Saturday, November 23, 2013

Federal Reserve trapped in QE trap , trying to wriggle free without blowing the present ponzi schemes sky high ( comprehending QR impact comes from ongoing flow rather than stock of holdings is recognition of the ponzi scheme aspect of QE Fed policy in place ) .... Hugh Hendry throws throws in his " Bear " towel and turns " bullish " , what happens when everyone is on one side of a boat ? Doug Noland's Friday Essay reflects on QE , whether the Fed can wind down QE , whether the Fed is hoist by its QE petard at this point , a review of the different QE programs that have been rolled out during the ongoing crisis and the way forward suggested by the Charles Plosser paper ...

"We Will Soon Learn How Strong The QE Trap Has Become"

Tyler Durden's picture

Submitted by Derrick Wulf via NoEasyTrade blog,
Reading between the lines of recent Fed communications, it’s becoming increasingly clear to me that the Fed wants to exit its quantitative easing policies as soon as possible.Though they’re loath to admit it, the architects of quantitative easing now recognize that their efforts are achieving diminishing marginal returns while at the same time building up massive imbalances, distortions, and speculative excesses in the capital markets. Moreover, they’re realizing that the eventual exit costs are also likely much higher than they had previously thought, and continue to rise with each new asset purchase. Never was this more clear than when the Fed first hinted at tapering its large scale asset purchases over the summer: equity prices fell, interest rates rose, volatility increased, and huge sums of hot money were repatriated from various emerging markets, causing significant disruptions to local overseas economies and currencies in the process.
The market’s strong reaction to the mere hint of a taper also threw cold water on the widely held belief among Fed officials that the primary impact of their asset purchases comes through the accumulated “stock” of their holdings rather than the ongoing “flow” of purchases. This sudden and unexpected realization among policymakers has forced a complete rethink of their strategy. Indeed, one of the most basic premises of their monetary policy assumptions has been shown to be false. Markets are, in fact, forward looking.
Fearing the economic impact of an unwanted tightening of financial conditions, the Fed quickly stepped back from the tapering abyss in September. Since then, FOMC officials, along with their staff researchers and economists, have been working diligently on devising a new strategy, floating numerous trial balloons along the way. Their primary objective is to allow for a taper and ultimate exit from QE while somehow minimizing the flow impacts of such a shift in policy. There has been a renewed focus on the Fed’s other policy tools – namely the overnight lending rates and forward guidance – as a means to that end. There have been active discussions about lowering unemployment thresholds, increasing inflation tolerances through “optimal control,” and cutting interest on excess reserves to help guide market expectations towards a lower future path of interest rates.
It is my belief that one or more of these options is likely to be adopted alongside a modest tapering of asset purchases, perhaps even as early as December. While central bank officials don’t want to disrupt the fragile economic recovery through a premature tightening of monetary policy, they are also well aware that the longer they wait, the more difficult it will become later on. In a word, they’re starting to feel trapped. They want to wriggle themselves free of this as soon as conditions will possibly allow.
I expect to see more public comments and newspaper articles indicating as much in the coming days and weeks. Economic data – namely the November employment report – will clearly play a very important role in shaping expectations as well, but barring a material deterioration in the employment and growth outlook, I expect a tapering announcement, coupled perhaps with an IOER cut or more aggressive forward guidance, to come sooner rather than later.
Implications for the markets, which may not yet be fully prepared for this outcome, are likely to be significant. In short, I would expect yield curves to steepen, the dollar to strengthen, equities to fall, credit spreads to widen, commodities to weaken (the metals in particular), and volatility to rise. How the Fed will then respond to these developments will be very telling indeed. Their hand will be forced, and we may all soon learn how strong the QE trap has become.
My preferred strategy until then is to buy inexpensive volatility, either directly or indirectly through longer-dated options, and to continue to trade the Euro and Yen from the short side.
I also like maintaining a core curve steepener, preferably in 5s / 30s (or long FVZ against a duration-neutral USZ short), and establishing some equity shorts near trend resistance around 1810 in ESZ (see yesterday’s note for charts). On the curve, with 5s / 30s now having cleared resistance at 240, I expect to see 300 tested again before much longer, with new wides to follow.

The first two major episodes of the current multi-year steepening trend – the crisis and the response – both widened the 5s / 30s curve by 200 basis points. If the third episode, the exit, follows a similar trajectory, we could see eventually see 5s / 30s hit 390.

Hmm , with the Bears turning bullish , how long might a collapse actually be from occurring ?

