The Fed’s Dilemma: No Wiggle Room

by LV

The Volatility Index (VIX) is a contrarian indicator that gauges whether overall sentiment in the market is optimistic or fearful.  Basically, the VIX is a measure of market anxiety. When the index is low, as it is now, the sentiment is optimistic. When it is high, the sentiment is pessimistic.  Note the following chart from the Financial Times:

For over a year now, the VIX, across a variety of asset classes, has been range-bound at levels last seen in 2006 and 2007, just prior to the Great Recession.  As seen in the chart above, volatility increased dramatically beginning in the second half of 2007, as an overheated housing market crashed bringing the stock market down with it.  History seems to be repeating itself, as investors appear to be put off by the extensive amount of Federal Reserve interference and the unbridled cupidity of high frequency traders in our financial markets.  These factors, among other concerns, have led investors to throttle back on market activity and this is reflected in the low volatility levels we are witnessing. Lillian Gett of the Financial Times warns that “market tranquility tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.”

The Federal Reserve was created by bankers for bankers one century ago.  Consequently, the first thing the Fed did when the markets nosedived in 2008 was rescue the big banks and they pulled out all the stops to do so.  All else was secondary. The Fed and U.S. Treasury successfully used the counterfactual argument that we were at the brink of a financial abyss to spook Congress into granting them extraordinary powers at the peak of the crisis in 2008.  At the Fed’s urging, the government bailed out the big Wall Street banks with taxpayer money. The Fed rushed to the rescue of recalcitrant bankers instead of opting for an orderly bankruptcy consistent with the principles of a capitalist system.  To reverse the slide in the economy, the Fed also drove the federal funds rate to near zero in 2008, where it has remained ever since. This Zero Interest Rate Policy (ZIRP) was later turbo-charged with a series of quantitative easing programs, where the Fed, on a monthly basis, purchases tens of billions of dollars of U.S. Treasury securities and toxic assets held by the big banks.  That influx of freshly minted money naturally found its way into equities in a big way and pushed up asset prices even as the general economy continued to languish.

The main beneficiaries of the Fed’s monetary policies have clearly been wealthy investors, whose considerable financial assets have risen in value as the stock market has risen relentlessly, without a significant correction for five years and counting.  On the other hand, the middle class has suffered the brunt of the damage as wages have remained stagnant through either unemployment, increased part-time instead of full-time work, or minimal salary increases.

One would think that Wall Street bankers would be delighted with the outcome as it relates to them and would act with more magnanimity in the future.  Instead, it appears that being rewarded for failing miserably made them believe in their invincibility. As any spoiled child will attest, it is unacceptable to suffer any setback for a prolonged period of time.  Hence, we have arrived at the point where bankers are complaining that Fed policy is now harming their profitability or, at least, the levels of profitability to which they have become accustomed over the years. They contend that normal market fluctuations have been unduly attenuated by Fed policy and this diminution in the amplitude of the wiggles; i.e. ups and downs, in asset prices has had a deleterious impact on their trading revenues.

To its dismay, the Fed never counted on the economy being mired in anemic growth for this long a time period.  By now, according the prior Fed forecasts concerning anticipated GDP growth, the economy should have recovered its health and the Fed should have been well on the way to reducing its balance sheet.  Instead, the balance sheet has ballooned to a record four trillion dollars. Any serious talk about increasing interest rates by the Fed is met with swift market pullbacks, but these are short-lived as Fed officials immediately walk back any notion that could be misinterpreted that they intend to raise rates anytime soon.  Investors have grown accustomed to a stock charts that continue to ascend up and to the right. It is taken for granted that, as long as the Fed continues its easy money policy, the market will continue its inexorable climb. Anyone who thought they knew better over the past several years and shorted the market got their heads handed to them.  All the bears did was provide fuel to the bull market as they got squeezed and had to cover their short positions at market prices. Numerous technical analysts repeatedly called for a market reversal, if not a major market crash, only to see it not come to fruition. They failed to recognize that technical analysis does not work very well with a rigged market, where the data being analyzed is corrupted.  Garbage in; garbage out. See previous article at: .   

Having been burned numerous times, most bears retreated to the sidelines some time ago, leaving mostly those with a bullish outlook in the market.  Hence, it is no surprise that market sentiment, as reflected in the VIX, is near record lows. Complacency rules. Fear is missing in action. When sentiment, whether it is fear or optimism, settles at extreme levels for a prolonged period of time, the market fails to exhibit the up and down fluctuations it normally would.   The swings in stock prices become muted and tame compared to what they would typically be. Becalmed markets are anathema to short-term traders, who need stock prices to swing up and down in a reasonably fluid manner, if they are to trade profitability. This is particularly true for high-frequency traders, who trade at millisecond intervals in huge volume.  The trading edge provided by clever algorithms is dulled as stock volatility declines.

