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Tuesday, February 9, 2016

Market Volatility



Posted at Mises.org:

From my reading, for the Fed to increase rates in the situation of overwhelming excess reserves requires directly reducing liquidity via reverse repos (an increase in the rate of interest paid on excess reserves was also necessary, but not sufficient).  For those interested, I have written several posts on this topic, culminating with this one.

A look at the activity of reverse repurchase agreements suggests that the level has been steadily increasing since January 2014 – yet the volatility seems only most directly correlated to 1) the Fed’s failure to change rates in September (as the market seems to have fully expected this) and 2) the move to raise rates in December.

So why the significant increase in market volatility only now, when reverse repurchase activity has been steadily increasing for two years?  I am not sure.  Perhaps the market is now acting on the conclusion that the emperor has no clothes.  Yellen is trapped.  Reversing course on the recent rate hike would demonstrate nothing but incompetence.

Increasing the overnight rate will require draining evermore and increasing liquidity from the system.  This attacks the price of financial assets from both ends – higher rates and lower liquidity.  Perhaps this can be overcome by increasing the balance sheet again, but then the Fed would be fighting against itself.

I have long believed that the Fed would not increase rates in any meaningful way until a) price inflation was meaningfully politically painful, and b) the market therefore forces the Fed’s hands.  Neither of these is evident today.  Even the Fed cannot fight the market, it seems.

What is in force today is seeing the nakedness of the power behind the curtain – and not only to Austrians.  Even those playing the game have all been watching for the day they believe the game must come to an end – just hoping they are faster and smarter than the next guy.  Maybe these recent events are the signal.

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