personal views of a former fed trader

Author: Joseph Wang (Page 3 of 5)

Negative Net Yields

Money is being poured into the system, and it has no where to go. The ON RRP is the escape valve, but it is fixed at 0% when money market fund (“MMF”) management fees are around 0.2%. The stars are aligned for continued flow into the money fund space, pushing front end rates towards 0% as it ultimately flows down the ON RRP drain. The Fed will continue to pump $120b/month into the banking system, European bank balance sheets will be less willing to hold additional liquidity under daily average reporting (see this post), and SLR/LCR constraints will eventually bind big U.S. banks (see this post). MMFs have been waiving their fees to keep net yields positive (without waivers Fidelity’s flagship Govie fund would yield -0.09%), but that can’t last forever. Negative net yields are coming. Cash investors are unlikely to idly sit and watch their money evaporate. In this post we outline some options for cash investors, show why the marginal flows will move abroad, and suggest that this is functionally a surgical rate cut.

Fidelity’s $130b Institutional Gov Fund (FRGXX) would be increasingly negative yielding without fee waivers
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The End of Bottomless Balance Sheets is Approaching

Basel III is the global standard for bank regulation, but each country implements it in slightly different ways. Previous posts showed how the SLR and LCR create constraints that impact short-term rates, but different methods of implementing those regulations also affect markets. European banks calculate their leverage ratio in a way that has made their balance sheets significantly more elastic between quarter-end dates. This difference was a key driver of quarter-end dynamics in recent years. But that elasticity is going away in the coming months even as forever QE continues to fill bank balance sheet with reserves. In this post we recap the recent TGA deluge, review how European banks calculate their leverage ratio, and show why the impending end to this loophole will force much higher ON RRP participation.

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SLR Sets Size, But LCR Shapes Composition

It looks like SLR relief is ending, even as the Fed is set to continue turbo QE. A bank’s balance sheet is like an office building – it can only accommodate so many tenants, and the bank wants the best tenants it can get. The size of the building is set by the leverage ratio, and tenants are judged by metrics that include their commercial value and costs. Right now there are many more potential tenants than vacant offices, so banks maximize returns by forcing the least profitable tenants out. As discussed before, banks will use negative rates to do this. The Liquidity Coverage Ratio (“LCR”) is one of the key metrics banks use to assess the costs of their tenants. In this post I sketch out why banks will push some deposits outs, how deposits are judged under the LCR, and where those deposits will end up.

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The BRRR Index

Asset prices rise when there is more money in the system, but you have to understand what ‘money’ is. M1/M2 is not a good measure as it is heavily influenced by Fed policy, which changes the composition of money rather than the overall quantity (see here for a walkthrough). The vast majority of money we come in contact with are bank deposits (the numbers in your bank account). Bank deposits are created by commercial banks when they either make loans or purchase assets. For the institutional investor, Treasuries are money – risk free, highly liquid, and fairly stable in value. Big money cannot just deposit billions at a bank and take unsecured credit risk. Treasuries are created when the Federal Government (“FedGov”) spends more than it receives in taxes. In essence, FedGov has a money printer and pays for its spending by printing Treasuries (see here). In this post, I briefly recap the moneyness of Treasuries, introduce a real time measure of FedGov printing, and explore asset price implications of the recent surge in spending.

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To SLR Or Not To SLR

There was much commotion last week on whether last April’s emergency SLR relief would be renewed before it’s expiration on March 31st. The “right” policy answer to this question is actually really easy, but politics matter as well. In this post I briefly explain what the SLR is, why a permanent exemption of reserves is the obvious policy answer (Treasuries are less clear), and the potential market impacts if the relief is not renewed.

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Negative Bill Yields Are Coming, Here are the Policy Options

It’s likely that bills will trade negative in the coming days as Treasury pays down existing bills, thus reducing their supply by a few hundred billion (see this previous post for more context). In this post I will discuss why large paydowns would push bill yields negative, the mechanics behind how IOR/ON RRP adjustments work and whether they make sense now, and other potential policy options to keep bill yields positive. It does not offer any view on which option, if any, may be taken. This post is meant to educate on a obscure corner of the market.

Is the increase in ONRRP take-up just month-end effects, or the beginning of a deluge?
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The Treasury is Dumping $800 Billion Out of the TGA, and it’s NBD

The Treasury stated in its refunding statement that it will reduce the Treasury General Account (“TGA”) to $800 billion by quarter-end, an $800b decline from where it is today. The TGA is the Treasury’s checking account at the Fed (like commercial banks, the Treasury has a Fed account and can hold central bank reserves). When the TGA is run down, that liquidity will enter the financial system as reserve assets for commercial banks (balanced by deposit liabilities to non-banks), and deposit assets for non-banks. This post briefly introduces the TGA, explains the mechanics of the upcoming decline, and discusses how the huge influx of liquidity could affect markets.

