DRW Trading Market Strategist, Lou Brien, Says Fed May Be Getting Ready To Twist

DRW Trading Group market strategist Lou Brien says that most observers figure the Federal Open Market Committee (FOMC) will announce Wednesday that they are going to utilize additional tools to further ease monetary policy. The most popular assumption, he says, appears to be a modern version of the sixties classic “Operation Twist.” This would involve selling shorter-term debt out of the Fed portfolio and using the proceeds to buy the long end. There is also some thought that the Fed will lower the interest they pay the banks on the excess reserves held at the Fed, in order to encourage the banks to loan more of the money that the Fed has already made available.

"Since the Fed extended this week’s meeting by a day solely to discuss the cost and benefits of the various potential tools that could be useful, it is likely they will do something. What is also likely is that not everyone on the policy Committee will walk away happy.

At their August policy meeting the FOMC pre-committed on the future path of the fed funds rate. Their post meeting statement said that economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” That strategy was just one of many that they discussed, the others, in the order they were mentioned in the meeting minutes, included: “additional asset purchases”; “increasing the average maturity of the System’s portfolio”  by following a method used in operation twist so as not to increase the Fed balance sheet; and reducing the interest paid on excess reserves. The pre-commitment was the only new strategy wrinkle, but that appeared to be a compromise. A few members wanted to do even more stimulus at the August meeting because the economy was deteriorating but three other members thought that the pre-commitment was too much because additional stimulus risked inflation without assuring it would help output or employment. So they decided to take extra time at the next meeting to figure out their next move.

Both sides of the argument were provided additional ammunition in the interim. For instance, the employment situation looks to have worsened, but the latest inflation data was hotter than expected. But the first among equals on the Committee, Chairman Bernanke, did not sound as though he thinks the Fed is done tinkering when he spoke a couple of weeks ago in Minnesota. Not only did he reiterate that the recovery stinks (I paraphrase) and the risks to the outlook are on the downside, but that inflation is likely to moderate in coming quarters. He also stressed the “unusual weakness in household spending” and that “even taking into account the many financial pressures they face, households seem exceptionally cautious.” The September report on consumer sentiment from the University of Michigan, which came out a few days after that speech, was a slight improvement from August for the headline index. But the report reinforced Bernanke’s perception of the consumer when it said, “when asked about prospects for the year ahead, just 17% expected their finances to improve in early September, the lowest figure ever recorded” in the sixty year history of the survey. Add to this the heightened potential for financial system contagion emanating from Europe and it is unlikely that Bernanke will not deliver something on Wednesday.

So what will be the result of the meeting? It seems as though no matter what they do the Fed will have to sell the sizzle because neither of the anticipated options appear to be a prime cut of steak.

If the Fed cuts the interest they pay on the excess reserves, will that be enough to get the banks to loan out more money? There seems to be as much of a problem with demand as there is with the banks being too restrictive, so the chances of this move being a game changer are slim. Additionally, there is the some thought that the huge pile of excess reserves is acting as a “rainy day fund” for the banking system that they may not be ready to give up and also the Fed may not want for them to be caught unprepared should something hit the fan in Athens or Rome. Back in February, before the U.S. economy took a turn for the worse and European debt still seemed like a problem that could be pushed down a multi-year road, the St. Louis Fed economist Silvio Contessi wrote in Monetary Trends about the security blanket aspect to the excess reserves. “Analysis of the cross-sectional data suggests that some banks may be maintaining such large reserve positions as a precautionary hedge in an uncertain environment. Many banks, especially smaller ones, likely recall the autumn of 2008 when repurchase agreement (repo) markets closed and, absent Federal Reserve actions, liquidity was unavailable at any price. As long as the strength of the recovery remains uncertain, there are few other investment opportunities, after adjusting for risk and taxes, with anticipated returns greater than the near-zero interest the Federal Reserve pays on deposits.”  Last week the ECB, in conjunction with other central banks, enhanced the dollar liquidity facility that was originally conceived of during the stressful time that Contessi referred to; although last week’s move was intended to ease the strain in funding markets, the fact that it was necessary may make the Fed think twice about changing the status quo of excess reserves at this time.

