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U.S. Monetary Policy: It’s Our Currency, But Your Problem

U.S. Monetary Policy: It's Our Currency, But Your Problem

U.S. Monetary Policy: It’s Our Currency, But Your Problem

Is Dennis Lockhart Serious? Probably Not

It was Richard Nixon’s treasury secretary John Conally who famously told the rest of the world to go pound sand when it complained about US monetary policy and Nixon’s default on the Bretton Woods gold clause. Conally’s audience at the time were European finance ministers who were told “it’s our currency, but your problem”. The major monetary and economic upheavals of the 1970s promptly ensued thereafter. As Conally would find out, this turned out to be a rather sizable problem for the US as well.

Policy of developed nations

We already noted yesterday that the protests of submerging country representatives against the  central bank policies of developed nations only received a cursory hearing at Jackson Hole. Following Christine Lagarde’s admonition that central banks should ‘coordinate their policies’ to avoid precipitating another crisis, Atlanta Fed president Dennis Lockhart proceeded to present his version of Conally’s famous saying, by pointing out that:

“You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, told Bloomberg Television’s Michael McKee. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

(emphasis added)

Lockhart was later seconded by James Bullard of the St. Louis Fed. In other words, India, Mexico, Brazil, etc., can go pound sand this time around.

A departure from US Policy

As Joan McCullough of East Shore Partners has pointed out in a piece written for John Mauldin, this would actually represent quite a departure from US policy since the 1990s. In light of the experiences of the 1970s, it has been standard operating procedure to rush to the aid of crisis-stricken foreign economies that got into trouble, which often happened because they tied their currencies to the US dollar.

As Mrs. McCullough points out, the US aided Mexico in the 1994 crisis, and Asian economies such as South Korea in 1997/1998, with the administration often circumventing a recalcitrant Congress in the process (e.g. the secretive ESF was employed in the Mexico crisis, forwarding $20 billion to it after Congress said no to $40 billion in loan guarantees).

The great US Policy: “Every man for himself”

She concludes that obviously, the idea that US monetary policy has always been of the ‘every man for himself‘ type is a blatant denial of reality. However, this time, with its ‘QE’ and ‘ZIRP’ policy, the Fed has painted itself into a corner it is very difficult to get out of. The ‘exit’ that will probably be attempted by September (unless economic data published until then continue to be as terrible as the most recent releases, most of which appeared to be screaming ‘recession dead ahead’), is likely to have grave repercussion for financial markets everywhere, considering that even talking about ‘QE tapering’ has pushed a number of emerging economies to the brink of crisis, or as was the case in India, has given them the final shove over the precipice.

Gently Popping a Bubble?

Several other authors, inter alia the always interesting David Zervos of Jefferies, have also provided contributions to Mr. Mauldin’ publication, which is entitled ‘Exit, Schmexit’. It can be downloaded here (pdf). Mr. Zervos had one comment that we want to repeat here, as it fits well with our remarks about ‘central bank communications’ strategies in yesterday’s post about the alleged need for ‘central bank shamans’.  Zervos on the Fed’s ‘taper’ plans:

“There is no doubt these folks are trying to delicately pop a fixed-income leverage bubble. They are deathly afraid of a souped-up version of the 1994 rout! They know that balance sheet expansion comes with the parasitic side effect of excessive private sector leverage. And as of now they feel the potential costs of further expansion are beginning to outweigh the benefits. The economy is recovering; QE has been working like a charm; but it’s time to nip the side effects in the bud. That’s the current Committee view!

As a consequence, there is a campaign underway by the FOMC to somehow convince us all that “soothing language” will be better than QE injections. That, of course, is like trying to tell Charlie Sheen that a warm cozy snuggle by the fireplace with a good book will be better than an eight ball. The market is not stupid, and neither is Charlie — both will freak out when u try to take their drugs away! And to be sure, we are 130bps into this freak-out session on 10yr rates. The bubble has been popped. And the question we should all be asking ourselves is, will the Fed lose control of the situation? My answer to that (for now) is NO! But I must say, there is quite a bit more room for a policy mistake than at any other time in the past few years.”

(emphasis added)

We should mention at this juncture that we believe that the ‘policy mistake’ has of course already been made: it consisted of the decision to print money with gay abandon in the first place. Prices all over the economy have been distorted, hampering and falsifying economic calculation. Is there a bubble in fixed income? You bet there is. The junk bond market has grown to a monstrous $2 trillion in size, with huge amounts of dubious debt issued at ridiculously low interest rates in recent years. The junk bond market has doubled in size in just seven years.

“It took three decades for the amount of speculative-grade debt to reach $1 trillion. It took about seven years to reach $2 trillion as investors sought relief from the financial repression brought on by near-zero interest rates.

The market for dollar-denominated junk-rated debt has expanded more than eightfold since the end of 1997 from $243 billion, according to Morgan Stanley. That compares with a quadrupling of the investment-grade market to $4.2 trillion as tracked by the Bank of America Merrill Lynch U.S. Corporate Index.

While Federal Reserve policies have pushed investors toward riskier investments to generate high yields, allowing even the neediest companies that might otherwise default to access capital markets,concern is rising that missed payments may soar when benchmark rates begin to increase. Martin Feldstein, a past president of the National Bureau of Economic Research, said last week that low rates should be allowed to rise because they’re driving investors into risky behavior.

“The growth in the market, and volume of supply is less important than quality of issuance,” Adam Richmond, a credit strategist at Morgan Stanley in New York, said in a telephone interview. “When we see a heavy volume of lower-quality deals, that’s when you need to worry a little bit.”

(emphasis added)

What Mr. Richmond fails to realize is that there is a direct connection between the volume of issuance and the quality and creditworthiness of borrowers. Often securities that look reasonably ‘safe’ at the height of a bubble turn out to be anything but when the bubble bursts. As we have pointed out at the end of May, even the government of Rwanda was able for the first time ever to place a large bond issue, at a ridiculously low interest rate to boot. Demand for the security was brisk – it was almost ten times oversubscribed. The buyers of this deal are by now already stuck with large losses after the recent rout in EM currencies and bonds. It is a good bet that the bonds issued by Rwanda have gone ‘bidless’.

What this feeding frenzy for the bonds of extremely dubious issuers tells us is that almost anyone was able to raise money over the past year at what have been the lowest rates for ‘junk’ in all of history. Issuance of products like ‘PIK’ bonds has soared as well. These ‘payment in kind’ bonds are essentially a pure Ponzi scheme, in which the borrower has the choice to service the debt by issuing more bonds instead of paying cash.


High yield bond ETF JNK – beginning to look a tad wobbly – via StockCharts – click to enlarge.


Numerous large bubbles in financial assets have formed due to the extremely lax monetary policy of recent years. That always happens when there is monetary pumping on such a colossal scale. It seems to us that there is no way to let the air out of these bubbles gently, therefore it seems actually likely that any attempt at ‘QE tapering’ will soon be followed by ‘full speed ahead’ again. Meanwhile, the crises in a number of emerging countries show that the bubbles are already fraying at the edges. Eventually, the problems will migrate from the periphery to the center, which is also why Messrs. Lockhart and Bullard are not quite credible with their ‘every man for himself’ assertions. We rarely agree with Mrs. Lagarde, but she had a point when she noted:

“IMF Managing Director Christine Lagarde warned that financial market reverberations “may well feed back to where they began.”

(emphasis added)



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