The Fed: Backed into a Corner?

This stuff isn't my area of expertise, but it is my bond-trading officemate's. He thinks the Fed's actions have backed them into a rat hole, and are hurting the housing market and all forms of credit. His arguments seem very logical to me. Far more so than Najarian saying on CNBC this morning that the Fed is keeping rates low to help credit card customers?! Huh? When the likes of Citi (C) are raising card rates to 25% on their best, high credit score decade + customers??

Ponder this:

The Fed continues to say it will leave rates near zero for a LONG time. Hence big buyers are scooping up huge amounts ($44B per month) of 2-year notes at absurdly low yields and a very tiny spread to the already pinned Funds rate. If the Fed were to suddenly change its tune, the owners of these (big banks, sovereign funds, etc) would get crushed. So the Fed is trapped - it can't publicly signal rates are going up without first secretly telling these big note holders that they are going to do so, so these guys can start unwinding. If they even signal this publicly, it'll be too late. Not to mention what would happen to the massive Fx carry trade bubble when the dollar strengthens.

Furthermore, by keeping the rates low, the Fed hurts the housing market. Banks do not need to, and are not, going out on the risk curve to make money. They can gather deposits for nearly nothing and make a big fat spread in treasuries. The long end of the yield curve is staying high (curve is very steep) because the bond vigilantes are afraid of inflation due to the Fed's easy money policy. Who needs to make mortgage (or small business etc.) loans when there is a "risk free" 3-400 bp spread ripe for the picking? Risk free, that is, until the Fed raises rates. Which they can't. But they have to at some point. Hence they have to give a "wink wink nudge nudge" to all the big players. Which they can't - that wouldn't be ethical and would hurt those not in the know.

Trapped indeed...

Comments

[Funda-Mental:]

What happened to USURY laws? When did we eliminate them? There is no need to have more than 10% interest in a 0 percent environment??

Nov 10 04:59 PM

[No Free Cake:]

Isn't this the same dilemna the Japanese central bank found themselves in?

Nov 10 05:28 PM

[Jasper M:]

On Nov 10 04:59 PM Funda-Mental wrote:

> What happened to USURY laws? When did we eliminate them?
> There is no need to have more than 10% interest in a 0 percent
> environment??

Because it's not the same 'environment' - at this point, a 91 day T-bill is probably going to get repaid. At this point, a credit card balance, well, um, not so much, no.

I am a net lender of $, so I see that point. I am relatively content with most of my funds in T-bills (as the man said, return OF my capital, not return ON my capital), at very nearly 0%. But there is Just No WAY I would lend on a credit card basis now, not at 10%, not at 25%. Most of that capital is Never coming home.

Nov 10 05:59 PM

[fleeing omega:]

"Hence they have to give a "wink wink nudge nudge" to all the big players. Which they can't - that wouldn't be ethical and would hurt those not in the know."

umm, ...can't? What have we been witnessing the past year or more? e.g.:
"the problem is contained to subprime.."
"the banks have all passed the stress test"
"we stand behind the dollar"

Nov 10 06:06 PM

[damienhaas:]

The irony is that by keeping the spread high, the FED has discourage lending and encourage speculating. In this kind of situation, you could have many stimulus and the real economy is not going to improve. Yes. AKA Japan.

Nov 10 06:22 PM

[The Geoffster:]

The only English words I saw in Japan were Sony and Mitsubishi.

Nov 10 07:06 PM

[ryanclarke:]

If you follow the Federal funds flow data and the earnings AXP, COF, Discover, etc. are posting you might guess the same as I ... the debt isn't being payed off ... nor is the debt being destroyed ... earnings are due to "writeups" but the consumer debt is still sitting there ... the Fed is trying to inflate it away. The Fed succeeded in the 1970s with such a policy ... my own prediction is a hybrid of 70s inflation with 30s deflation. My call is an S&P 500 at 500 by no later than December 2010 ... with pump prices sometime in the next two years well above $5 gallon for gasoline. Which comes first is up to the Fed but my belief is both will occur in the next two years ... and ten years from now when a new government in the United States is formed ... with a revised constitution ... is when Greenspan's wife will admit on Comcast TV the U.S. had been in a stealth depression since 2000.

Nov 10 07:09 PM

[MarketGuy:]

Article exerpt:
"Hence they have to give a "wink wink nudge nudge" to all the big players. Which they can't - that wouldn't be ethical and would hurt those not in the know."



This where the x-factor lay in the shadows. They WILL be unethical and tip off the players. Recent history has already proven such.

Nov 10 08:13 PM

[Augustus:]

Citi is raising rates on the good customers because they are the only ones who can pay.

Nov 10 09:13 PM

[Nelsanity:]

The Fed isn't backed into a corner. They are purposefully doing this so the banks can recapitalize 'risk free'.

Nov 10 10:16 PM

[Dirtnap:]

Exactly.


On Nov 10 10:16 PM Nelsanity wrote:

> The Fed isn't backed into a corner. They are purposefully doing
> this so the banks can recapitalize 'risk free'.

Nov 10 11:07 PM

[JeffDB:]

I think they've been backed into a rat hole for awhile now and neither they nor we are going to get out without a lot of pain.

The conundrum they find themselves in was quite predictable, and yet I assume they figured it was still their best option. The lesser of several evils, if you will.

As far as banks or other big players taking short term loans, deposits or other capital and investing it longer term, I think that is the height of stupidity and should have been strongly discouraged via the Fed's "moral suasion". That is exactly what brought the S&Ls down in the day, and that risk too should have been readily apparent to anyone in the finance industry.

It makes me wonder if the Fed hasn't just decided to heck with it all, they're going to leave rates absurdly low and try to deal with the fallout as best they can. Perhaps they'll let the dollar continue to fall and not worry about the inflation to come. Maybe they'll just continue to *be* the market for mortgages for the foreseeable future.

No matter what they do it seems to me that there will be significant fall out. Perhaps they've already made their decision when confronted with the option to "Choose your poison".

Nov 10 11:57 PM

[Andrew Butter:]

That's what you call a bubble - and it's cooking.

Nov 11 01:57 AM

[prairiedog555:]

Ever notice why all of your credit card bills go to South Dakota? The Democrats changed the usury laws.
Many states have a usury law which limits the interest rate that a company may charge.
Most of these laws capped interest rates at 18%. However, some states, such as South Dakota, do not have a usury law, allowing in-state businesses to charge as much interest as they want.

Congress has the power to regulate interstate commerce, which includes regulating nationally chartered banks which do business in more than one state. In the Supreme Court case Marquette v. First Omaha Service Corp. in 1978 the Court ruled that nationally chartered banks do not have to follow state law in which they do business, but only the law of the state in which the company is incorporated. Because state usury laws were not uniform this rendered all of them irrelevant as credit card companies picked up and moved to the states that allowed them to charge the highest interest rates.

After the 1978 ruling only national banks were exempt. If you banked with a bank which only did business in your state you were protected by your state's law. But a federal law now exempts state banks as well.

Nov 11 06:06 AM

[zagrebzagreb:]

Are you saying that its the Democrats' fault we don't have usury protection because of the Supreme Court's decision?

Nov 11 10:40 AM