February 12. Managing Expectations

It is a tale told by an idiot, full of sound and fury, signifying nothing

I am starting this week with a link to a speech by Vice-Chairman Stanley Fischer, as it’s quite informative about the sausage making of Fed policy.  This speech was given on Saturday.


The Macbeth quote at the top by the way, does NOT refer to Fischer.  I was thinking more generally about the times we find ourselves in.  However, there is a linkage between Fischer’s speech and our current political environment.  You can draw your own analogies, but mine has to do with expectations.


Fischer’s speech touches upon the modeling of the US economy that the Fed uses to shape its decisions (using the FRB/US framework, an “estimated, large-scale, general-equilibrium, New Keynesian model.”).  One key point is that monetary policy transmission works primarily through expectations: “…the expectations of decisionmakers, be they households, firms, or investors, are at the center of how monetary policy works–both in the real world and in FRB/US.”

Fischer then gives an example of Fed policy at work in the August 2011 meeting.  He notes that the “economic outlook had darkened considerably” over the summer, and that the Committee judged it merited a response, which ultimately took the form of a time schedule…the funds rate would remain low “at least through mid-2013.” What he doesn’t mention is this: Why had the outlook darkened?  Why didn’t the model capture this outcome?  Of course, perhaps those questions were considered, but were outside the scope of his brief speech.  There are other profound themes buried in the text, which I believe are becoming more important, for example, the difference between correlation and causation.

So, our President tweets tales that shape economic expectations (does the FRB/US model capture that?) and this week, Yellen testifies in front of Congress, with the opportunity to more clearly outline her thoughts on the path of monetary policy.  After the February FOMC meeting, the market reduced odds of a hike at the March meeting.  While wage pressures contained in the last employment report were subdued, other measures of inflation are clearly on the rise.  As a small example, yoy import prices released this week were +3.7%.  This series was MINUS 11.6 in Sept of last year, and has risen in spite of a strong dollar. [Chart below] What is also somewhat interesting in the chart is that it covers the August 2011 FOMC that Fischer references.  I might add that in 2011 oil had marched back up over $100/bbl, having been as low as $40 in ‘09 right after the crisis.  This week, oil closed at the high on Friday, and has more than doubled off last year’s lows, copper cleared major resistance (more on that below), and stocks closed at new highs. There are 20-odd thousand reasons for Yellen to feel comfortable about steering the market towards a March hike, but I just don’t think she will guide expectations clearly.


While I jotted down many topics to cover this week, I didn’t think I would give as much time to Fischer, but what is also quite important with respect to the Fed’s mechanics is the resignation of Daniel Tarullo, who has been at the forefront of financial regulation.  A Reuters story (linked at the bottom) notes that the banking industry is glad to see Tarullo go, as, according to the article, “Bankers had long complained he and his staff kept changing the stress tests and balance-sheet reviews in ways that arbitrarily ratcheted up capital requirements behind closed doors.”

It’s important to note that there will now be 3 vacancies on the Federal Reserve Board, and the President (that’s right, The Donald) is the one to appoint these members.  All seven members are voters, and March will be Tarullo’s last vote.  The four remaining are Yellen, Fischer, Brainard, and Powell.  So, while there has been a lot of talk about the dovish composition of the FOMC’s term in 2017, it may not stay that way.  Of course, it will likely become much MORE dovish with respect to macroprudential policy, yet another reason the current Fed might want to be proactive with respect to FF policy.

From American Banker March 2016  “Filling only the minimum number of positions on the Fed board and waiting ever-longer periods to do so is a further sign of the dysfunction of the U.S. political system. It unnecessarily puts the economy at greater risk.”


It’s somewhat interesting that NFIB (small business) Optimism index, which simply exploded in the wake of Trump’s victory, comes out just prior to Yellen’s testimony.  Last at 105.8, expected 104.5.  From the last report: “Small business optimism rocketed to its highest level since 2004, with a stratospheric 38-point jump in the number of owners who expect better business conditions” the highest reading since 2004.

We also have PPI on Tuesday, a speech by Lacker (preceding Yellen) , and then comments by Lockhart, and Kaplan.  CPI is Wednesday, as are Retail Sales. Industrial Production, and Atlanta Fed Business Inflation expectations.  Then another round of Yellen with Rosengren and Harker to follow.   The end of the week has little US data.


This note is already a bit long, so I will just briefly cite a few more items.  The chart below is the copper/gold ratio with the ten year note yield.  Gundlach mentioned copper/gold as a good indicator for rates.  Copper exploded to a new high Friday, and the ratio to gold is nearing last year’s high.

There are some that think the Fed can’t hike much due to enormous corporate debt levels.  This past week Moody’s issued a report noting that “US five-year corporate refunding needs reach an all-time record of $2T”. From 2004 to 2006 FF went from 1% to 5.25% in spite of the Fed knowing (and encouraging) a huge amount of variable rate mortgages.  Think they can’t make the same mistake twice?

Both the Fed and the ECB are talking about balance sheet reduction.  For example, I posted what I considered this important headline on Friday. *NOWOTONY: ECB TO DISCUSS REDUCTION IN QE MIDDLE OF THE YEAR.  To which a friend immediately responded.’ His friends call him MONOTONY.’  (thx JK)

A client mentioned that if an exogenous event causes stocks to begin selling off, that VIX might explode to unheard of levels because the underlying futures will not sport the liquidity needed for option shorts to cover gamma. (Not just forward call shorts on the VIX, but also shorts embedded in other structures).  There have been some large well-publicized purchases of VIX calls just above the 20 strike, but there are now a huge amount of instruments with embedded vol.  Doug Noland of the Credit Bubble Bulletin says this in his latest missive:  The VIX is low because of extraordinary confidence in counterparties.  Something to think about…

Posted on February 12, 2017 at 4:16 pm by alexmanzara · Permalink
In: Eurodollar Options

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