Ad Hoc Commentary – Yellen and the hike that is not supposed to be a hike

As we look into the initial rate hike, it becomes clearer that Yellen honeymoon had ended: “…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…”


The two year honeymoon we predicted began in the year of the Horse and ended in the Sep 2015 Fed meeting: “…We should add that the year of the Horse welcomes Yellen as new Fed Chairwoman. As yours truly asserted in the past, Yellen will likely have a nice honeymoon until late 2015, at which point she would likely need to find buyers in the bond markets…”


In a traditional world, you cut rates to loosen monetary conditions, and you hike rates to tighten monetary conditions. That was Maetro Greenspan’s world. Maestro Bernanke Fed added QE+Twist to the equation. Regardless what the mainstream press wants you to believe, QE+Twist is essentially refinancing long-term IOUs (US Treasuries) into short-term IOUs (cash, US Bills). Logically, one would expect the Fed to reverse QE+Twist before doing a rate hike. However, a reverse QE+Twist is politically impossible as it involves the Fed selling US Treasuries. The Fed probably cannot risk getting blamed for foreign central banks following the Fed’s lead in selling US Treasuries.


Now, let us talk about the only politically correct thing that Yellen can do – raising rates. Raising rates today is not simple. The traditional Fed Fund target rate is mostly irrelevant today because every systematically-important-bank has more reserves than they need. The Fed would thus need to spend money to ensure that rates indeed rise as the Fed dictates it to. There are two ways Yellen could manipulate rates higher. She can either overpay banks on interest on excess reserves (IOER), or she can overpay a larger pool of intermediaries on the repo market (RRP). Both manipulation is costly because IOER and RRP market are much bigger than the Fed Fund market that the Fed traditionally operated in. Perhaps like the Swiss National Bank (SNB) and their abortive EURCHF peg, the Fed would ultimately find that manipulation is costly.


That is why Yellen probably has the most difficult job in the financial industry. And it would be helpful if pundits bit their tongue before they throw any criticism at her. Tightening is a task besieged by great uncertainties. In all likelihood, the rate hike’s main objective is not to tighten monetary conditions. The hike’s main objective is perhaps to bail-out those that had suffered under zero-interest-rate-policy (ZIRP). That is why yours truly believes that RRP is going to be the main mechanism that the Fed will use to raise rates. So it will likely to be the hike that is not supposed to be a hike. Let me explain: instead of tightening monetary conditions, Yellen probably really wanted to bailout the pension and insurance funds. It is a noble goal, but one that will probably suffer from severe unintended consequences.


The rate hike will likely mark the end of the USD carry trade. It will probably lead to severe stress in the FX markets, with USD becoming dearer than gold. It will probably lead to Asian central bankers digging even more into their savings to defend their currency. We had China defending the Chinese renminbi. The uncertainty is so great that Yellen’s advisors are probably suffering from severe analysis paralysis.


Good luck in the markets.