How the world has changed! Marty Zweig's 1986 book, Winning on Wall Street, gained a lot of popularity after he famously called the market crash of 1987. One of the most noted Zweig precepts was the following:
Don't Fight the Fed!
What has changed?
The Challenge
Fed policy under Bernanke has a new challenge. The seizure in the credit markets has created a situation where the Fed Open Market Committee sees a challenge that has several different dimensions. From their perspective, the problem is not just one of adding liquidity. The Fed is attempting to address two specific additional concerns:
- The elevated LIBOR rate -- something that affects Adjustable Rate Mortgages, swaps, and many business loans. LIBOR, a rate little understood by equity traders, reflects the interest charged by non-US banks holding dollar deposits. It is elevated because the banks are unsure of the counter party exposure to structured investment vehicles that include mortgage securities. The lack of transparency in other bank's holdings makes short-term lending problematic. Why reach for a little yield, when there is a risk of bank failure? When LIBOR was adopted in many agreements, it reflected a reasonable risk premium to Treasury Bills. that was the usefulness - something better than the prime rate. The agreements did not contemplate a situation like the current one.
- Banks holding mortgage investments on their balance sheets may have difficulty in using these as collateral for additional lending. This limits their ability to do future lending, an important consideration. The discount window accepts these assets as collateral, but the rate is higher and there is still a stigma attached to this approach.
The Fed Reaction
The Fed chose this week to target the specific problem rather than to cut fed funds by 50 bp's instead of 25 bp's. Was this wise?
As we noted in our reaction to the Fed policy, the proposed auction process, the Term Auction Facility (TAF) is explicitly targeted to the perceived problems. We see the Fed as completely engaged in the process of reducing LIBOR and creating a market for mortgage holdings.
Earth to traders! The concept of not fighting the Fed has a new dimension. Get with it or lose.
The Fed succeeded only marginally with its effort at expanding borrowing through the discount window. It is trying something else. If it works, they will do more of it. If it does not, they will try something else.
The Market Reaction
We are struggling to recall a reaction to a new policy that was more negative. Partly because of the market decline on the day of the Fed announcement, and partly because of the timing of the new policy initiative, nearly everyone is negative.
Leading market pundits of both bullish and bearish persuasions condemn the Fed. Some are unhappy that the markets were misled. Some think the policy will be ineffective. Traders must remember that each day is a new one. Complaints about the sloppy Fed timing of announcements have little bearing on future prospects.
In his excellent blog, Harvard Economist Greg Mankiw highlights the bad press for the Fed. He notes, as we did last week, the divergence of opinion between professional economists and everyone else.
Our Perspective
When so many people have the same reaction, and we think it is incorrect, it provides an unusual opportunity. Leading critics think that the Fed members are not as intelligent as they are, that they are all academics and therefore out of touch, that they are "behind the curve," that another 25 bp's of fed funds would have made the difference, and that the Fed should include trucking company executives and fund managers (to pick at random two recent comments). More on these criticisms in future articles.
The criticisms often point to the lack of reaction in current LIBOR rates (using many incorrect time periods and many irrelevant expirations), while declaring the Fed's innovative TAF as dead on arrival. Anyone thinking this through should realize that the impact on LIBOR cannot be expected to happen until the auctions take place. We shall see this week.
Conclusion
We acknowledged that the timing of the Fed announcements lacked sensitivity to market reactions. The "false signals" were not planned nor expected. Those who do not understand government agencies tend to impute motives that were not really there. They think that organizations behave like a unitary actors -- with a clear, rational plan in mind. The simple explanation is that the Fed is doing multiple things, with various other cooperating agencies, on different schedules with different announcement timetables. One of the advantages for readers of "A Dash" is that we have the only approach (we think) that describes for readers the actual policy-making process.
Could the Fed have done better? Sure. But the process of transparency in policy announcements is new, and still developing.
Meanwhile, the question for investors is what to do now. At "A Dash" we take the approach that no one is stupid. We look for the best information from all sources.
We do not know whether the TAF will be successful, and neither does the Fed. They are attempting something innovative that might work. If it does, you will soon see many articles in mainstream publications that will get around to explaining what economists and our readers already know. It could be a solid market catalyst, and that is our position going into this week.
For readers with futures accounts, we have bought a few Jan 08 Eurodollar contracts. This is an interest rate instrument based upon LIBOR that should rally if the TAF is successful. For those who do not trade futures, a perceived success in the auctions should also help equities.
A Final Thought
We are astounded by one-sided review of the Fed -- in the mainstream media, in blogs, and on financial television. Those who act as the gatekeepers for such information - the sources we admire and regularly cite -- have not highlighted any of those who defend the Fed. Any investor who believes in a contrarian approach should find this an interesting opportunity.
