Speaking to - or "indoctrinating," which ever you prefer - a group of students at the University of California, Irvine last Monday, San Francisco Fed Chief John Williams defended the Fed's ultra easy monetary policy, asserting that the central bank's actions have been instrumental in stimulating growth in the years since the financial crisis. When discussing the potential repercussions of the FOMC's unprecedented actions, Williams said, in a sound byte which perhaps exemplifies the Fed's cavalier approach to conducting monetary policy better than any heard thus far,
"...the presence of uncertainty does not mean that we shouldn't be using these tools."
That's the academic way of saying it. In layman's terms, Williams said
"...just because we don't have any idea how this is going to turn out doesn't mean we shouldn't try it anyway."
If Williams were talking about a new recipe or perhaps a short cut to the beach on some back roads, this trade-off between unintended consequences and potential benefits might make sense. Unfortunately, he is talking about the purchase of some $4 trillion in assets and the complete manipulation of the U.S. Treasury bond and agency MBS markets.
Perhaps even scarier than Williams' contention that experimentation is the way to go when conducting monetary policy, is his seemingly naive characterization of the Fed's "exit" strategy. From Reuters' paraphrasing of Williams' speech:
"Once it comes time to exit its super-easy monetary policy, the Fed will target a soft landing, raising rates and then selling the assets it has accumulated."
Notice the false distinction of a "soft landing" here. This suggests that there is an alternative called a "hard landing" wherein, presumably, the Fed would dump all the securities on the market at once and raise rates suddenly. Obviously then, a so-called "soft landing" is the only option.
There will however, be nothing "soft" about this approach - especially not for the Fed. Note that thanks to the massive balance sheet expansion, the Fed's DV01 is going to be some $3-4 billion by the time it starts to unwind everything, so every time it raises rates it's going to take an enormous mark-to-market loss. The same will effectively be true when it sells its holdings. Combine the two "exit strategies" (selling assets and raising rates) and you have yourself a one way ticket to a negative equity position.
Given this, one certainly wonders if there will ever truly be a yard sale on Treasuries at the Fed, especially considering the effect such a move would have on the money supply. From Pater Tanenbrarum:
"If the Fed one day begins to sell the assets it has accumulated in the course of "QE," then there is a good chance that the money supply will actually decline, unless the commercial banks decide to simultaneously engage in a very determined credit expansion... Does anyone seriously believe the Fed will ever sell the assets it has bought and deliberately shrink the money supply? A certain bridge in Brooklyn comes to mind."
Despite all the uncertainties that we should or shouldn't worry about regarding the Fed's policies, one thing seems like a sure thing. Rates have only one place to go and that's up. Nonetheless, it is amazing the number of asset managers I talk with that understand this all too well but aren't willing to take the next step: short U.S. Treasury bonds (TLT). If rates can only go up, there will be fortunes to be made betting against the prospects for an orderly unwind. Ultimately, the arrogant declarations of folks like John Williams should bring to mind the old adage that "pride always comes before a fall."