Leveling the Playing Field

February 22, 2016

______________________________________________________________________________
FOMC Minutes
Well, that was more depressing than the Panthers offensive showing in the Super Bowl. The
minutes from the last FOMC meeting revealed a nervous (and confused?) Fed. Optimism,
frequently referred to as upside risk, was notably absent.
Three themes emerged:
1. Tighter financial conditions than expected
- The effects of these financial developments, if they were to persist, may be roughly
equivalent to those from further in monetary policy.
2. The risks are to the downside
- The Fed used the word downside eight times in its economic outlook and four times
in one paragraph.
- As we have been discussing for some time, the FOMC believes it is premature to alter
its economic outlook, but a minority of members have already concluded the risks are
no longer balanced.
- Admitted risks to GDP and inflation forecasts are to the downside.
- Several members expressed concern over the FOMCs lack of ammunition and
thought it prudent to gather more economic data before the next hike because, monetary
policy was less well positioned to respond effectively to shocks. Isnt it adorable they
are still talking about hiking?
3. The Committee doesnt know what to make of #1 and #2
- The Committee was uncertain about how global developments would affect the US.
- The minutes reiterated that monetary policy should not respond to temporary shocks,
but conceded that view depended upon those shocks not impacting longer term inflation
expectations.
- The effects from #1 and #2 remained to be seen.
- Several participants noted that monetary policy was less well positioned to respond
effectively to shocks that reduce inflation or real activity than to upside shocks, and that
waiting for additional information regarding the underlying strength of economic activity
and prospects for inflation before taking the next step to reduce policy accommodation
would be prudent.
Do they get brownie points for candor?

Heres What the Fed Means When it Says Tightening Financial Conditions
High Yield Spreads Over the Last FiveYears

But Still Not As Bad as 2008

But Even AAA Spreads Have Blown Out

But not nearly as bad as 2008

The Fed is clearly hoping that a pause will allow time to see a reversal of financial conditions
like we did in 2012, rather than an implosion a la 2008.
This brings us to an interesting measure of rates

Lurking in the Shadows - Shadow Fed Funds Rate

One of the struggles traditional economic models encounter is how to deal with the zero lower
bound, a model rendered obsolete by negative interest rates. Two economists, Dr. Cynthia Lu
and Dr. Fan Dora Xia, published a paper in 2015 that has gained quite a bit of momentum among
real market observers (unlike me). Their model attempts to account for central bank
accommodation to produce a real interest rate rather than just the target Federal Funds rate.
This tool has gained enough credibility that the Atlanta Fed is now publishing it on their website.
Heres their graph of the targeted Fed Funds rate relative to their effective Fed Funds rate, or
Shadow Rate.

The tightening really started once tapering began, in December 2013. Four months later, the
Shadow FFs reached its low of nearly 3.00%. By the end of 2014, it had tightened to -2.3% and
by May 2015 it was -1.4%.
It reached 0% in November 2015. The month before the Fed hiked.

This could help explain why a mere 25 basis point hike in December created such a dramatic
movement in tightening financial conditions. The Fed wasnt hiking just 25bps it was hiking
25bps after conditions had already tightened more than 300bps. It was also hiking in the face of
25% appreciation in the USD.
We pointed out last year that the average tightening cycle is 3.00% over 30 monthsisnt it
possible that a 3.00% increase in 18 months (as illustrated in the graph below) was the real
tightening cycle and the Fed actually at the peak of that cycle?
Taken in this context, can a negative Fed Funds rate or additional Quantitative Easing be ruled
out? Couldnt that be needed to help offset the dramatic increase in the effective Fed Funds rate?
Can the Fed really describe itself as accommodative if it oversaw a 3.00% tightening in 18
months? Can they afford to have a bias towards additional rate hikes in this context?

