Over the past few weeks there has been a tremendous amount of discussion in the media about the lack of liquidity in financial markets. Market pundits are tossing around a multitude of different theories for the reason of this collapse. Everything from the Volcker rule to HFT (high frequency trading) is being blamed. It seems like every big shot financial titan has felt the need to weigh in on this subject.
My favourite humble, private equity “do-gooder” Steve Schwarzman (May 22/15 – Billionaires behaving badly), wrote a Wall Street Journal op-ed that warned about this new risk:
Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.
The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling. A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.
Why should we care? Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. With individuals suffering losses and companies not able to raise capital, the economy will contract with layoffs, lower tax revenues and pain for middle- and lower-income Americans.
Of course Schwarzman hates the Volcker rule and blames the lack of liquidity on that new legislation. No CEO enjoys the government telling them what they can and can’t do. These guys have been complaining about the Volcker rule since the day it was first announced. I am sure they would blame global poverty on the Volcker rule if you gave them an opportunity.
But all these theories about the drying up of liquidity are missing the main culprit. Markets function through price discovery between buyers and sellers. For a market to be liquid, you need both sides of that equation.
The problem with today’s market is the price is wrong. Financial markets have been driven up by Central Banks monetizing their balance sheets. These elevated prices are not real. Well, I guess that’s an exaggeration, they are of course real, but they aren’t natural. This unnatural force has distorted financial markets, and in the process, destroyed liquidity. It is as simple as that.
To illustrate this point, let’s take the market for antique baseball cards. Right now there are wide variety of different collectors that will bid on new supply that turns up from garage sales or existing holders that want to sell for whatever reason. Now let’s imagine Warren Buffet decided he wanted to start a collection. In the process, Warren buys every card he can find, and sends the price up 3 fold in a few years. On the way up there is plenty of liquidity. All the collectors that were long show him offers. There is a solid bid, and an even more solid offer. But as the price moves higher, and higher, everyone who wanted to sell has already sold. The offerings dry up, so Warren needs to pay more to get even less cards. On the days where Warren forgets to buy, the sellers are surprised to find there are precious few other bids. Of course there are a few guys willing to buy in the hopes that Warren will return the next day, but that’s not a solid bid by any means. When Warren takes a week off to play bridge with Bill Gates, the price of antique baseball cards collapses as prices start to return to the “natural level.” Shocked that prices fell so hard, Warren returns to the market, and once again starts buying. Prices gap back up – after all there are few natural longs left to sell. The end result is that liquidity has completely collapsed because the price is wrong. If the prices were allowed to return to levels with other natural buyers, then liquidity would return.
This is exactly what has happened to the financial markets. There is little liquidity because prices have been goosed to the point where the only real buyers are Central Banks. If the market were allowed to return to levels where natural buyers would return, then liquidity would return. All the other worries about diminishing liquidity are missing the big picture. Nothing has changed in the market place except the price. And at bad prices, there is little liquidity.
Orphanides – probably the smartest Central Banker since Volcker
I recently read a great interview by MarketWatch’s Greg Robb with Athanasios Orphanides titled The Fed fears lifting interest rates, ex-insider says. I must admit that I had never heard of Orphanides, but he is an accomplished MIT economist that started his career at the Fed’s monetary policy division. Through his career, Orphanides has held a wide variety of roles within the Central Bank community. St. Louis Fed President James Bullard noted Orphanides unique experience of having attended both Fed monetary policy meetings and ECB council meetings. When I read his interview about why the Fed fears raising rates, I was struck by his sensibility and shrewdness (especially for a Central Banker).
Orphanides believes the Fed is way behind the curve, and should immediately raise rates. He articulates it with a clarity and simpleness that makes it tough to argue.
Orphanides: Let me mention why I am worried about the current cycle. Monetary policy operates with a substantial lag and it is very important to be preemptive in policy action. What this means is the Federal Reserve should try to steer policy towards what is normal, meaning not excessively accommodative and not excessively contractionary, before the economy actually reaches the state of full strength. In the current environment, since we are now a few years after the end of the recession, what this means is that policy should have started being normalized long before we reached the situation where the economy is almost at full strength. And this is what hasn’t happened this time. On this occasion what is the striking difference is that the Fed has not done anything to start the process of normalization yet, and, indeed, until last year it was injecting additional monetary policy accommodation in the economy and the economy has reached a situation where it is very close to its full strength.
