Across the Curve

“A Shot Across the Bow”

RBS Securities (the firm formerly known as Greenwich Capital) mentioned an interesting article by well respected research firm Wrightson in which Wrightson posits that some of the recent hawkish comments by Federal Reserve officials are a shot across the bow of leveraged speculators.Wrightson makes the salient point that if the trajectory of rates is unclear then leveraged positions are not such safe bets.

That is I think a key and under appreciated point with the new world of Federal Reserve transparency regarding policy.

The last Federal Reserve tightening cycle was completely transparent and consisted of 17 consecutive 25 basis point rate hikes which took the funds rate target to 5.25 percent from 1 percent. But Mr Greenspan diminished the effect of the tightening and never thoroughly damped down speculative excess as he made it manifestly clear that he would not raise rates in anything other than discrete 25 basis point intervals.

In so doing he allowed the junk which led to the current financial debacle to flourish.

When dealers and investors analyzed some of the detritus which was being created at the time, they knew that they had a clear path with no little hand financial grenades strewn across their path. The analysis of the returns to holding some of the junk was simple and easy and profitable and the lack of uncertainty encouraged production of garbage.

If dealers and investors had faced an uncertain and opaque future,then they would not have been as likely to load up on junk as they did.It would have been a much more cautious investing populace if the Federal Reserve had chosen a different path and left open the possibility that it might lob a couple of 50 basis point rate hikes in the path of investors.

If such a possibility had existed,then some of the speculative excesses which did develop might never have had a chance to hatch and history would be quite different.

In the matter of Federal Reserve policy , today is an historic anniversary. On this day thirty years ago Paul Volcker replaced the hapless policy of interest rate targeting with one in which the  Open Market Desk targeted non borrowed reserves.

That policy action had the desired effect and eventually strangled inflation.

Its unintended consequence was that it injected never before seen volatility into the bond business and turned the fixed income markets from sleepy backwater into a much traded asset class. Thank God for that!!!

Happy Anniversary.