personal views of a former fed trader

Solvency Constraints

The dollar rally may be set to continue as limits on quantitative tightening bind other central banks before it binds the Fed. The tail risks of QT have first appeared in the gilt market, where significant price volatility prompted official intervention. What appears to be a liquidity issue will ultimately become a financial stability issue as investors discover their “safe assets” are not safe. These concerns may prompt a policy response similar to that seen in Japan, where the price of sovereign debt is explicitly supported. Just as yield curve control led to significant Yen weakness, so a similar move by other central banks would also severely weaken their currencies. This post describes the link between bonds and financial stability, notes the existence of a central bank “put” on bonds, and suggests other central banks would likely cave first.

When “Safe Assets” are not Safe

A steady upwards march of sovereign yields would likely lead to financial instability by pushing some financial sector entities into insolvency. Global regulations post-GFC mandated many of these entities to hold sovereign debt as safe assets, but sovereign debt is actually not safe. They are free of default risk but can still suffer equity like price declines with volatility that approaches that of crypto. Recently, some investors in longer dated gilts were pushed dangerously close to insolvency and saved only by emergency central bank intervention. Note that losses from bonds can be redistributed through the financial system using hedges, but not eliminated.

Longer dated gilts have traded like meme stocks. Source: Bank of England

Financial crisis can arise when investors discover their safe assets are in fact not safe. The GFC arose in part because highly rated private label MBS securities that were considered safe were actually risky. The sudden repricing of those securities raised widespread solvency concerns that precipitated into a run on the financial system. Similarly, the European Sovereign Debt Crise arose in part because the debt of peripheral European sovereigns were considered safe when they were actually not. The repricing of peripheral debt raised solvency concerns of the European banking system and also led to a run on the financial system. The setup today appears similar, but this time may be different.

From Periphery to Core

Financial stability concerns will likely force all central banks to eventually support the bond prices of their respective sovereigns. Policymakers vividly remember the collapse of Lehman and will do whatever it takes to avoid a repeat. The prospect of a financial crisis led the BOE to immediately postpone QT and roll out unlimited bond buying, with the promise that the purchases are temporary. Their actions pumped up gilt prices and restored the solvency of some investors, but it is not clear if the price declines were merely due to illiquidity.

Market prices are ultimately determined by supply and demand, and these factors continue to suggest higher global yields. Central banks, who were large and price insensitive investors, are no longer buying. At the same time, net issuance in developed markets remains high from fiscal spending. The proximate causes of gilt market volatility was an anticipated surge in issuance to fund energy subsidies and tax cuts, as well as impending BOE gilt sales. But a similar event could easily take place in other markets. For example – central banks have been the overwhelming buyers of Spanish and Italian bonds but have now stepped back. The higher yields we see may be the market clearing prices and persist absent official intervention.

Central banks purchased almost all Spanish and Italian sovereign debt during the past few years. Source: Robin Brooks of the International Institute of Finance.

From Rates to FX

A central bank that rolls out support for its bond market is likely to see their currency depreciate. The potential policy options range from sterilized and limited QE to yield curve control, which is the policy of the BOJ. The result of YCC in Japan was tremendous Yen depreciation as investors moved out of Yen and into foreign currencies in pursuit of higher returns. That is the predictable outcome of any form of bond price support, which would mechanically widen interest rate differentials. The last jurisdiction to restart asset purchases would likely experience the most currency appreciation.

BOJ’s yield curve control prevented its bond yields from rising as global yields rose

The Fed is likely to be the last major central bank to backstop bond prices due to the relative strength of the U.S. financial system. After the BOJ and BOE, the ECB looks poised to be the next central bank forced to shore up its bond market. The financial sector is opaque, but market pricing and commentary appears to be indicating growing concerns over the health of European financial institutions. European banks and pension funds are large investors in European sovereign debt, and likely nursing significant losses. Once Eurozone yields are suppressed then a widening yield differential to Treasuries suggests continued dollar strength.

KBW Bank Index vs EuroStoxx Bank Index shows significant relative strength of US banks. Source: Marketwatch.

The actions of foreign central banks will also be supportive of the Treasury market, but eventually the same problem will appear in the U.S. Global bond markets are tightly interconnected and stability in foreign markets will help stabilize Treasury yields. However, the supply of U.S. Treasuries from fiscal spending and QT is very large even as prior marginal buyers are no longer buying. Eventually, the Fed will also have to step in too.