Hugh Hendry Capitulates: "Can't Look At Himself In The Mirror" As He Throws In The Towel, Turns Bullish

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"I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends."
      - Hugh Hendry
First David Rosenberg, then Jeremy Grantham, and now Hugh Hendry: one after another the bears are throwing in the towel.
As Investment Week reports, speaking at Harrington Cooper's 2013 conference this morning, Hugh Hendry said "he is no longer fighting the two-way feedback loop which is continuing to boost risk assets." The reflexive feedback loop envisioned by Hendry is the following and centres on the currency war being played out between the US and China, "in which US QE prompts dollar-denominated investment to head to China, and China fights the resulting upwards pressure on its currency by manufacturing an investment boom. Hendry said this creates a "global supply glut", leading to falling US inflation expectations (as this supply far outweights US domestic demand) - which in turn prompts the Federal Reserve to loosen policy once again." Rinse. Repeat.
Of course, there is a limitation here as we have explained previously, namely the amount of "high-quality collateral" which the Fed and the other central banks can and are rapidly soaking up, in the process destroying bond market liquidity, but that "discovery" will be made by the Fed far too late, despite even the repeated warnings of the Treasury Borrowing Advisory Committee.
And since Hendry is constrained by daily, monthly and annual P&L, he simply does not have luxury of waiting for the "fat tail" event, which incidentally will be quite terminal and thus hardly profitable for anyone exposed to fiat-denominated assets.
So the end result is that Hugh Hendry is merely the latest bear to throw in the towel:
"I can no longer say I am bearish. When markets become parabolic, the people who exist within them are trend followers, because the guys who are qualitative have got taken out," Hendry said.
"I have been prepared to underperform for the fun of being proved right when markets crash. But that could be in three-and-a-half-years' time."
"I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends."
So what does the newly christened "bull" like?
Though he first began turning more positive on the likes of US and Japanese equities last year, Hendry suggested this morning the current environment created more counter-intuitive opportunities. "This applies to European banks, Greek equities, Spanish equities. You have got to be in things that are trending," he said.

The manager's Eclectica Absolute Macro fund had a 64% value at risk equity allocation in September, up from 45% in August, with December 2013 Japanese TOPIX index futures his biggest single holding on a VaR basis.

Addressing attendees this morning, Hendry said his comments would take on a "confessional" tone, and admitted his performance over the past year had been "at best, mediocre". Hendry's CF Eclectica Absolute Macro fund has lost 2.6% in the nine months to 30 September, according to the firm.
In other words the "dash for trash" mentality, which we predicted in September 2012 when we forecast that the most shorted stocks would outperform the market (and they have), has just won another convert. That, and of course, Fed-balance sheet induced momentum chasing, in which the only thing that matters is one's view how many "assets" the Fed will hold at any point in the future (see from April: "Bernanke & Kuroda Capital LLC: Overweight S&P 500, 2013 Target 1950").
Finally, Hendry's "come to Bernanke" moment does not come easily:
The manager acknowledged his changing stance may be viewed by some investors as a 'top of the market' signal, but said he is not concerned by the prospect of a crash.

"I may be providing a public utility here, as the last bear to capitulate. You are well within your rights to say ‘sell'. The S&P 500 is up 30% over the past year: I wish I had thought this last year."

"Crashing is the least of my concerns. I can deal with that, but I cannot risk my reputation because we are in this virtuous loop where the market is trending."
Sadly, his last statement is just the latest confirmation that in the New Centrally-Planned Normal, FOMO  or Fear of Missing Out (the trend, the media appearance, the herd, the year end bonus, you name it) is indeed the new POMO as we warned in May.
And like that, everyone is now on the same side of the boat.

Plosser’s Limited Fed: A Statesman Takes a Stand

November 22, 2013 

The stock market melt up continues.  Meanwhile, intrigue only grows at the Fed.

November 19, 2013: “From NPR News, this is All Things Considered. I’m Robert Siegel. And I’m Melissa Block. Americans are utterly fed up with Washington. That’s the takeaway from the latest round of public opinion polls. Approval ratings for just about every leader and political institution from the president to Congress are now at record lows. NPR’s national political correspondent Mara Liasson reports on why and what the consequences might be. Bill McInturff, the Republican half of The Wall Street Journal/NBC polling team calls it a public opinion shockwave. He’s never seen voters express such disgust at both parties and their leaders. Bill McInturff: ‘October was one of the most consequential months in the last 30 years in American public opinion. And the consequences are all negative. The President’s job approvals hit a new low. His personal approvals turned negative for the first time. Republicans became the first political party with a 50% negative and every person in the Congressional leadership hit new highs in their negatives. No one was spared. America’s fed up and very tired of what happens in Washington.’”

