Last week, I posted some thoughts on the Minutes that provoked some debate about Fed Exit Sequencing (a fancy way of saying "stuff"). The post led to some exchanges from fun follows like Boes and Klein and "the K." One of the more lucid stances comes from my friend (yes friends have different opinions) Mark Dow, here in his tumbler, Behavioral Macro
Mark and I became friends exchanging ideas over Twitter and martinis at Nobu in New York. Although our conversations are more about dogs and the beach these days, he's a brilliant thinker and brings an incredible experience to the table. That said, I see Fed Sequencing risks in a different light.
In the protracted advertised hikes leading up to the Financial meltdown, we (and others) railed against the Greenspan experiment. Bernanke, you may recall, was practically cornered into hiking to start his tenure or risk the Dove label. This hike took place despite high real rates, an inverting yield curve and spiking oil. Because the increment and timing of adjustments had been predetermined, the system was able to avoid de-leveraging despite the above mentioned characteristics. This is key. Although the ghosts of LTCM floated about, the financial institutions were the real geared monsters. Morgan Stanley and Goldman were running at least 15x. Lehman was well north of that. Citi? Well, they were insolvent by many measures. Fast forward to today:
Regulatory changes have plopped assets on the balance sheets of the system. IOER (the Advil of damaged banking systems) has replaced the wholesale funding operations of Fin System 1.0. As Jamie Dimon (and his CFO) have pointed out, these Fed created "assets" are unwanted and relatively useless beyond regulatory filings. What is the logical reaction to raising the funding cost of an unwanted asset? Correct, it is to purge it, and shrink the system by design.
Thus, inching up the Funds Rate faces 2 conflicting pressures not relevant to the old system. On one hand, funds outside the Fed accounts can cap over the raise. On the other, The Death Star, Term Facility and internal term structure funding positioning, could lock up the new system much quicker than the days of the off balance sheet wholesale funded credit orgy. Although, I respect the "risk diffusion" argument, I am skeptical the risks are identical to the last experience. And again, the worst offenders were the system anchors themselves.
I continue to advocate a balance sheet approach to Leaving Wonderland. A quantitative regime needs to operate with quantitative tools. Applying Interest Rate Targeting Regime blunt instruments to multi-trillion dollar balance sheets reeks of Mid-evil Tonsorial blood letting to me. As I stated last week, Fed flexibility has been their finest attribute. Let's hope the haven't lost it. And keeping reading and listening to the heavily armed Bonobo (Mark Dow) after all, I'm just a dog watching TV.