Treasury issuance is basically $1t+ forever. That suggests higher yields absent Fed intervention. Source: U.S. Treasury

35 Comments

  1. Anonymous

    Besides the published QT in the US. 2 additional forms of QT are happening.
    1. Social security and Medicare trust funds are shedding about $20B a month for the next 12 years.
    2. No more treasury remittances from the Fed that was about $10B a month. Although it’s getting coverage today, it has been going on for a month already.
    So on top of the published QT, there is a hidden $30B a month that has to be funded somewhere else.

    • Rod MacIver

      Important points. Thank you.

    • Anonymous

      The losses on the Fed’s Treasury portfolio don’t actually materialize though, so the increase in Treasury issuance should be capped at the prior remittance level, while QT is in some way blunted by the remainder (I think? Pretty sure RRP interest goes back into the system and doesn’t affect the QT cap).

      The deficit accelerating should theoretically be “priced in” (well, it means the government is insolvent if it has to gobble up a larger and larger % of the economy, but theoretically there is some expected value where they are forced into austerity or where the Fed prints more money), but my guess is the market is too big to front run by much so flows (or if you want to think in macro terms, losses imposed on existing bonds to make room for new issuance) end up pushing yields up until a policy change happens.

      Just my amateurish understanding based on how the rates traders on the floor explained stuff to me.

  2. Effem

    Lower bond prices are a completely obvious response to large fiscal packages. Central banks are complicit to the degree they failed to warn their fiscal counterparts. The financial system should pay via bail-ins rather than making taxpayers pay via bail-outs.

    • Anonymous

      So account holders being hurt with a bail in are they not tax payers?

    • Chuck

      I have noted the time in two congressional testimony videos when chair Powell reported to congress that the fiscal side, “Is on an unsustainable path and has been for some time”. Here is one of them: https://youtu.be/agOrZsyhA7o?t=3031 I think the voters are the ones that need to be educated, and quickly, how all this ‘free’ federal money comes from debt, as congress and the administratin have become incentivized to use giveaways to buy votes.

      • Koh Phi Phi

        That YouTube clip is so powerful, specially the final remark from Senator Kennedy (53:20 of what video). I agree that voters are the ones responsible to get educated on the consequences of endless public spending so they can vote in full awareness. While the Fed and Govt are the ones dictating policy, the voters are ultimately the judge (and victims!) of such policies, so they hold the responsibility to scrutinize the actions of those they vote for.

    • Anonymous

      How does a bail-in system work?

  3. Anonymous

    Any guesses on time frame when US will have to step?

  4. Anonymous

    Can someone help me out: on that Treasury chart at the end, what are the blue bars? Is that the Treasury’s estimate of future issuance? And if so why is that so far off from the CBO and OMB?

  5. Rod MacIver

    Very important observations and perspective Joseph.

    I’m of the view that as humans, we have short term time horizons and will borrow against our future and that of our offspring until the market enforces discipline on us. That goes as much for our impact on climate change as it does on our willingness to borrow to support our current lifestyle, wars, etc.

    The US having less exposure to climate change than many small ocean countries, Pakistan, etc., and better credit, will borrow against the future to a great extent than other countries simply because it can. Inevitably though, discipline will be enforced. I fear than in the next two or three years millions of people will perish as a result of food shortages, wars, instability, climate change, etc.

    But anyway, thanks for your commentary here and on Blockworks Macro. I always learn something, and always appreciate your balanced, informed views.

    • Roga

      I heard some of the younger people at my work talking about the “climate wars” that will come, and I thought, “you poor schmucks, they’ve already convinced you that the wars they are starting are not their fault.” Climate change may be, if ever, a major contributor to the next round in ~2080. If you think it’s an immediate crisis on par with fiat debt, the surveillance state, and demographic collapse today, prepare to be misled into doing some terrible things to your fellow humans in the next few years in the name of carbon.

      • Shane

        Could not agree more. Big Brother and demographic issues are a far bigger concern if you are paying attention, rather than living in fear of sea levels that are only rising 30 cm per century, and hurricanes that are actually becoming less frequent and slightly stronger. People have very little ability to grasp what matters now.