These days I think often of Adam Fergusson’s classic “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.” One of the more fascinating and pertinent aspects of Fergusson’s historical account was how monetary policymakers somehow remained oblivious to the havoc they were instrumental in fomenting. Throughout the ordeal, top central bank officials believed monetary policy was responding to outside developments instead of being a root cause of deleterious processes that ended up tearing society apart. Despite what should have been an obvious disaster in the making, the central bank succumbed to constant pressure from various constituencies to step up its money printing operation.

Americans’ confidence in its politicians is at a multi-decade low. The popular refrain remains “Thank God for the Federal Reserve!” Somehow, it goes unappreciated that flawed monetary doctrine has been instrumental in fomenting societal stress, divisiveness and the steady erosion in the public’s faith in its institutions. A multi-decade period of unsound “money” and Credit has fueled an ongoing perilous cycle of asset Bubbles, booms and busts, gross misallocation of resources with resulting economic stagnation, and inequitable wealth distribution on a historic scale. Unfettered “money” and Credit on an unprecedented worldwide basis have been responsible for unmatched global financial and economic imbalances, including the deindustrialization and ever-growing debt overhang that hamstrings the U.S. economy. While it is difficult to hold much sympathy for today’s politicians, I’d argue strongly that years of unsound finance is at the root of today’s increasingly dysfunctional political landscape.

Fundamental to my “Granddaddy of all Bubbles” thesis are the momentous risks associated with governments’ and central banks’ reflationary policymaking – a policy course that for five years now has inflated the expansive “global government finance Bubble.” QE (“money”-printing) cost vs. benefit analysis has turned more topical of late. Again this week, top Fed officials (Evans and Rosengren) argued that QE benefits greatly exceed “marginal” potential costs. History will not be kind. At the end of the day, the loss of confidence in the Fed and central banking more generally will come at a very steep price.

In the spirit of “When Money Dies,” it is unwise for Fed officials to be so dismissive of the costs associated with its experiment in inflationary monetary policy. After all, monetary inflations unleash processes that are unpredictable both in course and eventual outcome. I adhere to the view that asset inflation is potentially more dangerous than traditional consumer price inflation.

Can the Fed actually wind down QE? Or is the Fed’s (prisoner to dysfunctional markets) balance sheet on its way to $10 TN? What would be the consequences? Fed officials have no idea at this point how any of this will play out. Indeed, I’ve seen no indication that they have much understanding of the impact of QE to this point – even with the benefit of hindsight. Officials seem to suggest that expanding the Fed’s balance sheet to almost $4 TN has had only modest impact other than to somewhat force long-term interest rates lower. At least publicly, they’re sticking with the story that so long as their QE “money” sits idly on the banking system’s balance sheet as “reserves” it’s having minimal inflationary effect. It’s just not credible that, with the Fed pumping “money” directly into the securities markets, the focus of cost analysis would remain on consumer prices rather than the myriad distortions and maladjustment associated with asset inflation and speculative Bubbles.

As master of the obvious, I would argue that QE has had profound, albeit disparate, impacts primarily on the financial markets. Moreover, the key is to appreciate that the effects of liquidity injections into the marketplace significantly depend on the prevailing market dynamics at the time. In this regard, there are important differences between “QE1,” “QE2” and the ongoing “QE3.”

“QE1” saw the Fed’s balance sheet expand from about $900bn in September 2008 to end ‘08 at almost $2.3 TN. De-risking and de-leveraging were the prevailing market dynamics at that time. Importantly, it was not a case of the Fed unleashing $1.4 TN of liquidity upon the real economy or even the financial markets. Basically, “QE1” accommodated a transfer of bond/MBS holdings from leveraged players (Wall Street firms, banks, hedge funds, mortgage REITs…) to the Fed’s balance sheet. From a cost/benefit perspective, one can argue that the “QE1” was instrumental in stemming a potential daisy-chain collapse of major financial institutions along with the global derivatives “marketplace” more generally.

“QE1” benefits were readily apparent, while most would argue the costs were minimal. I would counter that myriad associated costs were enormous if not evident. “QE1” was instrumental to the ongoing general expansion in global Credit and speculative excess, including the further ballooning of the “global leveraged speculating community” and global market and derivatives Bubbles more generally. “QE1” stopped in its tracks what would have been a painful but healthy cleansing of an “inflationary bias” and financial market speculation infrastructure that have been flourishing for the past twenty years. “QE1” also reversed what would have been a major restructuring of our services/consumption-based economy – and we would have been in a better place today because of it.

