The Emperor, the Gladiator & the Lion

David R. Kotok
Chairman and Chief Investment Officer
The Emperor, the Gladiator & the Lion
August 30, 2010


The last surviving gladiator stood alone in the Coliseum as the crowd shouted approval of his victories. The emperor called for a lion. In bounded a fierce beast that loped to the gladiator. As it was about to pounce on him, the gladiator whispered in the lion’s ear. The beast promptly sat down. The crowd roared approval.

A frustrated emperor called for a bigger lion. That one, too, sat down after the whisper in his ear.

Once the cheering throngs calmed down the Emperor summoned the most ferocious of the lions. The huge cat shook the stadium with his roars and leapt into the arena. About to eat the gladiator, the cat heard a few words and promptly sat down.

The emperor put thumbs up. The crowd roared again. Emperor to gladiator: “Tell me what you said and I will give you half the empire.” Gladiator: “All I said was that the meal comes after the speeches.”

Federal Reserve Chairman Ben Bernanke delivered his speech in Jackson Hole at breakfast time. He explained the Fed’s recent balance-sheet decisions and clarified policy with this framework: “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

Emperor Ben discussed four tools. The last in the list, namely, that the FOMC increase its inflation goals, was mentioned, and the Chairman explained his opposition to it. Of course he left all doors open for future consideration.

Crowds liked the speech, stock markets rallied. Treasury bonds corrected (sold off) their deflationary pricing as market yields rose following the Bernanke commitment to avoid a deflationary recession. Emperor Bernanke showed the assembled that he still had his clothes.

ECB president Trichet gave the lunch speech. Like Bernanke, he rejected the inflation option. He worried about sovereign debt and the expansion of its use. In contrast to the US policy of gradualism, Trichet argued firmly that sovereign debt must be reduced relative to GDP. Trichet wanted markets to see that his Eurozone empire leaders also still wore their clothes.

I recall another, earlier set of speeches at Jackson Hole. Then-professor Ben Bernanke and his research partner Mark Gertler presented arguments for explicit inflation targeting and central bank accountability. In that speech, Bernanke and Gertler discussed monetary policy and asset price volatility. This 1999 view occurred at the early stage of the housing-price inflation in the United States and in the heyday of the tech-stock bubble. At the same 1999 symposium, new ECB president William Duisemberg made the anti-inflation case and described the policy framework for his role as the leading central banker for a new currency in its first year of existence. Both of these speech texts and the discussion reside in the archives of the Kansas City Fed website.

Professor Ben is now Chairman Ben. His true colors were clearer then. Being emperor requires some tempering of one’s expressiveness.

We will excerpt from the discussion held after the Bernanke-Gertler paper was presented in 1999. Of particular note is Bernanke’s response to Rudi Dornbusch, a prestigious and well-liked economist who, sadly, is no longer with us. Bernanke said: “I have studied the Depression quite a bit in my career, and I think there are two distinguishing mistakes that the Federal Reserve made. The first was to allow a serious deflation, which an inflation-targeting regime would not have permitted. And the second was to allow the financial system to collapse.”

No more explanation of today’s Bernanke Fed policy is necessary. Emperor Ben and Professor Ben are the same person.

Readers can find details about the current emperors’ views. The Bernanke and Trichet 2010 speeches are public and available on their respective central bank websites.

So is there a gladiator? The answer is yes. His name is Brian Sack. However, he was not present at Jackson Hole, according to press reports.

Is there also a ferocious lion? Yes again. And, it has already roared in the debt markets

Brian Sack runs the Fed’s System Open Market Account at the NY Fed. He is bright, pleasant, and articulate. He followed Bill Dudley into this position when Dudley graduated and became NY Fed president.

As the leading gladiator in the New York Fed’s coliseum, Brian has presided over the $140 billion of mortgage runoff to date. He is going to manage the annualized runoff of up to $400 billion of additional mortgage-related paper held by the Fed. This new tool received a lot of attention in Bernanke’s speech. Bernanke described how the acceleration of payments from foreclosure and refi could lead to a “perverse outcome” because a “weakening of the economy might act indirectly to increase the pace of passive policy tightening.” Bernanke clearly explained why the FOMC has stabilized the size of the Fed’s balance sheet as it makes this lateral transfer of existing portfolio from mortgages to treasuries.