        • Rod MacIver

          It’s all about emotion, all about which points of view and which politics make you feel better about the decisions you’ve made in life, and how you live, and how you feel about yourself.

          Climate change deniers never cite science. Science, which has changed our lives so profoundly, from medicine to the internet to how we get what we get, Amazon for instance, to the mundane like how reliable our cars are, is ignored by those who would rather ignore climate change.

          Those who study this stuff, the scientists, are as uniform on this as are cancer researchers who study smoking.

          As a guy who makes his living trading options, my thought is if there is a 10% chance they are right, in which case civilizations ends, and a 90% chance they are wrong, in which case nothing changes, the trade is to not take the 10% risk.

          • Jason

            Climate change ‘science’ is not science. If governments pay billions to fund ‘research’ the conclusions will be obvious.

  6. HJ

    eventually during the end game of YCC, people will final remember the oldest bubble: GOLD and its little brother SILVER.

  7. Pierce

    Dumb Question: There’s $2 trillion+ sitting in the RRP facility, on which the Fed now has a negative carry. I realize there’d be a duration mismatch, but couldn’t Treasury issue bills that would be purchased by these RRP investors, and use the proceeds to: (1) provide support for (ie buy in) outstanding Treasuries that are being repriced due to QT; and /or (2) finance new fiscal needs?

    The net result would be a shortening of duration for a significant component of US debt.

    Lol .., please be kind because I know we are effed , and I also really don’t know what the eff I’m talking about. Just trying to slow the pace of the Grim Reaper ☠️

    • Koh Phi Phi

      I have been asking myself exactly that! Those $2.4T currently sitting at the RRP are an asset not being utilized. So, why not using them to run an Operation Twist?

      • JimD

        Because they are supposedly tightening?

  8. Kolya

    Which yields will central bankers try to control – nominal yields only, real yields only or both? If both we will lose information provided by the market for inflation indexed bonds. I suspect yield curve control will result in higher rates of inflation all things being equal. If central banks suppress long rates while trying to fight inflation with short rates that will produce another set of distortions (e.g. reducing incentives for bank lending).

  9. Blake

    What happens when someone does the math and realizes there is no way US can repay debt with higher interest rates?

  10. Oliver

    If everyone ultimately flees from and dumps sovereign bonds – where do the trillions go? Stocks or gold?

  11. Engin YILMAZ

    Great problem is that central banks try to control both short and long term interest in the same time

  12. Spencer

    The unified theory to macro is that banks don’t lend deposits. Deposits are the result of lending. Therefore, the payment of interest on interbank demand deposits reduces the supply of loan funds (inducing nonbank disintermediation, e.g., the 2019 repo spike).

    I.e., the banks can outbid the nonbanks for loan funds, but not the other way around.

    The banks need nationalized as the economy is being run in reverse.

  13. Spencer

    Monetary policy is not transmitted through interest rates. Monetary policy was transmitted through legal reserves (which Powell discontinued).

    Now we are lost without a rudder or an anchor. As I said in response to Powell removing legal reserves: “The FED will obviously, sometime in the future, lose control of the money stock.” May 8, 2020. 10:38 AMLink

  14. Casey

    BOE moves foreshadow FED dilemma which is likely coming. Not sure what part of the plumbing will get clogged but with such large moves in rates, treasury supply/demand and fiscal requirements, the s*** will get stuck somewhere. The dilemma will be policy (increasing interest rates and QT) vs stability. My bet is that policy will be sacrificed for stability.

    • Koh Phi Phi

      Ultimately, at some point, if the Fed needs to choose between the bond market and the currency, they will choose to save the bond market. No question about it. The question is “when” they’ll have to make that decision.

  15. SK

    Why is the Fed still paying the overnight fed funds rate on the RRP (currently 3%)? That is $2.2 trillion in cash that could find a better home elsewhere. If there really is a liquidity problem in the treasury market, can’t the Fed encourage the RRP money to move into treasuries by lowering the rate that it pays on cash to below fed funds? Clearly there is tremendous demand for a true risk free investment (overnight at the Fed) so lower the rate to make it less attractive and allow the liquidity to move into the market. I’d love to know what I’m missing and why this isn’t being considered.