I’ll concede that the original QE was likely necessary to forego major financial and economic restructuring. Yet it was then critical for a diligent Fed to be on guard against speculative excess - rather than actively spurring speculation and asset inflation.

“QE2” saw the Fed’s balance sheet expand from $2.3 TN in October 2010 to $2.9 TN by June 2011, with market impacts pushed well into 2012 by an additional $400bn of long-term Treasury purchases associated with “Operation Twist” (Fed sells T-bills and buy bonds). To be sure, “QE2” pushed already potent “inflationary biases” to dangerous extremes. After trading as high as 3.6% in early 2011, 10-year Treasury yields sank to 1.45% in May of 2012. Benchmark MBS yields dropped from 4.40% to as low as 1.82%. Government, mortgage, corporate and municipal bond yields collapsed (prices spiked higher) as hundreds of billions flooded into myriad fixed-income funds and instruments.

It's certainly worth noting that “QE2” was instrumental in the surge of destabilizing late-cycle “hot money” flows into emerging market (EM) economies. International Reserve assets (indicative of EM inflows) jumped from about $8.6 TN in October 2010 to almost $10.5 TN by June 2012. It remains too early to gauge the true cost of “QE2” in terms of fixed-income excesses and EM financial and economic Bubble distortions. But the impacts were enormous and clearly of an altogether different nature than “QE1.”

The Fed began talking open-ended QE late in the summer of 2012. They claim it was in response to a stubbornly high US jobless rate. I still believe it was more related to acute global financial fragilities. The Fed’s balance sheet began 2013 at about $2.9 TN. Today it’s almost a Trillion higher, in by far history’s largest ever direct injection of central bank liquidity into the financial markets. As always, it’s fascinating to follow how speculative dynamics play out in the markets. With cracks surfacing in both bond and EM Bubbles, the prevailing 2013 “inflationary bias” shifted overwhelmingly (perhaps fatefully) to equities.

As an illustration, follow the trail of outflows from a somewhat less popular “Total Return Bond Fund” (TRBF). To fund outflows, TRBF sells Treasuries to the Federal Reserve. TRBF then transfers Fed liquidity to exiting investors that then use this “money” for investment in the now extremely popular “Total Stock Market Index Fund”. This fund then takes this “money” that originated with the Fed and bids up stock prices.

Or, how about an example where a hedge fund moves to exit an underperforming emerging bond market. Here the fund is unwinding a leveraged “carry trade” that involves selling the EM bond and liquidating the EM currency position. With the EM bonds and currency under intense (“hot money” outflow) pressure, the local EM central bank intervenes with currency purchases (sells dollars to buy the local currency). To fund these purchases, the EM central bank sells Treasuries to the Federal Reserve. The central bank then uses Fed liquidity for purchasing currency from the hedge fund, and the hedge fund then has “money” to rotate into 2013’s speculative vehicle of choice - US equities.

Any serious discussion of QE costs would now have to also consider the risks associated with a full-blown equities market Bubble. And, from my perspective, the Fed’s QE-induced equities Bubble joins a historic fixed-income Bubble to achieve virtually systemic distortion in the pricing and risk perceptions of financial assets generally. If Fed officials actually attempted a cost benefit analysis prior to commencing “QE3”, I seriously doubt they contemplated a 40% surge in the broader U.S. stock market.

It seems an increasing number of Fed officials recognize the need to rein in the growth of the Fed’s balance sheet. As Federal Reserve Bank of Atlanta president Dennis Lockhart (under)stated Friday: “There is a fair amount of uncertainty related to the longer-term consequences of growing the balance sheet. There could be some things that happen that are unanticipated.” You think?

I would also like to draw attention to a paper presented last week (Cato Institute’s 31st Annual Monetary Conference) by Federal Reserve Bank of Philadelphia President Charles Plosser, “A Limited Central Bank.” Mr. Plosser’s exceptional analysis is music to my analytical ears and has provided a glimmer of hope that some learned Statesmen will rise up and ensure this monetary inflation doesn’t spiral completely out of control. I can only hope his paper becomes a rallying cry throughout the Federal Reserve system.

From the “highlights”: “President Charles Plosser discusses what he believes is the Federal Reserve’s essential role and proposes how this institution might be improved to better fulfill that role. President Plosser proposes four limits on the central bank that would limit discretion and improve outcomes and accountability. First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective; Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities; Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach; And fourth, limit the boundaries of its lender-of-last-resort credit extension. These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”