So the idea behind Bernanke’s Operation Twist (OT) is that very low long-term interest rates will inspire investment in ways that he imagined would be the case with QE2, the basis of which he expressed in the Washington Post last November. As a matter of fact, OT is sort of QE on the cheap; the Fed pays for long-end paper by selling the short stuff they already have on their books; don’t even need the change in the sofa cushion to accomplish the task. San Francisco Fed researchers compared the 1961 version of OT to the QE2 program in an Economic Letter in April. “In many respects, Operation Twist was similar to the Federal Reserve’s recently announced program of Treasury purchases, dubbed ‘QE2’ by the financial press. First, both programs aimed to lower longer-term interest rates without lowering short-term rates. In the case of Operation Twist, the program sought to prevent further gold outflows. In the case of QE2, lowering short-term rates was not an option because the federal funds rate had already been reduced to its lower bound of essentially zero. Second, both programs involved purchasing large quantities of longer-term Treasury securities. And third, both programs financed those purchases by selling or issuing short-term government liabilities. During Operation Twist, the Fed sold off some of its holdings of short-term Treasury bills. During QE2, it issued bank reserves, which are nearly identical to Treasury bills in that both are short-term liabilities of government agencies—the Federal Reserve in the  case of bank reserves and the Treasury in the case of Treasury bills.”

Hmmm. The best that can be said of QE2 is that the economy may have been worse off had it not existed; that may be true, but that’s a bit tricky to prove. What we can say is that the GDP growth was below one percent during the quarters that QE2 was underway, the labor market did not find its footing and is again deteriorating, housing is still in a depression and, although the stock market rallied during the process, the SP 500 is now trading exactly where it was when the program began early last November. Therefore, it seems to me that by pursuing OT Bernanke is hoping for a different outcome from a similar strategy that he tried last year, that has not turned the economy onto a consistent growth trajectory. The debt overhang is likely to thwart any Fed policy from real success, but that will not prevent Bernanke from doing all that he can to help with the recovery process; but does he really want to circle the same block again only to end up where he started, again.

With that in mind it could be that Bernanke will feel the need to enhance OT so that its effect will not be as fleeting as was QE2, at least in his judgment. It could be that he will attach a duration component to OT in the same manner that he pre-committed to the future path of the funds rate. In other words saying that the Fed will be the bid in the long-end of the Treasury market for the next year or so, given certain, but  unspecified economic data thresholds; maybe creating an unofficial, but evident, ceiling on long-end yields. In his famous deflation speech of November 2002 he said there were “at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination.” The first approach  was the pre-commitment on the fed funds rate, which the Fed instituted in August. The second part of the combo, which he said was his preference, was to announce an explicit ceiling for yields on longer-maturity Treasury debt. This is something that could be done, or at least intended to be done, by pursuing an  OT strategy that has a time component attached to it. Fed Vice Chairperson Janet Yellen is on board with the idea that communicating a forward commitment on policy duration is an important component of monetary policy. In a speech she gave in February she noted, “In particular, financial conditions depend on market expectations not only concerning the amount of the FOMC’s purchases but also concerning the anticipated timing and pace of the eventual unwinding of those holdings.”

In a nut shell, I think it is possible that if the Fed goes to OT today they will attach to it some sort of duration component, in coordination with the pre-commitment on the Fed funds rate that they put in place at their last meeting."

Profile: Newedge's Scott Skyrm On Destiny And The Rate Outlook

Scott Skyrm, global head of money markets and repo for Newedge, says he always knew he'd be involved in the financial industry. In a recent interview, he speculated that when the economy does turn it will turn very quickly, and the markets will become very volatile.


1) Please describe your role at Newedge. When did you join the company?