    • Spencer

      The O/N RRP turns inside money into outside money. Contrary to the FED’s spurious accounting, re: “the bond underlying the repo transaction is still recorded on the Fed balance sheet”, O/N RRPs are contractionary.

      That, of course, is an accounting error according to the Federal Reserve Bank of Chicago’s “Modern Money Mechanics”. “If the buyer of a reverse repo or a security sold by the Fed is a nonbank (which 90% of RRPs are), and pays for the purchase using its bank account, the money supply is directly affected”.

  16. Anonymous

    There are “pros” on TeeVee now proclaiming that the “Fed cannot go bankrupt”.
    This is a true statement – but misses the bigger point.
    The Fed is now accounting for its ongoing “losses” as a “Deferred Asset”. Sure. Why not!
    The ongoing “losses” are substantial and growing – since all the Fed does when it “raises rates” is pay the banks and the MMF more money as IORB or interest on RRP.
    So whats the problem?
    The best analogy I can think of is this: The Fed and the current money system is like a game of Monopoly. The banker never runs out of “money” – because he is allowed to use bits of paper to create whatever “money” is needed. Or in households with laptops – can simply type in whatever is needed into a spreadsheet.
    Thats fine. And necessary to keep the game going.
    The question is can you pay for the pizza delivery with your monopoly money?!

    See, since we abrogated the gold standard in 1972, the Dollar was supposed to be “as good as gold”. In other words, the monetary system would be run with such discipline that no one would need to question the value of the fiat currency.
    The entire thing is based on that elusive thing called “credibility”. Which , by the way, was a mistake in the first place.
    But anyhoo – sure the Fed can create Deferred Assets or whatever, heck why even subject themselves to double-entry bookkeeping ? Its a Monopoluy game, everyone is drunk and the banker does whetever the heck he wants.
    The question remains – at what point does the pizza guy decide he aint gonna accept your “money” for his pizza.

  17. Anonymous

    Just to add : The whole point of having all this elaborate financial machinery – the accounting, the financial statements, the Fed heads giving speeches, the Open Markets desk. All that.
    Whats the whole point?
    Why cant the govt simply do away with all that and just print money?

    The whole point of the Fed etc is to create a system that is so impeccable and so transparent that people will sell their precious labor or materials for that paper. The Dollar. And that paper across time proves to be widely accepted – so you can save some and spend it on other stuff later.
    Thats the Whole Point.

    So to go on TeeVee and say something ridiculous like the “Fed cant go bankrupt” is showing a childish level of understanding.
    Its not about the accounting , the “Deferred Assets” etc. Everyone knows anyone can do that .
    Its about Credibility. You lose that – you lose everything.

  18. Anonymous

    Ofcourse there are more ways than one to establish “Credibility”.
    Maybe the rules of arithmetic ( widely adopted by humanity) preclude establishing credibilty based on the monetary machinations of a dozen academics.
    Maybe that credibility has to be established by force.
    Maybe thats where we are.

    Its like this. lets say you have a big chess match. You have spent weeks bragging about your chess prowess, your IQ , partying etc and spent zero time on careful study.
    Your opponent spent years of careful study.
    The game starts, you are still surging with testosterone. Then we get to the 20th move and you realize you are losing with no way to recover. What do you do?
    1. Resign. And vow to study more ( Un American!)
    2. Stretch your hands out say you are bored, let the 2 big sloppy dogs in and ask for a beer break. The dogs tip over the chess board , you spill beer all over the pieces.
    So obviously the game is over. Your nerdish opponent is confused.
    And you can continue to brag to your girlfriends that you are a chess genius.

    • Anonymous

      The wife throws a screaming fit at the beer spilled and throws her wine glass at our champ. A screaming match ensues, the cops are called. The children are crying.
      Our poor , well studied chess opponent …. slinks away . He did have a perfect Dragon Sicilian opening and the opponent made a huge blunder on move 15… etc . But dogs, screaming, cops etc – he does’nt know how to deal with that.

      • Anonymous

        So – whats the best chess strategy for our hapless nerd?
        How do you win against a violent , insane opponent?
        You cant.
        The best strategy is to not play.

  19. Anonymous

    No one is willing /able to get on TeeVee and say clearly … how the Fed raises rates. What do they actually do? No one. I wonder why?

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