Two Different Conversations In The Marketplace

James Bianco has run Bianco Research out of Chicago since November 1990. He has been producing fixed income commentaries with a circulation of hundreds of portfolio managers and traders. Jim’s commentaries have a special emphasis on: money flow characteristics of primary dealers, mutual funds, hedge funds, futures traders, banks, and institutional investors.

Prior to founding Bianco Research, Jim spent time in New York as Market Strategist for UBS Securities, and Equity Technical Analyst at First Boston and Shearson Lehman Brothers. He is a Chartered Market Technician (CMT) and a member of the Market Technicians Association (MTA).


October 28, 2009

Two Different Conversations In The Marketplace

Below are some passages from Don Kohn’s speech on October 9 in Washington followed by an FT article written be Gillian Tett (who is one of the best financial journalists in the business).

Currently there are two conversations in the marketplace. One conversation, which Gillian Tett writes about, is among professional investors about the effect of cheap money on asset prices. The other conversation, as vocalized by Don Kohn, is common in Federal Reserve speeches and is about anything but the effect of cheap money on asset prices. I started in this business in 1984 and I cannot remember a time when these groups have been having such different and stark conversations. Usually both groups have the same conversation and argue about conclusions.

My take on Kohn’s speech …

“The Federal Reserve has no models or research to judge the effect of 0% interest rates on the financial markets. Their research is only geared toward its effect on the real economy. So, they do not know if a 0% funds rate (or a 0% financing rate) is creating the third financial bubble of the last dozen years.

Kohn’s speech would have been fine and useful had he given it before the credit crisis as a call to beef up research in this area. But to say it 10 months after the Federal Reserve cut to 0% and blew up its balance sheet to $2+ trillion is unsettling to say the least. It confirms an often-heard comment that “they do not know what they are doing.”

Didn’t Kohn just say this with respect to current policy’s effect on the financial markets?

This will complicate the Federal Reserve’s efforts to assist the economy via monetary policy. Their silence on this subject was deafening. Kohn’s “we don’t have a clue” speech was, in my opinion, not helpful.

What to do?

The answer is very simple … less transparency. Let more uncertainty creep into the markets and punters will be less willing to leverage up.

The problem is the Federal Reserve is doing the opposite. Last week the NY Federal Reserve issued a press release saying they were testing reverse repos.

God forbid some over-leveraged hedge fund momentarily got afraid the exit strategy started and sell! We cannot have that, so we have to make sure everyone knows carry is safe!

Then, we have this endless discussion and loathing about getting rid of “extended period” in the FOMC statement. Why is this so hard? Get rid of it and other forward-looking statements.

The fact that the Federal Reserve jumps through hoops to make sure everyone knows the steep yield curve and carry are safe encourages the formation of a bubble.

Many I talk to think this is exactly what the Federal Reserve wants. They want to bail out the financial crisis with another bubble and leverage traders are only too happy to oblige.

Vice Chairman Donald L. Kohn

At the Federal Reserve Conference on Key Developments in Monetary Policy, Washington, D.C.

October 9, 2009 Monetary Policy Research and the Financial Crisis: Strengths and Shortcomings

It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research.10 For example, the standard framework used in dynamic general equilibrium models, with its simplifying emphasis on a single representative agent, does not lend itself to analysis of financial intermediation.11 …

Research on the credit channel and developments within the financial sector should be paired with work on asset prices and their role in the transmission of economic shocks and monetary policy. In neoclassical models, asset prices affect spending and investment decisions through substitution and wealth effects. But these channels fail to capture the multiplicity of interactions among asset prices, credit, and real activity that became so important in the current crisis, and in particular, how fluctuations in asset prices can affect the availability and terms of credit to different types of borrowers. This failure to capture all of the elements in play is most apparent by looking back at the course of house prices and their effect on the financial system and economic activity. It is now clear that house prices in the United States became overvalued over some period leading up to 2006. The rise in house prices contributed to an increase in credit availability, and the bursting of the bubble, by affecting financial intermediaries as well as households, had larger adverse effects than anticipated. Lower house prices caused the prices of mortgage-related securities to decline, which weakened the balance sheets of a broad array of financial institutions. Financial institutions’ need to rebuild their capital positions led them to adopt more-restrictive lending practices. The restriction on credit supply in turn put downward pressure on asset prices on economic activity, further damaging banks’ asset values and setting off another round of credit restriction. The various mechanisms that have tended to amplify asset price movements and the feedback among those movements, credit supply, and economic activity were not well captured by the models used at most central banks.

Our limited knowledge of the determinants of asset prices and their effects on credit has made it more challenging to respond to the crisis and explain our actions to the public. We have had to relax our standard assumptions that financial assets are highly substitutable, and that their rates of return can be readily arbitraged. For example, the degree to which assets of different types and maturities are imperfect substitutes is central to understanding the large-scale asset purchase, or LSAP, program of the Federal Reserve. Our purchases of longer-term Treasury, agency, and agency-guaranteed mortgage-backed securities were undertaken to support aggregate demand. These actions were designed to lower mortgage and other interest rates by exerting downward pressure on yields on assets that are only imperfectly substitutable for very short-term assets, and whose substitutability for those very short-term assets likely has decreased in the crisis period. In addition, discussions of the effects of the buildup in reserves at the Federal Reserve and other central banks often emphasize the imperfect substitutability of reserves for other bank assets, even when those reserves are remunerated at something like a market interest rate. More generally, while most of the literature on the effects of monetary policy assumes that the federal funds rate is the single relevant tool for monetary policy, the financial crisis has shown that a wide array of policy measures, acting on the prices of different assets, may be needed in extreme circumstances. The research literature that could help gauge the potential impact of these measures–and the exit from them–is disappointingly sparse.

A better understanding of asset prices, the credit channel, and their interaction also would seem to be critical for successfully carrying out some of the tasks central banks and other authorities are being urged to take on in the future. Discussions of macroprudential regulation of financial institutions have noted the tendency for financial crises to be preceded by bubbles spurred by financial liberalization or innovations, and how the most pernicious crises have been associated with disruptions to credit provision that resulted from excessive leverage.18 And increasingly, central banks are being encouraged to “lean against the wind” in the face of asset price bubbles. As researchers, we need to be honest about our very limited ability to assess the “fundamental value” of an asset or to predict its price. But the housing and credit bubbles have had a substantial cost–and the final bill is not yet in. Research on asset prices, credit, and intermediation should help to identify risks and inform decisions about the costs and benefits from a possible regulatory or monetary policy decision attempting to deal with a potential asset price bubble.


  • The Financial Times (Oct 23) – Gillian Tett: Rally fuelled by cheap money brings a sense of forebodingEarlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.“Forget about the events of the past 12 months . . . the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players . . . jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

    I daresay this missive reflects some element of hyperbole. But I have quoted it at length because the question is becoming more critical. … Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this pattern. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.

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