So we are in that sense behind the curve. Why do I stay that? In order to understand where we should be, we need to assess where we think a normal level of policy accommodation would be. In the current environment, if we take guidance from the FOMC’s own assessment, the FOMC is telling us they need to raise the federal funds rate by a few hundred basis points to reach what they consider to be an appropriate level for the long term. But what is missing from that is that, in addition to easing with interest rates in the current recessionary episode, the Fed has injected additional massive policy accommodation with quantitative easing. This will also have to be undone. And since the Fed has communicated that it does not intend to reduce the size of the balance sheet, interest rates will have to be raised even more than they would have to be raised in a normal recovery in order to normalize monetary policy. So the monetary policy tightening that needs to be engineered is quite substantial and this is why I believe they are already behind the curve.
I found this great chart from MacroBond that illustrates Orphanides point perfectly:
We all know how the Taylor Rule has been indicating the Fed should have raised rates ages ago:
According to this model, Fed funds should be north of 2%, not hovering at 0%. And this is Orphanides main point:
Orphanides: Part of my historical analysis has convinced me that it is incredibly difficult to come up with accurate estimates. I don’t think that I can have an estimate that is better than the estimates that the Fed staff and other analysts are coming up with. [The Fed policy committee estimate is 3.65%] My concern is that whatever reasonable estimate one may have, and from the range of estimates that I see, we are very, very far away from that. This is why I don’t think it is about a number. This is not about the difference of a 25 basis point adjustment in the federal funds rate. We are talking about a few hundred basis points that would need to be adjusted. The Fed may find itself in the very, very uncomfortable situation of having to engineer in a hurry if they want to avoid returning us to an environment of rising inflation.
MarketWatch: The Wall Street consensus is that the Fed is on hold next week and will wait until September. Is that too long a delay?
Orphanides: Here is the difficulty. This is one of those situations where the longer the Fed waits to start the process of normalization, the more likely it is that the Fed will face a nasty dilemma. And what is that dilemma? The dilemma will be that they will realize that they need to tighten policy very abruptly to control inflation. And of course if they were to do that, that would risk growth. Or they would have to say, “oh well, this 2% target after all we don’t really have to take it seriously, let’s let inflation rip.” This is the dilemma that the Fed is really setting up for itself by procrastinating on lift-off.
MarketWatch: Some people think that inflation is just a thing of the past and the point out the Fed can’t even get the price level growing at its 2% annual rate target. What do you say to them?
Orphanides: It is true that inflation has been weak and contained, but we can identify two reasons for that. First of all, the recession we had a few years ago was one of the worst recessions we’ve had and which actually put sustained disinflationary forces in the economy. The second element which I believe is quite important is that all the credibility that the Fed accumulated in the past 30 years, especially during the Volcker–Greenspan period of disinflation and then, with some reverses, the Great Stability.
That credibility anchored inflation expectations very well, and one of the reasons why inflation is, and may remain for a while longer, stable is because of how well anchored inflation expectations are. The problem is this. If the Fed allows an overheating of the economy, the inflationary forces will start dominating and eventually even the anchor of inflation expectations may be lost. Historical experience suggests that this has happened in the past, and historical experience also suggests that the last thing anybody should claim, who has studied monetary history over time of the central banking and inflation.
MarketWatch: Why hasn’t the Fed moved off of the zero bound? Your lecture at the St. Louis Fed spoke of a fear of lift-off. Where you saying the Fed is afraid to raise interest rates?
Orphanides: I see a great reluctance for lift-off. One cause is the muddled mandate of the Fed, and the other is the Fed does not have any clear rules. So what we have unfortunately in the Fed is policy that is effectively discretionary. And whenever you have discretionary policy, policymakers are open to all of the problems humans have. George Akerof, [a Nobel-winning economist and Janet Yellen’s husband], in a 1990 lecture on procrastination and obedience explains when people take decisions without rules, then short-term biases may be introduced and lead to outcomes that are not desirable outcomes. The salient cost becomes the most important. If you don’t have a rule, you may be fooled into trying to avoid the most salient cost.
MarketWatch: So you want a better policy rule? And an end to the Fed’s dual mandate?
Orphanides: One safeguard to avoid this nasty dilemma would have been if the Fed had a crystal clear mandate to preserve price stability. The problem with the Fed’s mandate is that it is muddled. In 1977 when Congress revised the law [that included the dual mandate for the first time], they could not quite agree on more sensible legislation, and they instructed the Fed to simultaneously achieve price stability and maximum employment, and the two are not compatible. If we have an overheated economy, in order to contain inflationary pressures and preserve price stability, the Fed would have to tighten and compromise on its mandate of maximum employment. And I believe that because of the costs of high unemployment and because of the costs of the last recession being more salient than the cost of allowing prices to deviate from price stability, we are more likely to observe a mistake where the Fed may simply take risks it should not take on price stability to avoid fears of increasing unemployment.