Policy Ammunition
Recent volatility is due, in part, to a lack of faith in the Feds ability to handle a true crisis right
now. Hard to blame markets for this response because in the FOMC minutes we learned the Fed
also believes neither monetary nor fiscal policy being well positioned to withstand substantial
adverse shocks. So, with that fun little backdrop lets consider what ammunition the Fed does
have at its fingertips. Some of this will be more reassuring if you believe the Wu-Xia model,
because then the Fed has about 3.00% of easing available to it
Tool 1 Guidance
This is the tool being used currently. The Fed is sending signals to calm markets without
committing itself to a timeline. It is reiterating faith in the US economy to weather the global
storm while simultaneously being open to additional intervention.
Tool 2 Explicit Pause
The Fed comes right out and says it will not hike further until conditions warrant or an explicit
timeline (like the 2012 statement about not hiking until at least mid-2015).
Tool 3 Reinvest Maturing Assets
The Fed has over $400B in assets maturing over the next two years. It could reinvest proceeds in
the long end of the curve to help keep mortgage rates low. In a more aggressive intervention
plan, it could initiate Operation Twist again and actively sell front end assets while buying long
end assets to flatten the yield curve.

Tool 4 Quantitative Easing

This is where I disagree with most economists (they are far smarter than me, so weigh their
opinion more heavily). I believe the Fed would begin another round of QE before it would cut
FF, while most economists believe the opposite. I think Yellen et al dont want to cut rates
unless absolutely necessary. Heck, they are still publicly stating they have a bias towards hiking
rates. There is no precedent for successfully hiking rates off of 0%, does the Fed really want to
retreat already?
I think the more likely outcome is QE to the tune of at least $40B/month. The focus would be
Treasurys, but if the housing market wobbles they could also buy MBS.
The tightening of financial conditions in the Shadow FFs graph above really began with
tapering, not the first rate hike. Why not re-engage the very tool that led to the run up in
effective rates?
Step 5 Cutting Interest Rates
If GDP slows to 1% or less or if the stock market really craters, the Fed may be forced to cut
interest rates. As I stated in #4, I think Yellen really wants to avoid this. It would likely be
coupled with strong forward guidance about keeping rates low for the foreseeable future. In fact,
I think the Fed wants to avoid this so much that if they do end up cutting, it will probably be to
take FF negative
Step 6 Negative Interest Rates
Yep.
I dont think this the most likely scenario, but it cant be ruled out. The Fed is stress testing
banks for negative rate environments, making comments about the negative interest rate
experiment in Europe, saying it would be prudent to investigate Negative Interest Rate Policy
(NIRP), etc. It is in play.
But with the 10yr Treasury still yielding about 1.50% more than it German counterpart, Yellen
will likely try to shape the curve in that way before dragging us down the NIRP rabbit hole.
Plus, dont you think shes looking at Congress like, Can we get a little help here on the fiscal
front? Too bad for her its an election year.
During her testimony to Congress, Yellen said the Fed had to investigate the possibility of
negative interest rates but that a move was unlikely because she does not expect the FOMC is
going to be soon in the situation where its necessary to cut rates.
Approximately 25% of the worlds GDP is experimenting with negative rates in some fashion
right now. Results are mixed (except for bank stocks), but some of the largest concerns havent
materialized, probably giving the Fed some reassurance. Fed Vice Chair Stanley Fischer said in

a speech two weeks ago that negative interest rates are working more than I can say I expected
in 2012.
The market is pricing in about an 8% probability of negative rates over the next twelve months.
But that probability is based on an economy that expanded at a 2.4% clip last year and a 4.9%
unemployment rate. I wonder how much those odds jump if the US economy slows or even
contracts?
I think negative rates are something the Fed will and probably should consider if the situation
arises, former Fed Chairman Ben Bernanke said in the interview last month. Former
Minneapolis Fed President and uber dove Narayana Kocherlakota noted last week,
since October 2015, Ive argued that the Federal Open Market Committee (FOMC) should
reduce the target range for the fed funds rate below zero.
Current Fed Chairperson talking about NIRP. Check.
Current Fed Vice Chairman talking about NIRP. Check.
Former Fed Chairman talking about NIRP. Check.
Former Fed officials talking about NIRP. Check.
Oh yeah, its in play alright.
Approximately $6 trillion in global sovereign bonds are now trading with negative yields, twice
the amount from just two months ago. Eighteen months ago, that amount was zero.
The downward spiral to NIRP is gaining momentum.

Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument or as an
official confirmation of any transaction. Your receipt of this material does not create a client relationship with us and we are not acting as fiduciary or advisory
capacity to you by providing the information herein. All market prices, data and other information are not warranted as to completeness or accuracy and are subject
to change without notice. This material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable
law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group, LLC does not provide legal or tax
advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall not be copied, reproduced, or redistributed without the express
written permission of Pensford Financial Group, LLC.