With the crude oil market pulling back and worries about Europe intensifying, today one of the legends in the business sent King World News a power piece that warns the global economy is continuing to deteriorate as worries about the Greek crisis intensify.
By Art Cashin Director of Floor Operations at UBS
February 10 (King World News) – Not Your Father's Rate Raise – As Wall Street watches carefully to see if "patient" is removed from the next FOMC statement and breathlessly await Janet Yellen's Humphrey/Hawkins testimony, there is very little discussion of the likely unusual manner and methodology of a rate hike in today's banking system.
The various QEs and other Fed stimuli have flooded the banking system with so much money that we are awash with "excess free" reserves. In fact, it appears that there are over $2.57 trillion in these reserves that are well over the reserves that are required by the Fed. In order to keep that huge excess from turning into something mischievous, the Fed is currently paying the banks the princely rate 0.25% to keep the reserves in the Fed's vaults.
It seems to me that given the current situation that the Fed's most likely means of raising rates would be by hiking the rate they pay for the excess free reserves. Since the banks could then earn the new rate risk free, they would demand a slightly higher rate to lend to business and the public.
Not many other people are discussing the rate hike methodology. The vast majority are obsessed with the timing. The only one I've noticed is my friend, John Hussman, who agrees that a rate hike could likely come by raising the payment on excess free reserves. (Although he doesn't particularly like the process as you will note below.)
John and I agree on another thing about Fed policy. That is that there is a logical interim step before raising rates. Here's what John wrote in his terrific note back on February 2nd:
Where I think Plosser and I might disagree is that, in my view, the first step by the Federal Reserve should not be to raise interest rates – indeed, in the face of what we view as a clear deterioration in global economic prospects, I question that this would be particularly constructive – and would cast a great deal of blame toward the Fed if the weakness continues. Not to say that raising rates would have much actual effect on economic activity, as the only form of economic activity that has proved responsive to zero-interest rate policy are those activities where interest itself is the primary cost of doing business: financial speculation and leveraged carry trades.
But hiking rates by paying interest on reserves, rather than by normalizing the monetary base, would have no promising effects. In my view, the primary response to a hike in the Fed Funds rate (achieved by raising the interest rate paid on reserves) would be to draw currency out of circulation and expand the already grotesque mountain of idle reserves in the banking system.
Rather, I think the Fed should – and should immediately – cease the reinvestment of principal as assets on the Fed’s balance sheet mature. There’s utterly no sense to these reinvestments, as 1) the balance sheet could contract by about $1.4 trillion without moving short-term interest rates from zero (see A Sensible Proposal and a New Adjective), and 2) at the present 10-year Treasury yield of 1.64% and interest on reserves of 0.25%, the breakeven curve on new bond purchases by the Fed – the future yields that would result in zero total returns, even after interest income – are just 1.81% on a 1-year horizon, 2.02% on a 2-year horizon, and 2.29% on a 3-year horizon. Future yields any higher than that will produce net losses to the Fed.
So, before they start with hiking rates, they could take the more measured step of letting the balance sheet shrink, a little at a time. That would give them a chance to tighten in measured steps so they would monitor the markets reaction to each step. At least it seems logical to me.
Futures Shoot Higher On Hints Of Compromise In Greek Talks – Not to reinvent the wheel, here's how my pal, Peter Boockvar over at the Lindsey Group described this morning's shift:
Sources are saying the EU Commission will propose giving Greece a 6 month extension of its current bailout program as it seems that Greece is softening its rhetoric behind the scenes with its demands. Whether this proposal gets acted on remains to be seen but Yanis Varoufakis, the new Finance Minister, yesterday said that Greece will adhere to 70% of the reforms in the current bailout agreement and this seemed to have been the first step of backing off from their original demands.
Tomorrow the European Finance Ministers do meet. In response, the euro has come off its lows and the Greek 3 yr note yield is falling by 100 bps to a still high 20%. With it's in everyone’s best interest to figure out a deal as a majority of Greek’s want to stay in the euro, an agreement was always the most likely outcome putting aside the tough negotiating tactics on each side.
Consensus – Given the shift in futures, we'll look first at S&P resistance points. First will be yesterday's 2055/2058 then the recent triple top 2064/2068. Should they fail and roll over, look to 2037/2041 support. Stay wary, alert, and very, very nimble. ***ALSO JUST RELEASED: Marc Faber – Governments To Seize People's Gold CLICK HERE.
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