Nevertheless, emperors only give broad policy outlines. Moreover, their committees (FOMC) ratify them. However, the gladiator must tame the lion.

Brian Sack is involved in the largest purchase of US Treasury securities in the Fed’s history. In addition, he is trying to estimate the prepayment speeds of those mortgage pools. Moreover, his goal is to keep the total balance sheet of the Fed stable while attempting to minimally induce dysfunction in operating markets.

His task is to subdue a most ferocious lion. To do it, he has to buy US Treasury bills, notes, and bonds at the pace at which the mortgage prepayments arrive. This coordination is difficult enough in “normal times.” In this crisis period of high refi volume and of large foreclosure volume, it is nearly impossible to estimate these speeds with any accuracy. Bernanke admitted as much in his speech, as he discussed the Fed’s balance-sheet realignment from GSE mortgage paper to treasury holdings while maintaining the overall size of the Fed’s balance sheet. Moreover, those of us in the portfolio-management business know that doing this also requires constant recalculation of duration in order to gauge market impact. The Fed does not do these trades in isolation. The rest of the world is watching, trading, investing, swapping, hedging, and attempting to front-run the Fed’s tsunami every single minute. In sum, it ain’t easy to be a gladiator.

Jim Bianco, an articulate and thoughtful observer of financial markets, has accurately described the Fed’s portfolio-management dilemma as a huge “convexity trade.” Jim’s eponymous research firm notes how the Fed creates a piling-on effect with it transactions. According to Jim: “At-the-money option-adjusted spreads (ATM-OAS) for 30-year Fannie Mae to-be-announced pools tracked long-term Treasury yields until the housing market collapse … reduced prepayment risk by destroying the market. The reduction in ATM-OAS continued through the Federal Reserve’s purchases of $1.25 trillion of mortgage-backed securities and even crossed into negative territory by mid-July.” Jim further noted, “The decline in ten-year treasury yields accelerated once [the Fed’s mortgage purchases] ended and once the March 2009-April 2010 global equity rally ended. This drop in yields has started to raise ATM-OAS levels … to levels reached only twice before, in June 2003 and December 2008.”

Can Brian Sack tame the beast? Will the Fed maintain a duration-matching tactic? So far, it does not seem to be doing so. That is why the longer end of the US treasury curve has rallied so strongly since April. Can the Fed avoid Bernanke’s “perverse outcome” if it ignores duration matching? We will assuredly find out in time.

At Cumberland, we are watching the Fed’s trading closely. Portfolio alignment is in spread positions and not in treasuries. The results have been good for our clients. We are engaged in hedging parallel shifts in the yield curve as a way to soften the impact of interest-rate volatility while capturing the spread narrowing that is inevitable once the Fed completes its transitions. Like other friends and colleagues in the independent, separate-account, portfolio-management business, we too feel like the gladiators in the arena. And there are many lions on the prowl these days.

I recall a visit to Jackson Hole many, many years ago. It was in the halcyon days, when income velocity was assumed stable, when the worry was an oil price shock, when speeches examined the disintermediation effects of deregulating interest rates, and when debates centered on which “M” had forecast power. In that era, one could walk to the tent in the back of the lodge and easily approach a gracious and friendly Milton Friedman. A prominent consultant from New York named Greenspan held court in the corner. Security was absent then. We could take a drive through Yellowstone, stop at Jackson for some conversation, then see if the trout were rising as we floated the Snake or the Green Rivers.

On Thursday, we are off to Leen’s Lodge for Labor Day weekend. A few of us will talk about markets and the Fed and the annual gathering we held three weeks before Jackson Hole. We will look for the early reds that brighten New England foliage. Maybe some faint aurora will be visible in the night sky. The waning crescent moon will be nearly new. With luck, the weather will be clear, the nights cooling down into the 50s, and the bass actively interested in fattening up as they prepare for winter.

Tight lines.


David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors,

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