Reinforcing stock market placidity is the flight of retail investors who have retreated to the sidelines in large numbers as the market marches into record high territory.  Even the village idiot knows, at some point, that it is probably not a good long-term strategy to buy high and then sell higher as the market keeps making new highs on a regular basis.  Market volume is dominated by high frequency traders who use manipulative computer programs to front-run honest investors 24/7 with impunity. Laughingly, the SEC claims it has been studying the self-evident scam for years but can’t quite decide whether stepping in front of stock transactions at the speed of light to scalp pennies and nickels in huge volume is a problem or could possibly result in an uneven playing field.  But investors see right through the charade. They are tired of being duped and juked by high-speed computer algorithms, leading them to curtail or abandon their trading activity in what they perceive to be a rigged market.

Therefore, it is more difficult for market manipulators to earn as much as they usually do since there a fewer marks to separate from their money.  It’s like a sailboat without strong winds to propel it along. It simply can’t go as fast and travel as far as it otherwise would under normal trade winds.  The same analogy applies to high frequency traders who cannot haul in as much in profits as they otherwise would under normal market conditions. In other words, traders need the market to fluctuate or wiggle in a more traditional manner and they need a sizeable supply of active market participants, if they are to make the same level of trading profits to which they have become accustomed.  And the profits to which they have become accustomed are considerable. Reduced market participation and reduced market volatility translate into reduced trading revenues.

As a result, several spokesmen at Goldman, Citigroup, and JPMorgan have voiced concerns that lingering low volatility is negatively impacting trading revenues. They are blaming Federal Reserve policies for distorting normal market behavior.  They want the Fed to remove its heavy thumb from the scale so there is more bounce in the market. It’s time, in their view, for the Fed to leave market manipulation in the capable hands of the proprietary trading desks in order to restore profits to their proper levels.

So, what is the Fed to do?  Not only are bank depositors, particularly seniors, sick and tired getting next to nothing on their savings, but now bankers are starting to complain that they are not getting the returns they believe they deserve.  

When big bankers squawk, the Fed listens.  If past is prologue, the Fed would normally be inclined to do whatever favors the big banks.  And, if that means increasing volatility to increase trading gains at proprietary trading desks, the Fed would normally be disposed to grant the banks their wish.  But there is a problem with making such an accommodation: increasing volatility is usually accompanied by declining equity prices.

Wall Street firms will position themselves to stay out of harm’s way, as they usually do, when the general market declines, but they will also be in a position to profit by the increase in stock price fluctuations caused by increased volatility.  In other words, market fluctuations, which are conducive to surefire high frequency trading gains, are more important to them than which direction the market is heading. The bears will return to the market making for a choppy trading environment.  As far as high frequency algorithmic traders are concerned, the ripple on the ocean’s surface is more important than the level of the tide. But the reverse is true for investors who are primarily concerned with the level of the tide and don’t want to suffer losses in a sinking market, especially after the Fed encouraged them to take on more risk.  

Hence, the Fed finds itself caught on the horns of a dilemma.  Satisfy the banks and leave market forces alone, thereby risking a potential market collapse.  Or satisfy investors by keeping the market artificially afloat by continuing the easy money policy indefinitely.

As a matter of self-preservation, the Fed does not want to be blamed for setting off a major market panic.  The Fed realizes that any serious market setback will again hurt those least capable of sustaining the losses and will provide ammunition to those who want to rein in or end the Fed.  As much as the Fed may want to please Wall Street, they aren’t going to walk the plank that easily. They are still smarting from their failure to recognize the housing bubble that crashed around their ears not that long ago.  Instead of doing something they might regret, the Fed is seeking a middle ground where they gradually return interest rates closer to a normal range, hoping nothing untoward happens in the interim. A glacial return to normalcy, however, is likely to distort market behavior even more in the future and may have other unintended consequences.  

This was the ineluctable outcome once the Fed embarked on a course of monetary easing over a protracted period of time because it threw a monkey wrench into the natural rhythms of our financial markets.  The result is an aberrant market which is showing telltale signs of manipulation. It is behaving more like a fixed horse race, where the horses leave the starting gates and line up along the rail in a pre-determined order, like a merry-go-round, until they cross the finish line.  

Sooner or later, the piper must be paid.  Instead of letting our capitalist system work to expunge excesses and accepting the pain that it engenders over the short or intermediate term, the Fed decided that it was more important to protect the worst offenders and distribute the pain over a very long time frame to those least culpable of causing the problem; i.e., the American middle class.

This is what happens when a tiny group of unelected insiders at the Federal Reserve make monetary policy decisions with little oversight.  Perhaps, the Fed initially thought they could control market forces through monetary machinations. But, with so many market variables at play, not the least of which is the fact that we live in a globally interconnected financial system, it turned out to be a dubious experiment.  The forces of supply and demand tend to seek their own level of equilibrium. Any attempt to manipulate and alter the natural balance is doomed to failure. It is foolhardy to think monetary policy can be cleverly managed to avoid the pain associated with poor financial decisions over the long run.  It doesn’t work that way for an individual with his or her private finances nor does it work for central bankers on a national or global scale.

The Fed appears to have painted itself in a corner where they are damned if they do and damned if they don’t.  Sitting on the fence is getting more and more uncomfortable for the Federal Reserve but jumping off is likely to be much worse.  

This leaves the Fed very little wiggle room in their quixotic quest to suppress and contain normal market forces, which are stronger than any group of individuals who may think they are more powerful.  In all likelihood, this will not end well, nor should it.