MarketWatch: Do you think Fed should sell some assets from its balance sheet?
Orphanides: This is a choice. One of the reasons I am worried that the Fed is behind the curve on lift-off is because the Fed told us that they prefer to normalize policy by raising rates first. From my perspective in terms of normalizing policy, they could keep interest rates this year where they are and not raise interest rates, if they had adopted the alternative way to normalize policy which would have meant reducing the balance sheet by one or two trillion dollars. It is because they told us that they are not going to do that I think it is even more important that they start tightening earlier and at a good pace.
In terms of what goes first, there are good arguments on both sides. There is an adverse effect from the Fed’s interference with mortgage markets for example. The Fed is engaging in credit policy, subsidizing a particular sector of the economy, and I am not sure this is an appropriate objective for monetary policy. I could see that as an outcome of exceptional policy at the zero lower bound but this is not something that I think should last for a long time. But if their analysis suggests they want to have a slower pace of normalization, that’s OK. I can actually see why they would not want to create disruptions in either the Treasury market or the [mortgage-backed securities] market and accept that. But then in order to ensure overall stability in the system, I would have expected them to start tightening either even earlier and by more.
MarketWatch: What is the impact of Fed policy by having the European Central Bank moving in a different direction?
Orphanides: The problem with the ECB is they did not ease monetary policy as much as it should have two to three years ago. It only started this year to implement a policy of QE which was sorely needed. The Fed has injected massive [liquidity] in the system and during the period when the ECB was tightening, so effectively, the Fed has already more than accommodated over the past three years the easing that the ECB is now doing. I do see that this suggests the dollar may be strengthening some. I actually see this as a healthy sign because this is a reflection of the fact that the U.S. economy has improved so dramatically relative to the euro-area economy. So I would not be concerned about this. I think once we take into account the relevant policy over the past three years, there is really no issue.
This interview is just jam packed with wise observations. I don’t have too much to argue with. Orphanides does a great job of summing up the “ZIRP was an emergency low rate, and the emergency is long passed, let’s raise rates” crowd. Orphanides gave a speech to the St. Louis Fed earlier this month, and I have to assume his message was the same.
My suspicion is the Fed is closer to raising rates than the market realizes. The always great Martin Enlund posted a terrific chart that highlighted the market’s reluctance to price in Fed hikes:
There is an accident waiting to happen. The Fed has gone so long without raising rates, no one believes they will ever do it. Watch out for the reaction to be way larger than would have otherwise been the case.
My tirade against those in power who abuse it
I am going to channel my inner ZeroHedge’s Tyler Durden and rail against the system. This morning former IMF head Dominique Strauss-Kahn was acquitted in a French court because “he couldn’t have known the women in the orgies he participated in were prostitutes.” Yes, of course DSK. The beautiful half dozen twenty-something young women at your friend’s party all want to join your orgy because you are such a sexy 66 year stud muffin.
I don’t care what people do in their private lives. I am not judging DSK (like he claimed in court) for his deviant sexual practices. He could have sex with a goat for all I care if the goat was into it. But let’s not forget why he was on trial in the first place. He “allegedly” raped a maid in an NYC hotel (which was never proven but was “settled out of court” for a huge sum of money). During his trial in France, a prostitute took the stand and told the story of pleading with him to not have to do the acts he requested. She recounted crying afterwards. What kind of sick f%# can make a hooker cry? These poor women have seen a lot. You need be a deranged sort of world class sadist to bring a prostitute to tears.
Meanwhile, Navinder Singh Sarao sits in a London jail (Apr 23/15 – The Keyser Söze of futures villains) because he “spoofed” the E-mini futures contract with 188 lots above the offering that “was never intended to be filled.”
Dominique Strauss-Kahn is a rich insider who “allegedly” abuses women in unconscionable ways, but doesn’t have to answer to any of his “alleged” crimes. Meanwhile, some trader in his parents basement is railroaded by the system in a desperate attempt to find a scapegoat for the failings of a bloated bureaucratic regulatory agency that doesn’t understand markets.
This is yet another example of how the system is abused by those in power. We are stepping closer and closer to the point where the masses rise up against this oppression. As DSK was leaving the courtroom with a big smile on his face, I am pretty sure I heard him say something about “cake.”
Thanks for reading,
Have a great week-end,