As per usual, the latest FOMC statement conjured up a storm of befuddlement about any number of topics. Most of the concerns, should they even be categorized thusly, amount to debated levels of disingenuousness surrounding oil prices (only a month ago there was nothing “bad” about a 60% collapse in the world’s primary resource input). However, there were a few notes about “market” prices and capacities that sounded almost like veiled warnings, or maybe even just warming to warnings.

The most highlighted passage, and it was emailed to me by several people, was surely this:

Finally, the increased role of bond and loan mutual funds, in conjunction with other factors, may have increased the risk that liquidity pressures could emerge in related markets if investor appetite for such assets wanes.

Apparently we should be worried that if retail fund investors start to actually and fundamentally value their fund holdings they might reach a conclusion irreconcilable with the heretofore unbreachable “reach for yield.” Asset prices that reach unbelievable levels might not stay there forever?

I don’t really see how that is any different than any previous credit cycle, only that we are now supposed to feel differently that it has spread so far into the retail end of things. This might come as a shock to people who are conditioned to think of a “smart money” vs. “dumb money” divide, but if you actually review the panic in 2008 (starting, of course, in August 2007) it was the “smart money” that panicked hardest, fastest and most devastatingly. Retail investors sat on the sidelines, for the most part, glued to their positions by Ben Bernanke’s surety about “contained” and the “worst is behind us.” The plethora of 201(k) jokes was cuttingly precise in that manner.

In other words, institutions acted then exactly like how the Fed apparently worries about bond funds now. Liquidity capacity degeneration in that pre-panic period formed a huge bottleneck, not at all unlike the possibility presented by bond funds. I worry nothing about bond funds in the past five years because they aren’t really anything difference of kind in terms of systemic weakness, only of type (which is why central banks always fight the previous battle). Forgive my lack of special “appreciation” over retail investors, I just don’t see any distinction worth mentioning – bottlenecks don’t care about type.

I find this very much like regulators examining and worrying about Step 99 in a 100 step evolution of liquidity events. The funny thing was that bond funds and retail investors weren’t much of any part of the October event. Fund investors will be the cascade at the end, the last, big push over the edge, as real liquidity in the “smart money” institutions will dry up first within the esoteric bowels of a system that absolutely nobody actually understands anymore – it is next to impossible to even define elasticity as any number of factors, none of which are really much related to traditional currency or, heaven forbid, “money”, are candidates for spreading pricing irregularity far and wide (gamma trap anyone?).

Only after pricing goes in the “wrong” direction (for policy, not fundamentals) and stays there, will the thundering herd of the crowded trade, with or without retail investors doesn’t much matter at that point, lead to dire and disorderly outcomes. The Fed is looking to defuse the lit fuse already two inches from detonation as a primary safeguard? It’s kind of like banning short selling on bank stocks as a primary tool defusing panic in mortgage-led wholesale, collateralized global financing – it helps nothing directly, and it’s already too late once it gets that far. Forget the continued raging transformation of the dollar into the “dollar”, and all the global ramifications that are already set in motion, instead focus energy and attention on retail bond fund investors.

I suppose it is nice they even bothered to notice their own fingerprints, though.