Trump Yellen Gunfight at the Not So O.K. Corral

This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/bonds/trump-yellen-gunfight-at-the-not-so-ok-corral?post=113017&uid=4798


In the real gunfight at the O.K. Corral, which took place in Tombstone, Arizona in 1881, a long time feud between the Earp brothers and a group called the cowboys came to and end. The Earps were the sheriffs and the cowboys had threatened them over illegal activities they were engaged in. The Earps, though some were wounded, survived and the cowboys were routed.

We hope that the new gunfight is more civil, with weapons being used confined to words and economic ideas. The end remains to be seen. The gunfight has not yet occurred. I believe it will.

The first shot that will be fired is Yellen's fast draw on interest rates. They will likely be raised in December. Getting ahead of inflation is important if Trump attempts to gain a massive stimulus package. The issues that lead to this gunfight boil down to full employment and clearinghouse systemic risk. While it can be argued that there are a lot of people out of work, who have dropped out of the unemployment rolls, the Fed views the American economy as fully employed.

Full employment coupled with a large stimulus and Federal spending could result in an acceleration of wage appreciation. The Fed does not want that, preferring to wait until a recession hits to seek help on the fiscal front. Trump wants movement now.

One might wonder why Yellen is so quick to act to get out in front of inflation. I believe Blackrock when they say bond demand is massive, and that a lot of those bonds are being used for collateral and being reserved as collateral in the event that the derivative clearing houses (CCP's) weaken. These clearing houses net derivatives trades,  and that reduces risk. But that netting creates risk for the houses. In order to net properly, collateral is required, mostly long bonds of course:

A clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the clearing firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing firm's collateral on deposit. Also, it acts as a clearing firm.
If the counterparty is weak, or the collateral goes bad, by losing its value, the clearing house, a systemically risky financial marketplace is put under pressure and could fail:

As the clearing house concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized[1] in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting or a market crash. [Emphasis mine]
Therefore, I believe this is one of the most significant reasons that the Fed will and must get on top of inflation. It no longer can wait until inflation gets out of hand. This is the essence, in my view, of the new normal. It is not good for main street. But it is what it is. The collateral cannot be ruined.

According to the FT, there is significant CCP risk, and it has been understated. CCP's receive the ultimate shifting of risk from the banks. They are systemically risky, perhaps Too Big to Fail!

Donald Trump is pretty old school. He is stuck in the last century. He will likely balk at limitations on his desire for almost unlimited growth. He wants 4 percent growth and inflation. This would likely put the CCP's at risk. And that could undermine Trump's desire for massive supply side policy.

Trump is likely to bring a bazooka to the gunfight, called Trumponomics, which views the new normal as a temporary phenomenon. This, in my view, is very risky business and could be compared to the illegal activity of the Cowboys. Trump seems to want to break some new normal economic rules. He could win the gunfight and lose the West, the economy of the Western World. Yellen is determined not to let that happen. Compromise is in order. Holster your firearms.

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