Investors have grown accustomed to bold moves by the Federal Reserve to defend against the evil unknown. The Fed's easing has become almost chronic and this has caused the markets to coin the term "Greenspan put," reflecting that the Fed, particularly under Alan Greenspan, would ease or provide sufficient liquidity to protect the market from a meltdown--no matter what the source.
Dr. Greenspan's successor, Ben Bernanke, has earned the "Helicopter Ben" moniker for his apparent willingness to provide sufficient liquidity to defend the economy against the ravages of deflation. Unfortunately, excessive easing has not only emboldened investors with false confidence, it may have also created a bit of "pushing on the string" as investors have grown to expect the Fed to lower rates enough to make carry-trade investing once again profitable.
In a December 1999 speech, the then executive vice chairman of the Fed, Peter Fisher, remarked with respect to Y2K awareness, that several new measures had been adopted, including extending "the maximum maturity of our repo operations to 90 days," expanding accepted collateral to include mortgage-backed securities and shifting "our normal settlement and custody arrangements for repo transactions to tri-party custodians." Mr. Fisher goes on to state, "By providing these options...we are writing 'flood insurance' to the dealer community against potential worst-case financing market contingencies around the year-end."
It seems odd that the Fed would be willing to write flood insurance to Wall Street and that Wall Street was, and continues to be, more than happy to accept such a generous gift from the Fed.
In 2008, the Fed is accepting even more types of collateral in exchange for giving investment banks Treasury securities. The current state of financial market disruptions are the direct result of the Fed pushing and maintaining a 1% fed funds rate for a solid year, while consistently downplaying any form of inflation pressures. Such a long period of unnecessary stability produced investor complacency, income greed, and biased analytics that ignored the fat tail risk.
Corporate bond issuance has improved dramatically during the second quarter, with new issuance at $416.4 million over the past two months, versus the $444.4 million raised in the first three months of the year. This is a strong signal that capital markets are up and running and that investor appetite for risk is growing.
In today's market, it will be the fixed income investor that suffers from both price depreciation and from the lack of income protection from inflation.
The sooner the Fed takes action to remove the flood insurance, the quicker the necessary adjustments will occur.
The bottom line is that the Fed has been tapped to solve so many problems in the U.S. that its dual purpose of maintaining full employment and price stability has been usurped by financial market disruptions. By focusing almost exclusively on financial market conditions, the Fed can lose its grip on either price stability or employment, or even both, which would be stagflation. Capital markets are based on price discovery and if the Fed is going to be the official financial market backstop, then it will also promote artificial pricing--a bad practice for all concerned parties.
Chief Investment Officer, Clearbrook Financial
Princeton, New Jersey