The Fed’s Broken “Lever”

December 2, 2021

The famous Greek physicist, engineer and inventor Archimedes was quoted as saying, “Give me a lever long enough… and I shall move the world.”

(I have a feeling that Archimedes would have been a pretty successful trader too!)

He knew there was nothing too big that the laws of physics couldn’t conquer. But I imagine he also knew there were real-life limits to the applications of said laws. 

He was never going to find a lever that big…

The Federal Reserve’s original mandate was something along those lines. 

Give us the tools we need (control of the country’s monetary policy) and we shall move the world (or at least fine tune the economy by keeping inflation and unemployment in check). 

Unfortunately of late, they haven’t come to grips with the fact that they no longer have a big enough lever.

“Moving” the Interest Rate Markets

Their original “lever” to manage the economy is something called the Fed Funds rate. It’s the overnight lending rate banks charge each other for lending excess reserves. By tweaking this lever, the Fed could increase or decrease the amount of money in the financial system. 

Today that lever has become all but irrelevant. 

Over the last 30-plus years, their mandate has unofficially changed… Today their job is bailing banks and other financial institutions out of hot water. 

It dates back to the late 1980s and something called the “Greenspan Put.”

In October of 1987 the stock market crashed, losing some 34% of its value in just 5 days. It shook market confidence like nothing else in recent history.

Alan Greenspan, then Chairman of the Fed, came to the rescue with what became known as the “Greenspan Put.”  In a nutshell, the Fed eased interest rates to dole out a bunch of cheap cash that investment banks could use to beef up their balance sheets and start buying stocks again.

Financial Armageddon was averted. Who could argue with that kind of success?

The “Greenspan Put” unofficially became a new lever in the Fed’s monetary tool box. 

Actually it became the de facto response to every crisis the markets would face going forward. And thanks to that, the slope got very slippery…

It ramped up into high gear during the last two major crises in the market: the tech crash in 2000 and the housing bubble in 2008. In both cases the Fed rushed to the aid of the wounded investment banks to prop them, and the markets, up.

Did it save the world? It absolutely saved a lot of rich Wall Street CEOs.

But by using this lever so often, they’ve also worn it out. 

New “Levers” Up Their Sleeves

Today the Fed has effectively pinned short term rates — once their main monetary policy lever — to near zero. 

As a result, they’ve had to come up with some other levers to try and manage monetary policy.

One method is something they’ve been doing for nearly the past two years —direct asset purchases. Every month the Fed has been buying $120 billion in Treasury and mortgage backed assets in an attempt to keep rates from climbing. (Among other things, keeping rates low keeps the interest the U.S. Government would have to pay on it’s bottomless debt down.)

Another technique is called “Operation Twist,” where the Fed sells short term securities and then uses the proceeds to buy long term securities. This has the same curve-flattening effect as buying assets outright, but at least it doesn’t expand the Fed’s balance sheet.

Finally there’s another technique (not-so-subtly) called “Yield Curve Control.” For this, the Fed would pick a spot on the curve — most likely the long end — and buy securities there to maintain a specific yield. This is a more “targeted” version of their asset-buying spree. 

But here’s the thing… Having flooded the financial system with cheap money (all the way back to the Greenspan Put) they no longer have a lever big enough to control the market. (In truth, they never really could “control” the market — it’s just too big.)

And now they’re facing a reckoning. 

At some point things will become so uncertain, the market will start dumping the short end of the curve (pushing yields higher) and rushing into the safety of the long bond (driving yields down). The yield curve will invert again and we’ll be signaling the next disaster

But what will that trigger be?

We’ll talk about that in your next issue.

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily