personal views of a former fed trader

Category: Notes (Page 1 of 4)

Mechanics of a Devaluation

The inflationary process is in its early stages, and it will be particularly strong because it arises in part from a devaluation of the world’s reserve currency. Governments throughout the world printed and spent trillions in their pandemic related efforts, but none of their actions came close to the American response. American households literally received trillions in newly printed money that they are just beginning to spend. Inflation will become more obvious as that money moves through constrained supply chains and the global dollar system. Most foreign countries tether their currency to the dollar, effectively forcing them to at least partially import inflationary U.S. policies. In this post we follow the free money as it makes its way through the domestic and global economy, explain why reserve currency devaluation is particularly inflationary, and suggest prices have further to rise.

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Debt Ceiling Procedures [RESTRICTED FR]

The Fed and Treasury have seen enough debt ceilings to develop a playbook that can be pieced together from past FOMC transcripts and Congressional subpoenas. The Fed does not want to interfere in debt ceiling negotiations, which are part of the political process. But a default by Treasury may trigger enough market turmoil to affect financial stability and ultimately prompt Fed action. At the moment, Treasury debt maturing around late October is already exhibiting some signs of distortion. Treasury will make noises to scare Congress into action, but it understands the importance of avoiding default and will prioritize debt payments once it runs out of headroom. Prioritization can support the Treasury market indefinitely, and even if that support is withdrawn the Fed stands ready to act as dealer of last resort. In this post we detail the debt ceiling playbook as the ceiling moves from not binding to binding, and review the nuclear option in case things still don’t work out.

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Wealth (Side)Effects

The “wealth effect” is thought to boost consumption, but common sense (and some evidence) suggests it would also impact the need and willingness to work. Household wealth has surged over the past quarters for broad segments of the public, with an overall increase of $5.8t just over 2021 Q2. Fiscal policy pumped $1.3t of cash onto household balance sheets, but the market gods have also made a hefty contribution. Over the past two years home prices nationwide rose 25%, the S&P 500 is up 45%, and crypto gains have changed many lives. At the same time, the labor participation rate is depressed, employees are resigning, and wages are rising. Older workers can now retire early, and many others have enough of a nest egg to walk away from work they don’t need. In this post we estimate the distribution of wealth increases, pencil in the missing crypto wealth, and suggest that the Fed may be running the economy much hotter than they realize.

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Tapering Towards Neutral

The market impact of the Fed’s taper will be moderated by a significant decline in Treasury and Agency MBS issuance. An imminent taper is very likely now that a press trial balloon has been floated right before blackout and even the ECB is tapering. At the same time, Treasury is expected to lower coupon issuance and Agency MBS production is expected to continue to slow. In light of this, tapering can be thought of as maintaining the level of QE accommodation amidst significant declining issuance. While the mechanical impacts of taper will be blunted, the Fed’s taper announcement will still tighten financial conditions by bringing forward rate hike expectations. The Fed hopes to avoid another taper tantrum by separating taper from lift-off, but that is hard when one necessarily precedes the other. In this post we show how declining Treasury and MBS issuance will off-set Fed tapering and review the Fed’s communications challenge.

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Too Much Money

There is a plumbing explanation for the conundrum of lower nominal yields and higher inflation. Many factors affect yields, but they are in part determined by who has money and the investment constraints they face. QE mechanically increases the investible “cash” of investors who are most inclined to buy bonds, and they have been buying bonds. In our two-tiered monetary system $1 of QE creates $2 of money – $1 of reserves (money for banks) and $1 of bank deposits (money for non-banks). On the reserves side, some banks have significantly changed their behavior and begun deploying their reserves into bonds. On the bank deposit side, the wealthy ended up with the bulk of the newly created bank deposits. The wealthy tend to spend their money on assets, and they appear to be rebalancing some of the deposits into bonds. In this post we show how low rates are pressuring banks into adding bonds to their growing regulatory liquidity portfolio, how the skewed ownership distribution of new bank deposits may be leading to more bond buying, and suggest that low yields may not be a reflection of economic conditions.

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China Repo Facility

The new FIMA Repo Facility helps patch up a weakness in the Fed’s global dollar safety net. Since the GFC, the Fed has assumed the role of lender of last resort to the off-shore dollar banking system through it’s FX Swap Facility. Foreign central banks (“CBs”) could borrow from the Facility and use the proceeds to backstop the dollar needs of banks within their country. This helps prevent dollar panics abroad, which would affect the Fed’s ability to control domestic dollar interest rates. The Facility covers virtually all major dollar users, except China. The dollar needs of Chinese banks are backstopped by the Chinese government’s large Treasury holdings. This set-up works, until the Treasury selling is so acute that the market malfunctions and everyone has trouble monetizing their Treasuries. In this post we review the role of the Fed’s FX Swap Facility and show how the new FIMA Repo Facility is largely a China Repo Facility designed to both strengthen rate control and the Treasury market.

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Reserve Demand Post-SRF

The Fed’s new domestic Standing Repo Facility (“SRF”) makes Treasuries more fungible with reserves and will thus slightly impact the composition of GSIB liquidity portfolios. Post-Basel III GSIBs are required to hold large High Quality Liquid Asset (“HQLA”) portfolios that in practice largely consist of reserves. Although reserves and Treasuries are equal under the letter of Basel III, regulators prefer banks to hold reserves because they are more liquid. This distinction was further highlighted last March when many investors had trouble liquidating their Treasuries. An SRF addresses this concern by allowing GSIBs to instantly convert HQLA securities to reserves. The primary mechanism through which the SRF impacts markets is thus through GSIB HQLA portfolios. An SRF means GSIBs can hold fewer reserves, and more Treasuries. In this post we review the SRF, show that reserve demand is not currently constraining GSIB HQLA portfolios, and suggest the SRF’s market impact will be slight.

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The Primary and Secondary Market for Money

Domestic businesses have steadily increased their borrowings even though overall bank business lending appears to be declining. In general, businesses seeking to borrow money (bank deposits) have two main sources: banks or the debt capital markets. A bank loan leads to the creation of new bank deposits and increases the overall money supply, while issuing a corporate bond changes the ownership of existing bank deposits. These two markets for money operate under different constraints and serve different but overlapping borrower segments. In the past year, larger businesses rotated away from from banks to the capital markets while smaller businesses continued to borrow from banks. In this post we describe the two markets for money and show that together they show significant strength in the demand for money from domestic businesses.

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Two Rotations

The 5bps RRP hike created a wedge between the opportunity costs of 2a-7 money market funds (“MMFs”) and non-MMF cash investors that is setting the stage for a tectonic rotation. By August month-end around $1t in Treasuries and Agencies held by MMFs will mature and most of the proceeds will be reinvested into the RRP. The RRP is offering the same yield as bills but allows MMFs to conserve their WAM/WAL dollars for more attractive investments. As the same time, some non-MMF cash investors will be moving out of their 1bps MMF shares or 0% bank deposits and into slightly higher yielding bills. MMF portfolios are earning more from the 5bps RRP hike, but passing on virtually none of it to their investors. This makes 5bps bill yields attractive to non-MMF cash investors. At the same time, bill supply is shrinking as Treasury cuts issuance to stay under the debt ceiling. In this post we preview the two upcoming rotations created by the 5bps RRP wedge, and suggest that these forces will slowly push short-dated bills back towards 0%.

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Who’s Still Borrowing?

The demand for money market funding across all major borrowers is declining even as the supply of money market funding continues to increase. Prior posts described the structural forces increasing the supply of money and pushing money market rates lower, but declining demand for money plays a role as well. The vast majority of money market borrowing is from the U.S. Treasury, GSEs, repo dealers and commercial banks. They have all been reducing their borrowings in money markets, with some reductions likely structural. In this post we review each of these major borrowers and explain why their borrowings have declined.

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