The Fed’s control over interest rates can also be viewed as control over the quantity of a certain type of money. The mere prospect of rate hikes mechanically reduces the market value of Treasuries, which are widely held as money like safe assets. The declines in value are net losses to the financial system that are also unevenly distributed and cannot be hedged system wide. The losses are further transmitted across asset classes as diversified investors rebalance their portfolios by selling other assets. When investors are leveraged and markets are fragile, the rebalancing can lead to significant market volatility. In the coming months the Fed may place further upward pressure along the entire curve by signaling more hikes and aggressive quantitative tightening. In this post we review the mechanics of rate transmission, show how its impact is magnified by high debt levels, and suggest an increasingly aggressive Fed would repeat the 2018Q4 meltdown in risk assets.
Raising Rates
The Fed is raising rates across the curve through two mechanisms: hiking overnight rates and quantitative tightening. Market participants understand that the Fed controls overnight interest rates so they price short to medium term rates based on the expected path of overnight rates. Mechanically, the hikes are priced in by lowering the market value of Treasuries maturing over the next few years. Fed communication thus far has shepherded the market to expect a series of rate hikes ending with a policy rate of around 2.25%. That would be a historically low terminal rate, and former Fed officials suspect that there is upside risk to that expectation.
Fed deploys balance sheet policies to influence longer dated interest rates, which are largely driven by supply and demand dynamics. QE exerts downward pressure on longer dated rates by boosting Treasury prices through outright purchases. There is limited consensus on the impact of QE, but buying $5.7 trillion of anything usually raises its price. QT ends this source of demand and effectively increases the supply of Treasuries to the private sector, which would place downward pressure on their prices. Even without QT, Treasury already projects a historically high ~$2t in issuance this year. QT would further increase supply and potentially lead to a deeper sell off in longer dated Treasuries.
Reverse Wealth Effect
The impact of higher rates is magnified by the historically high level of public debt in the financial system, as higher debt levels imply higher levels of losses. Unlike private sector debt, losses from public debt are net losses to the financial system. Private sector debt is a zero sum transaction where losses by the lender are balanced by gains to the borrower. Wealth is redistributed, but the total level is unchanged. Public sector debt is different because the losses of lenders end up as gains on the balance sheet of the sovereign, who does not care about its wealth. The Federal government will not tax less or spend more because it is wealthier. Note that hedging can transfer these losses among borrowers, but it does not reduce the total loss borne by the private sector.
The losses on Treasuries flow through the financial system as diversified investors rebalance their portfolios. The assets managed by these investors are vast and include the ~$2t target date complex, hundreds of billions under risk parity strategies and parts of the multi-trillion self managed retail accounts. Monetary tightening effectively haircuts the asset levels of all these investors and leads them to sell other assets to rebalance. In addition, many leveraged investors that pledge their Treasuries as collateral for derivative transactions or other risk assets may be forced to shrink their positions.
This selling takes place when market depth across asset classes has not come close to scaling with the surge in asset prices. The resulting market fragility can already be seen in trillion dollar companies trading like penny stocks. In late 2018, a market implied terminal rate of ~3% was enough to implode all risk assets. We might still get to that level in the coming months and further top it off with aggressive quantitative tightening.
Another Fed Put
Raising rates is tricky in a world when the fulcrum asset is a fixed rate security. If it makes sense to have a “Fed put” on the S&P 500, it makes even more sense to have a put on the systemically important Treasury market. As some central bank officials have suggested, it may be a good idea to maintain a bit of quantitative easing as soft support for asset prices while rate hikes occur. Such an approach might allow for a more orderly reduction in monetary accommodation. The Fed does not appear to think this way, but one more meltdown might change its mind.
What do you mean by “market implied terminal rate of ~3%” ?
“terminal” is the rate that the Fed stops hiking to as in termination of hiking.
Final interest rate to which the Fed implied it would raise rates to.
Great Article Joseph. A pleasure to read as always. We have 10% of NTA in 9 month puts on TLT and the question is for me is where is the strike price of the Fed put? Surely they won’t stop tightening until the 30y is at least 3%? My wife and I discussed our exact TLT position on our most recent podcast if you’re interested https://youtu.be/OhfzcyVN6pc Keep up the great work I feel like I should be writing you a cheque every time I hear you speak
Hi Mitch, I am not the expert that Joe is but right now I think you would need some unexpected tail scenario under which the long bond gets to a yield of 3%. It could happen if something comes totally unhinged but if the Fed tightens a lot that usually kind of slows economic activity and longer term yields come down while short yields go up in line with the federal funds rate.
Yeah my current opinion is that they want it above 3% to sufficiently slow the housing part of the CPI and will use QT to get the rate there depending on how much the market moves it by itself. We’ll see what the pure market price for all bonds are when the fed stops buying in March 👍
they don’t stop buying in March. they stop adding to the size of the BS. They still roll over their purchases until QT starts. This means they will still be purchasing 10s of billions every month…
Stop buying as much I should have said
Hello Jospeh. Thanks a lot. Do you think the real economy is more or less interest rate sensitive than 2018 ? People tend to talk about the rising public debt but they dont talk about the maturity profile. Moreover households’ s balance sheet looks to be a in very good shape. Looking forward to know your thoughts. Thanks a lot.
I think households are more sensitive to rates today than in 2018 due to extended wealth effect coming from the abnormal post-Covid home equity and retirement portfolio rallies.
great analysis thx Joseph, discovered new colours in my crystal ball
Great post! Very insightful as usual, except here I’m lost: “ Public sector debt is different because the losses of lenders end up as gains on the balance sheet of the sovereign…” How is the rate hike a gain for the treasury? I get how borrowers in financial markets who used the treasuries as collateral now see the value of the pledged securities diminish and thus are forced to add more securities or sell assets, but why is that a gain for the sovereign? Maybe I misunderstood something.
