Wednesday, November 04, 2015

Slicing The Federal Reserve's December Layer Cake

Here we go again. Federal Reserve Chair Janet Yellen is making noise about an interest rate increase. If it's not happening in 2015, it's probably not happening in 2016 either. One of my finance friends is very kind and intelligent. She often shares her wisdom with me on what this serial messaging means. It all comes down to a "layer cake" metaphor. Here is what the cake tastes like to me.

A public official's message to the general public is built on several layers of meaning. Most of those layers are intended for a general audience but other insiders hear the message too. General statements about a desire to raise rates are for the general public to hear. The public must remain confident that central bankers care about a normal economy. That reassurance is one layer of the cake.

Expressing faith in higher rates someday pushes bond yields up now, while prices of existing bonds decline. The second-order effect is to gradually make bonds less attractive as an asset class. Investors are thus less inclined to put new money into bonds, and more inclined to give bonds a lower weight in blended portfolios by selling some now. Reducing bond overweights makes an eventual bond market crash or crisis less severe, with a less stressful imposition of exit gates on bond funds. That scenario is another layer of the cake.

I cannot name my contact or describe her background in detail. She often speaks in guarded metaphors because she has access to privileged and confidential information she cannot discuss in public, and certainly not with me in private. I totally respect confidentiality imperatives. Suffice it to say that her assessments reflect a widely held culture among public policy officials, and this culture also informs the decisions of private sector financial executives. One could even say this culture circumscribes the decision making ability of private actors, because it signals how far they can push innovation before they cross a red line into public sector decisions they cannot influence.

The Fed still owns an enormous amount of mortgage-backed paper and cannot destroy its balance sheet by playing with rates. The policy innovations standing ready to impose bond fund exit gates, trading halts, and money market backstops are mostly for public officials to adjudicate, and mostly for private sector actors to execute. Wall Street's key influencers need enough advance warning to ensure their capital market decisions do not constrict the Fed's ability to act in a crisis. The Fed also continues to push for stronger capital buffers and resolution authority for SIFIs, and Wall Street gets that message too at the same time it gets the interest rate messages. That's why layer cake messaging matters.