We have been criticizing monetary policy for well over a decade now. Many of our concerns can be found in our other commentary. This morning the Wall Street Journal contains an editorial entitled, “Jerome Powell’s Price-Fix is In”. The essence of the piece was that the Federal Reserve is seriously contemplating fixing the US Treasury curve across all maturities. The idea is that the Fed wants the yield curve to effectively be static. The consequences of this are many and we will try to address a few of them here.
The Term Structure as Pricing Numeraire
The Treasury term structure of interest rates is the numeraire used for all fixed income valuations throughout the global economy. It represents the discount rate for a default free cash flow at each maturity. From this default free rate every other asset class is valued by adding premiums to it. In this way, all risky assets are valued. So, it serves as the basis from which literally all securities are valued from whether it is equities, real estate, commodities, currencies, or private assets (and all contingent claims on these assets). The level, slope, and curvature of the term structure serves as an information signaling device for the global capital markets. The literature on the informational content of the curve is vast but many believe that the geometrical shape of the curve contains information regarding economic growth, inflation and so on. Without this dynamic the pricing dynamic throughout the capital markets will suffer mightily. In other words, if the Federal Reserve makes it static the entire valuation framework will be destroyed.
We have presented this graph in other commentary, but it is worth illustrating here to contextualize this new policy tool being considered by the Fed.
The Fed wants to add to their toolbox by fixing the entire term structure. Can you imagine what happens to the curve above if the Fed is forced to buy up US Treasuries to maintain its target yield? They will have to add so much liquidity to the market their balance sheet will explode. The line will go vertical. We were concerned with the balance sheet prior to this proposed policy change. Now the operational concerns are beyond contemplation. Additionally, the potential volatility of liquidity throughout the market will become unprecedented. So, while the prices to Treasuries stay virtually static, the underlying operational aspects of the markets will become untenable and approach chaos.
The reasoning why the Fed wants to do this is difficult to understand. Perhaps, it is merely a political power grab. Exploiting the recent capital market turmoil to increase their power base. This would be the traditional political playbook. We would not be surprised by this in the least. Or, perhaps they are simply trying to increase their abilities to bleed down their balance sheet. If they want to decrease liquidity throughout the banking system, they can sell Treasuries and remove cash from the system. Of course, this assumes they want a higher yield curve than currently stands. Given the macro economic back drop this seems extremely unlikely. The asymmetry of this perspective is dangerous as well. Once the precedent is set, and the tool implemented, the Fed will misuse it for generations to come.
Many market participants look to the Fed in what is almost an ecclesiastical manner. We say wake up to reality. The Fed is not helping the capital markets we depend on to aggregate wealth. They are destroying how markets function. The faith based legacy perspective must be refreshed using recent chairpersons. Not since Alan Greenspan has the Fed had a chairperson that gave a hoot toward anything other than their own reputations. They spend all their time now justifying their actions to preserve their egos. Their actions were monstrously short sighted and ill considered. Every disruption seems to be met with more policy mechanisms that are based on panic and fear. No deliberation whatsoever. The Fed needs massive restructuring toward a Taylor rule framework. Remove the political and economic rewards of the Fed completely. It’s the only way we can return to a properly functioning market.
The sheer hubris of this idea is so preposterously insulting to the core principles that underly our capital markets that I feel intellectually violated. Removing the price finding mechanism from our term structure will destroy trillions (possibly quadrillions) of derivative securities. When you remove all return variation, valuation models simply revert to static models and thus are useless. Moreover, the ultimate numeraire throughout the capital markets is the UST curve. Removing that dynamic will destroy all risk and return relationships that are generally utilized for asset allocation decisions. The Fed seems determined to flat out destroy the entire way markets function. This madness must stop. They are a danger to every investor in the world. These simple-minded political appointees must be controlled, not empowered further.
Equities are now at a point in the investment cycle where they are exclusively relying on exogenous forces to defend current valuations. At the turn of the century, we experienced similar mis-valuations. Then, markets were still operating correctly, and valuations eventually cleared to fair value. Now, due to the Fed and fiscal idiocy, markets are no longer functioning correctly. The Fed is not allowing the markets to clear and thus the exogenous dependency. We have become a market that exclusively depends upon the decision making of political appointees. Politicians and their appointees never make decisions that will adversely impact their personal ambitions. So, our capital markets are waiting for the moment when the rest of the world tires of the dollar and US Treasuries. At that moment, policy makers will no longer have anything left to counter those forces. In the meantime, we manage risk with a close eye on the machinations of the underlying flows throughout the capital markets.