed Chief’s more intriguing
comment. When asked what a more neutral level of accommodation might look like,
the Fed Chair opined he would know it when he saw it.
It seems that “Neutral
Accommodation” is the new obscenity.
Considering how transparent, measured and predictable the
Fed has been in this tightening cycle, one wonders why the sudden reversion to
obfuscation. As the Fed moved away from 40-year low rates, bonds have failed to
keep pace. Rates are actually lower today then they were when the Fed first
started tightening.
Perhaps the Greenspan has grown weary of being ignored by
the bond market.
While the Fed Chief has many virtues, predicting what
markets will do is not one of them: He’s been notoriously wrong on natural gas prices, equities, crude
oil, and now bonds. If there is a disagreement about where interest rates are
going to go between the Fed Chair and the Bond Market – the so-called conundrum
– than that’s an easy bet to place.
My money is on the Bond market.
Words like “measured” and “accomodative” have been used. Yet, the Mortgage Finance industry, developed and aggressively marketed variable-rate products, interest-only loans, and flexible home equity lines of Credit.
Wall Street investment bankers focused on issuing variable-rate corporate debt, while the “financial engineers” in structured financed set their sights on transforming $100s of billions of variable-rate and subprime mortgage loans into enticing collateralized debt obligations (CDOs), MBS, ABS, and myriad derivative products.
After the “warnings”, an enormous amount of interest-rate hedging was put in place that was, in reality, untenable. Again, I would assert that the Fed’s warnings of higher rates and the market’s rational reaction (large-scale hedging and bearish speculating) assured either a self-reinforcing downward spiral in bond prices (spike in rates) or an unfolding major “squeeze,” a derivative unwind, and destabilizing drop in rates.
Much like in the NASDAQ 2000, we are now witnessing the latter….a short-squeeze and unwind of interest-rate hedges throughout the Credit market.
If the offset between long-term and short-term rates were to shift in the opposite direction would it then be called a proundrum?