Saturday, September 12, 2015

The Imaginary Federal Reserve Toolbox

The NYT weighs in on how the Federal Reserve may adjust interest rates this month. The Fed drops a lot of trial balloons and its information operations campaign has prepared the media. The FOMC's open market operations are not as potent as they were before the crisis. Other central banks' recent experiments with adjustments in the middle of macroeconomic stimulus offer abject lessons in how effective the Fed's new tools can be.

China and Europe have gone full-steam ahead with stimulative experiments, albeit in different ways. China has begun liquidating some of its foreign currency reserves. The liquidation has not yet ignited a run on the US dollar because other major reserve currencies still look weak by comparison. Australia and Canada, for example, have seen their currencies weaken against the dollar because collapsing commodity prices have crashed the value of their natural resource exports. Europe continues a form of monetary stimulus while Greece muddles through a transitional government. The next Greek crisis offers a final opportunity to test the euro's resilience.

The US dollar's strength amidst the macroeconomic chaos approaching both China and Europe offers the Fed a very short window of opportunity to experiment with a non-traditional interest rate increase. Paying banks not to lend is generous as long as the Fed's ginormous balance sheet of agency securities is sufficiently solvent to fund such payments. If a significant amount of mortgage loans move to non-performing status, many agency notes become toast and the Fed will be hard-pressed to continue paying banks not to lend.

The Fed is about to open a new chapter in money market fund history. Borrowing from money market funds would effectively be an accounting trick that places a new asset on those funds' balance sheets called "Loan to Fed," or some such name. The notional amount of the loan may be enough to prevent money funds from "breaking the buck" and causing the kind of chaos in overnight lending that almost destroyed the US financial system in 2008. It's a brilliant innovation, especially if the money funds who nervously anticipate paying negative interest rates can sustain the Fed's remittance to the US Treasury.

The likely rise in interest rates in September 2015 is a sleight-of-hand move. It will be one of those times in financial services that the back office will drive the front office, all while most of Wall Street and the financial media will only be watching the front office. The stock and bond markets will know that the experiment works if money funds do not break the buck for the rest of 2015. Hedge funds and other private investors should watch money market funds and other ultra-short duration instruments rather than long-term metrics such as mortgage rates. If money funds panic and the CBOE VIX suddenly goes vertical, the Fed may be forced to raise its official target rate by more than 25 basis points.