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The Debt Jubilee is Already Here

Debt jubilee is debt forgiveness, and it’s already happening at a staggering rate for public sector debt. Sovereign debt is fundamentally different from private debt in that the sovereign makes the rules and never has to repay its debt. When the Fed purchases a Treasury, and then continues to roll over that Treasury forever, then that debt is effectively cancelled. That is why public sector debt is not deflationary, nor a drag on growth. This post walks through the mechanics of our modern day debt jubilee, and how it can help deleverage private sector debt.

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The U.S. Treasury is Steepening the Curve in a Big Way

The U.S. Treasury’s most recent quarterly refunding statement is out and it looks like they are steepening curve. Just as the Fed can influence the shape of the yield curve by adjusting the maturity profile of its asset purchases (see Maturity Extension Program aka Operation Twist where the Fed flattened the yield curve by selling short-dated Treasuries and buying longer dated Treasuries), the Treasury can influence the shape of the yield curve by deciding on where to issue on the curve. In this post we discuss the how supply and demand dynamics can affect the shape of the Treasury curve, and why the Treasury curve can continue to steepen significantly.

The 2s10s curve is still historically flat

Basic Supply and Demand Factors Affect Yields

Putting aside fundamentals, such as expectations for the future path of Fed policy or inflation, Treasury yields are affected by basic supply and demand dynamics. If Treasury issues a lot of debt, then yields will go higher. The Treasury market is the deepest market in the world, but a large enough surge in debt issuance will still need to be digested. Investors may not immediately have enough cash on hand to absorb the issuance, and yields may need to rise to attract investors from other corners of the market.

This dynamic can easily be seen in $300 billion surge in Treasury bill issuance in early 2018, which pushed bill yields as a spread to OIS to widen 20 basis points in a matter of weeks (the Overnight Index Swap is an estimate for the expected path of Fed policy and used here to separate higher bill yields due to expectations for a Fed hike). The Treasury bill market is the most liquid part of the Treasury curve with a very large investor base, including the multi-trillion money market fund complex. However, $300 billion is also a large chunk of debt. Bill yields had to increase to attract money away other short-term investment products like commercial paper and bank CDs.

How the U.S. Treasury is Steepening the Yield Curve

Treasury is changing the composition of their issuance: fewer short-term debt and more long-term debt

The Treasury seeks to issue debt at a rate that is “regular and predictable,” and at the least expected cost overtime to the tax payer. In practice that means that they set a predictable auction schedule for coupon securities and meet any unforeseen cash needs by issuing Treasury bills (coupons are Treasuries that mature in 2 to 30 years and pay semi-annual coupons, as opposed to Treasury bills which are issued on a discount basis and mature within a year). For example, the unexpected surge in Covid related government spending in 2020 was first met by significant bill issuance in April and then larger coupon issuance sizes in the following months.

The Treasury projects that for the current quarter it will be reducing the amount of bills outstanding by $400 billion and increasing the amount of coupons outstanding by $700 billion (Note that the Fed will also buy around $240b this quarter). The Treasury’s projections do not take into account any stimulus legislation, so the projections may change if further fiscal stimulus is announced. But as it stands the Treasury is effectively steepening the curve. Decreasing the supply of Bills lowers short-term rates, while increasing the supply of longer dated coupons raises longer-term rates.

Yields Are Set to Move Higher (Until the Fed Steps in)

The Treasury is prudently managing their debt by taking advantage of historically low long-term rates, and a Fed that is actively buying. Since longer term rates are low, it makes sense to issue more longer dated debt. The Treasury behaved the same way the last time QE was in full force. But the level of issuance this time is unprecedented, and is currently projected to be $2.5 trillion in coupons this year and the next. Back in early 2020 a $1 trillion in net issuance would be a large number, but now the Treasury is consistently issuing over $2 trillion. Even with the Fed’s buying $80 billion a month this still a sizable amount over a short period of time.

Office of Debt Management Projects $2+ trillion in net coupon issuance

The Fed would never allow yields to go too high and it has absolute control over the yield curve. Note that central banks around the world have been able to effectively engage in “yield curve control” and pin certain parts of their yield curve (See Japan pinning their 10-year and Australia pinning their 3-year). But with U.S. 10-year real yields bouncing around historic lows of -1%, it seems that there is still room for the market to move yields higher before the Fed would step in. This is especially true if higher yields are accompanied with a narrative of higher economic growth. With short dated rates anchored by both the Fed and the large level of cash in the system, higher longer dated yields imply that the curve should continue to steepen.

Zombie Concepts: The Money Multiplier

The money multiplier is a theory on the link between the quantity of base money (central bank reserves) to the quantity of broad money (bank deposits, currency) in the financial system. In this theory, the central bank adjusts the level of base money in the system, which gives commercial banks greater room under their reserve ratios to lend, which then increases the quantity of broad money. This sounds reasonable, but is inaccurate because commercial banks (and the banking system as a whole) are never constrained by reserves in their lending – they can always borrow more reserves, manage their liabilities differently, or evade regulations by moving their activity off-shore. In this post I’ll show why there is no such thing as a money multiplier.

Carpenter and Demiralp (2012)
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