In Terminal Velocity (16) “Show and Tell” it was suggested that the Fed may wish to do what the Israelis recommend; and show rather than tell. We suggested that:
“The Fed has once again talked itself into a corner. The Israelis have developed a pragmatic approach to decision making, in which they say “Don’t tell me, show me”. A Fed Policy that shows and doesn’t tell, may well be the best way to go. Unfortunately, the Fed only tells; but it will be forced to show soon.”
The Fed’s actions in this corner, of its own making, show how it does not apply the same rules to itself that it applies to the lesser mortals in the capital markets. The latest Balance Sheet data shows very clearly that the Fed has stopped buying MBAS (mortgage backed assets).
One might argue that this is a signal that the “Taper” has started, but this would be wrong.
As the chart above shows, the Balance Sheet continues to get even larger; so there is no “Taper” as yet. The Fed has simply avoided taking the losses, which it has applied to the holders of MBAS, by stopping buying. Rising interest rates reduce the prepayment risk associated with mortgage securities. A portfolio of the MBAS therefore gets longer in duration and risk as interest rates rise. The Fed had therefore “hedged” this risk (aka avoided losses) by stopping buying. As credit spreads have widened, the Fed has effectively become long Treasuries and short Credit Risk, in its recent MBAS buying strike whilst continuing to Treasury Twist. As an arbitrage trade it is peerless; until one understands that it has been literally talking its own P&L, ever since Bernanke voiced worries about a bubble developing in risk assets. One Fed Governor’s communication policy is therefore a bond investor’s insider dealing. No doubt the Fed will say that since the housing market is showing strength, it no longer needs to buy any more MBAS. It looks equivocal at best and a little sneaky at worst.
In Terminal Velocity (12) “Normalization?” we suggested that the Fed was going to take the price volatility onto its own balance sheet, in order to smooth the path to a normalised Yield Curve[i]. We stand corrected; clearly the Fed wants to have its cake and eat it. It wants a Normal Yield Curve and also wants someone else to take the losses in getting there. Having seen the record outflows from Bond Mutual Funds and Bond ETF’s, it is clear that this bond investor epiphany has happened[ii]. Should the Fed now wish to arrest the steepening of the Yield Curve, before it becomes a serious headwind, it will need goodwill and faith from the bond markets. Having just jammed this same constituency of the capital markets, all goodwill and faith have gone. Bond investors are now saying “Fool me once shame on you, but fool me twice shame on me”.
One is reminded of the way that the Fed’s European sister central bank has forced bond investors to get “Bailed-In” rather suffer red ink on its own books. Central bank communication policy can be neatly summed up as “Do as I say but not as I do”. One wonders how long asset managers and their fiduciaries will tolerate this systematic abuse, before driving yields to levels that the central banks do not want.
The Fed and the ECB have been saved, once again, by weak economic data which makes the bond markets reluctant to weaken further. The central banks should not assume that it is their communication policy that is working however. Once again, they are being saved by the same weak economic data that they are supposed to be reversing. Bond investors however, may now demand a higher yield premium to compensate them for having to accept the volatility and abuse that the central banks are supposed to be assuming onto their own balance sheets. The combination of rising yield premium and weakening economic data may call the central bankers’ bluff; and make them realign themselves with long term bond investors rather than ephemeral policy makers.
In a related note, the Chinese have stopped releasing economic data because it does not suit them to do so. This represents the extreme version of what all policy makers are attempting to do to capital markets at this present time. As it is now becoming clear that the Fed sees the US data well in advance of the markets and then positions itself before talking up its positions, it would be quite reasonable to expect bond investors to stop taking US data at face value. It would also be reasonable for bond investors to demand higher yields in lieu of this situation. Communication policy stops working when investors lose faith in the integrity of the communicators.