Government is short the bonds, public is long them, so raising rates is a gain for the sovereign.
Cogent
Excellent work. Thankyou.
The entire point of the exercise is to bring wealth down to bring demand back in line with aggregate supply. The Fed doesn’t want anything disorderly but surely they are ok with perceived wealth falling.
Based on the price action in treasuries since the last FOMC meeting, the flattening of the 2s5s curve suggests (partly) that the market thinks there’s an increasing probability of the fed not getting rates very high because of either a recession or some market structure reason like you outlined above. Do you have a view on the “hiking into a recession” piece of this argument?
Thanks in advance.
How exactly does the federal government get richer as a result of bond prices falling (rates rising).
They still own the same coupons on the principal no matter what happens to prices
It’s all about the accounting. Private debt is marked to market under ifrs while Public doesn’t need to be accounted for in that way. That’s what creates this mismatch.
Great article as always.
Why do you think terminal rate could be higher? especially, given Powell mentioned that we will be in ‘Era Of Very Low Interest Rates’.
My belief is that Fed will not try to crush the demand to curb inflation because..
(1) Removal of extreme accommodation as opposed to “tightening”.
(2) Powell still believes (correctly, I guess) that this inflation is NOT a monitory phenomenon but mostly a supply shock driven; He also mentioned that monitory policy can not fix supply issues.
Opinion?
Fantastic ~ thanks for your views. Post 2008/09 crisis Fed and central bank balance sheets drive asset prices until we get another new normal
I agree with your likely outcome here. However, we may end up needing an implosion of risk assets to cool off current inflationary pressures.
We are already clearly below natural levels of unemployment, wage gains are running almost 9% annualized (using last months MoM number), and a lot of inflation in the pipeline hasn’t even hit CPI yet (OER, apartment rents are still lagging public data in a big way).
Of course, Fed should try as best they can for an orderly “walking down” of markets, but don’t think a steep decline is avoidable at this point.
Jospeh, great article, very clear.
Really appreciate your work Joseph. And thanks again for signing my Central Banking 101 book.
Wonderful perspective.
Never thought about the mismatch you mention (and a lot else) but was wondering about the other half of the mandate, i.e. unemployment. What happens if rising rates
impact unemployment (negatively) and you have inflation that is not transitory? Other than an ugly situation what gives first?
QE is a pseudo asset, standing in for confidence until confidence can be revived. It’s a ‘put’.
The neutral level of QE = revived confidence.
QT is a ‘call’ on that confidence.
QT with confidence below the neutral level (presumed in the QE) must realise the difference. In the same assets in the QE, unless regulated into other assets.
To tighten, CBs need benign conditions where G and R are > inflation, and R < G. So growth needs to be higher than rates, and rates need to be higher than inflation.
That world does not exist today, nor is it projected to exist in the coming decade.
QT now must result in asset value destruction.
Great post thank you.
A question:
“Public sector debt is different because the losses of lenders end up as gains on the balance sheet of the sovereign, who does not care about its wealth. The Federal government will not tax less or spend more because it is wealthier”
You don’t take into account the ricardian equivalence ?
I don’t think Ricardian Equivalence exists in practice. Certainly in the US higher spending is simply met by increased debt issuance – it would not be rational to assume that taxes would go up (in fact taxes were recently cut).
Hi Joseph,
Can you explain the effects of the Fed selling of MBS’s on long term treasury yields. In a recent article Lauren Mester from Cleveland Fed talks about the possibility of selling off $2.7tril of MBS and holding US treasuries.
Thanks,
Doug
Hi Joseph,
Can you explain the effects of the Fed selling of MBS’s on long term treasury yields. In a recent article Lauren Mester from Cleveland Fed talks about the possibility of selling off $2.7tril of MBS and holding US treasuries.
Thanks,
Doug
Could you clarify which overnight rates the Fed is targeting and how?
It cannot be the traditional Fed Fund rate, because that market is meaningless (safe for some federal loan institutions) . Will they increase IOR? … further rewarding Banks’ reluctance to take on risk? Judging from z1 loan data, they’re not taking on risk anyway. is it the repo rate? I was under the impression that repo rates are a function of collateral scarcity, which – via QT – should lead to a rise in collateral availability, and hence a drop in repo/bond spreads? or the reverse repo rate…? Again that was a function of collateral shortage according to the official statements.
I would greatly appreciate your insight?
Thank you. I purchased your book and am looking forward to ‘grinding’ through it. Today, 2/10/22, Weston Nakamura @acrossthespread (Twitter) makes a case on Real Vision (YouTube) for the significance of BOJ’s QE posture relative to global markets. I’m curious regarding your interpretation of his thesis (?) that the CBJ is the tail that “wags the dog.” I understand that Japan is a leader in Debt/GDP and that the CBJ has engaged QE astronomically, but I am not sure of the significance. Help?
In regards to the fed selling MBS off the balance sheet, who would be the buyer’s and what rate of return would they require?
Hi Joseph,
I watched your video with Blockworks in which you mentionned that hiking rates would have an inflationary impact because the Government would issue Treasuries to pay the interest on their debt. But if the new issues are only use to pay the interests, the net impact on the TGA would be nil and there would be no additional money in the system.
Am I missing something in the reasonning?
Thank you very much and congratulations for your very clear explanations
superb blog kepp it up
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