I am the global head of money markets and repo. We have two trading/sales desks in New York, two in London and one in Paris. money market products include bank CD's, commercial paper and short sovereigns. Repo financing products include U.S. Treasuries, European sovereigns, corporate bonds and municipal bonds. I joined FIMAT in 1999, which later became Newedge.

2) What did you study in school? Was it your intention as a student to get involved with the markets? If not, what was your intention in terms of professional ambitions?

I studied economics at Lehigh University. I have a B.A. and an M.S. I always wanted to be involved in the bond market.  I always knew that this would be my business. My father was in the muni bond market. At one point he ran the muni bond department at PaineWebber. When I was a kid, I would visit my dad in his office and he would let me make some (sales) calls. He would make a deal with me so that every phone call I made, I would get $1. I realized that the more calls I made, the more money I would make. It was a great lesson. I felt it was a challenge.

3) How would you describe the current interest rate environment?

My group is involved in short-term interest rates. The current environment has extremely low rates and little volatility. It is not optimal for a trading and sales desk, but we continue to add clients.  In the past, periods of very low rates (1994 and 2004) were followed by significant rate volatility and rates moved higher very quickly. I can't predict when rates will move higher (Fed tightening), but when they do move higher it will be at a quick pace and the markets will be volatile. When the economy does turn, it will turn very fast.

4) Has the credit crisis of 2008 been almost shaken out of the markets and economy?

In terms of my markets (short-term interest rates), the answer is yes. The markets are normal. There's no abnormal illiquidity, but there are permanent structural changes in the markets. For instance, banks are more concerned with balance sheet and capital. There is also more stress on minimizing both and creating more synergies within a bank to maximize returns.

5) What factors are having the biggest impact on the money market space right now and on repo?

The products are becoming commoditized.  The low-interest-rate environment and minimal volatility had a major impact. Dodd-Frank and Basel III will have a significant impact on the Repo market. As trading activity migrates out of banks, the activity still needs financing. Client financing is becoming a larger and more significant business for banks, while at the same time banks are pursuing strategies to financing themselves more efficiently. So liquidity and funding are much more important for banks and bank clients.

6) The over-the-counter repo market is now one of the largest and most active sectors in the US money market. Does the current economic and interest rate environment leave the money market and repo area in line to see more or less interest in coming days? Why?

Repo is my main business. The repo market continues to grow as the Treasury issues more and more securities to fund government. Secured lending will only increase in the current regulatory and liquidity concerned environment.

7) How could the use of cleared products change the OTC interest rate space?

The OTC interest rate swaps market is undergoing a process which occurred in the repo market in the late 1990's. Back then, in the repo market, banks and dealers wanted a central clearing counter party to take advantage of accounting netting practices to reduce balance sheet, and minimize counter party, risk and trade processing.  The swaps market is undergoing the process now, in a similar way.

The repo market is a source of secured and cheap financing. It could prove to be important if we have a credit crisis again.
 
8) What new products in the space will be hot in the next year? Why?

Banks will couple/bundle more products together in exchange for financing.

In today's environment, there's little reason to provide clients with balance sheet intensive financing unless the bank is earning multiple sources of revenue.

Banks are becoming more and more like execution facilities for clients and less like "dealers."

9) What will be an important trend in the space in coming days?

Central party clearing has significant advantages. It nets out balance sheet, pools credit exposure, and reduces operational risk and processing. Ultimately, there will be one central party clearing entity that wins out over all others. It's kind of a horse race right now

10) How do you see your role developing at Newedge going forward?

We have a very successful repo and money market group. In the past, the business was developed along regional lines. In general, since the beginning of the credit crisis, clients have wanted to diversify their counterparty relationships.

We are now coordinating the business globally. We expect significant synergies and cross-selling opportunities from this strategy. We can also take expertise developed in one region and export it to another region. It's harder to coordinate business across many times zones, but the upside potential is quite significant.