Ad Hoc Commentary – Yellen honeymoon ends

Can we have a show of hands?

  1. Who believes the official unemployment numbers?
  2. Who believes the official inflation rate?
  3. Who believes that a group of very intelligent individuals uses the above to determine short term interest rates?


Anyone who believes all of the above should watch more television and stay that way. For the rest of us, we know that interest rates are at best an indirect tool to achieve maximum employment and price stability. However, interest rates are a direct tool for determining the preferred currency for the global carry trade. Before the credit crisis, people borrowed in JPY and bought up the world. When the JPY carry trade ended, it ended up in tears as JPY moved from strength to strength.


Today, the carry trade is very much alive and the preferred funding currency is not the JPY but the USD. Recent USD strength had led to some unwinds. However, if the JPY carry trade unwind is any guide to the future, then we can safely conclude that the USD carry trade unwind had barely started.


The economic signals from within America had been flashing red for a rate hike for more than a year now. However the Fed remains hesitant. If we judge the Fed by their action, we can say that unemployment and inflation rate is not their main worry. In all likelihood, their main worry today is: How to reign in the USD carry trade; and how to avoid a debt crisis since we did not deleverage much since 2009? That is probably why the Fed keep disappointing the very cogent and intelligent rate hawks. It probably also does not help the hawks that the Chair is widely regarded as a dove. In any case, the honeymoon is over. At some point, she would need to reign in the USD carry trade without stoking a debt crisis.


There are two actors in the system: one creditor, the other debtor. The longer you hold rates at zero, the longer you punish the creditors. Warren Buffet called America’s pensions the ‘gigantic financial tapeworm’. We probably have a starving tapeworm today. The zero interest rate policy (ZIRP) is starving the worm of interest income. If rates are not raised, at some point, the tapeworm would be nonviable, but if rates are raised we remind ourselves that the tapeworm is a parasite. Keeping ZIRP is probably not going to work because pension bankruptcies would likely make welfare states ungovernable. However, if rates are raised, we face the uncertainty of a resulting financial storm coming from the USD carry trade unwind. Probably there is merit for the Fed to do a gigantic hike and then keep it there for a long time. In this way, you stop the anticipation from running wild, and hopefully stop the carry trade unwind from running wild.


There is no simple solution and that is probably why it is so difficult to understand the Fed’s minutes yesterday. The Fed probably thought they knew how the USD carry trade unwind will proceed in a rate hike environment. However, the recent price action probably threw a spanner into their ‘carry trade unwind model’. Their quants are probably going to add a few more factors and re-calibrate. The smartest guys in the room are probably more worried that the model will fail again. Yesterday Fed meeting did nothing to reveal the magic sauce for determining interest rates. All it probably did was create more confusion and lose some credibility. If the Fed does not move by December, then probably the phrase lame duck is going to be thrown around more often not just at politicians but also at central bankers.


Good luck in the markets.