I can’t imagine Paul Volcker, the former Fed Head, who passed away over the weekend, had much time for QE or zero interest rates. He succeeded in addressing out-of-control inflation 40-years ago by tightening money supply. Pumping money at markets since 2009 has been a far less efficient policy. Although Volcker became something of a Winston Wolfe, a highly experienced exponent of the art of Financial Clean-up – he understood how the Laws of Unanticipated Consequences work in financial markets. I suspect today’s conflicted, distorted and mistuned markets left him unimpressed. His grasp of finance feels an increasingly rare talent.
Volcker’s career spanned 60 years, including my own early days. Back in the 1980s, as Fed Chairman, he engineered a massive deliberate slowdown to stifle runaway inflation, by addressing money supply. Interest rates peaked at 21.5% in 1980! It’s been the subsequent fixed income rally that’s funded everyone’s glittering careers in finance. Perversely, his success at stemming inflation set the market environment and accommodative conditions of the last 40 years that’s driven many of the excesses of finance.
One unintended consequence of a long-term bond rally was to allow banks to become increasingly empowered and “greedy”, fuelling the era of investment banking excess from the 1980s right up to the crisis of 2008. It was no wonder Obama called in Volcker to Chair the Economic Recovery Board, putting restrictions on the trading activities of the big banks – The Volcker Rule.
Through his career “Tall-Paul” understood the dangers of financial institutions wedded to increasingly complex financings. Since its inception the banks have successively unwound the Volcker rules brick by brick, supported by financial geniuses like Donald Trump (US readers: obvious sarcasm alert.) Volcker was one of the key figures behind the evolution of financial markets over the last 50 years. Would he be impressed by the successive waves of boom and bust and crisis, and the looming deflationary threat over the past 10-years? I suspect not.
What would Volcker have thought of the structural problems at the core of the current REPO financing crisis? Although he was criticised over his bank regulatory record, I am sure he would have harrumphed his scepticism at capital rules that encourage the 4 largest banks to divert the market liquidity they’ve historically provided through repos because long-end T-Bonds attract a lower capital charge than 40-day Repo loans. He would have pointed to the insatiable demand from hedge funds for leverage as drivers of demand.
The complexity and interplay between the contradictory bluster of Liquidity requirements, Liquidity coverage ratios, capital weightings, and the unintended consequences of 10-years of regulatory mission creep lie behind the increasing short-end squeeze. The response – as it has been since 2009 – is to pump more and more money at market problems. Financial rescue? or financial repression of any underlying volatility? Yesterday, the Fed received bids for $43 billion for year end funding, pumping $25 bln into the market. As the BIS has pointed out… something structural is going wrong! (One of my coveted No Sh*t Sherlock awards is winging its way to Basle.)
The short-end liquidity/Repo crisis is just another example of how distorted markets become.
How to fix it all? Markets need to be free to fail – but are now so complex and intertwined with sentiment and growth, it’s inconceivable the financial/regulatory/business complex won’t remain tied at the hip. Years of mollycoddling markets via ZIRP and QE , and now QE that isn’t QE but Repo support, all to avoid instability simply embeds more instability into the very foundations of the markets. Volcker understood… We are trapped within the laws of Unintended Consequences…