“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare
short-term repo funding turmoil that cropped up in mid-September continues to
be discussed at length. The Federal Reserve quickly addressed soaring overnight
funding costs through a special repo financing facility not used since the Great
Financial Crisis (GFC). The re-introduction of repo facilities has, thus far,
resolved the matter. It remains interesting that so many articles are being written
about the problem, including our own. The
on-going concern stems from the fact that the world’s most powerful central
bank briefly lost control over the one rate they must control.
clear is the Fed measures to calm funding markets, although superficially
effective, may not address a bigger underlying set of issues that could
reappear. The on-going media attention to such a banal and technical topic could
be indicative of deeper problems. People who understand both the complexities
and importance of these matters, frankly, are still wringing their hands. The
Fed has applied a tourniquet and gauze to a serious wound, but permanent
medical attention is still desperately needed.
The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.
The Fed is
hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal
policy and is the strongest in the developed world. By all appearances, the
U.S. is also running at full employment. At the same time, they have a hostile
President sniping at them to ease policy dramatically and the Federal Reserve board
itself has rarely seen internal dissension of the kind recently observed. The
current fundamental and political environment is challenging, to be kind.
Two main alternatives
to resolve the funding issue are:
More aggressive interest rate cuts to
steepen the yield curve and relieve the banks of the negative carry in holding
Treasury notes and bonds
Re-initiating quantitative easing
(QE) by having the Fed buy Treasury and mortgage-backed securities from primary
dealers to re-liquefy the system
putting forth their perspectives on the matter, but the only real “permanent”
solution is the second option, re-expanding the Fed balance sheet through QE.
The Fed is painted into a financial corner since there is no fundamental
justification (remember “we are data-dependent”)
for such an action. Further, Powell, when asked, said they would not take
monetary policy actions to address the short-term temporary spike in funding.
Whether Powell likes it or not, not taking such an action might force the need to
take that very same action, and it may come too late.
Those That Caused the Problem
There was an
article recently written by a former Fed official now employed by a major hedge
is a Director of Global Economics at the D.E. Shaw Group, a hedge fund
conglomerate with over $40 billion under management. Prior to joining D.E. Shaw,
Sack was head of the New York Federal Reserve Markets Group and manager of the
System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC).
He also served as a special advisor on monetary policy to President Obama while
at the New York Fed.
with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at
the Peterson Institute for International Economics, argue in their paper LINK
that the Fed should first promptly establish a standing fixed-rate repo
facility and, second, “aim for a higher
level of reserves.” Although Sack and Gagnon would not concede that
reserves are “low”, they argue that whatever the minimum level of reserves may
be in the banking system, the Fed should “steer
well clear of it.” Their recommendation is for the Fed to increase the
level of reserves by $250 billion over the next two quarters. Furthermore, they
argue for continued expansion of the Fed balance sheet as needed thereafter.
What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.
Walks and Quacks Like a Duck…
Gagnon did not give their recommendation a sophisticated name, but neither did
they call it “QE.” Simply put, their recommendation is in fact a
resumption of QE regardless of what name it is given.
To them it
smells as sweet as QE, but the spin of some other name and rationale may be
more palatable to the public. By not calling it QE, it may allow the Fed more
leeway to do QE without being in a recession or bringing rates to near zero in
attempts to avoid becoming a political lightening rod.
The media appears
to be helping with what increasingly looks like a sleight of hand. Joe
Weisenthal from Bloomberg proposed the following on Twitter:
To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.
challenge, as we see it, is that these former Fed officials do not realize that
the policies they helped create and implement were a big contributor to the
financial crisis a decade ago. The ensuing problems the financial system is now
enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of
what they call them, are more imprudent policies to address problems caused by
imprudent policies since the GFC.
The Great LIBOR Liquidation
We are thrilled to introduce Jess L. as a new contributor to RIA. Jess started her career nearly two decades ago as a market maker at Goldman Sachs, followed by a stint at Merrill Lynch. After that, she moved over to the buy-side as a Portfolio Manager at Caxton Associates before ending her career at Millennium Partners. Throughout her career, she has had the opportunity to trade a number of different asset classes, but the one nearest & dearest to her heart is the front-end of the USD rates curve. She now lives in Malibu with two children, adoring husband, and border collie – Rosie.
The fate of LIBOR is
likely to precipitate one of the largest one-off structural changes to the
interest rates market in our lifetimes. Regulators are growing increasingly
concerned because we’re ill-prepared for what comes next. Thus, more ad lib
experimentation by policymakers.
It’s a tectonic shift in
a $400 trillion+ market.
On Monday, New York Fed
President John Williams gave a speech entitled “LIBOR: The Clock is Ticking” to
address the ultimate liquidation of a ubiquitous benchmark rate. He summed up
the motive behind invoking time-bomb imagery as follows.
“Some say only two things in life are guaranteed: death and
taxes. But I say there are actually three: death, taxes, and the end of LIBOR.”
If nothing else, there
are really just a few take-away bullet points.
The shift from LIBOR to
SOFR rates is happening & has massive implications.
The fate of benchmark
rates will be driven by events such as last week’s move in repo. The Fed’s
decision to embark on OMOs will extend far beyond October for a number of
reasons. Key among them? Protect the sanctity of the incoming LIBOR
We’re talking about $400
What’s $400 trillion between friends?
400 trillion is such a
large figure, it’s really, really difficult to
Imagine human beings
began counting to 400 trillion around the time of the first discovered form of
writing (about 32 centuries ago). A weary descendent today would be still
counting… with 99.75% remaining.
If (in a more financial,
but equally less pragmatic way) you were somehow able to cover the surface of
the Earth in gold plating a meter thick, $400 trillion would get enough gold
for a second copy as well – and then some.
(while recreating a cult movie classic) you spent $400 trillion on gas, you’d
have enough to drive the distance from here to Alpha Centauri – and back. About
40 times. In a Winnebago.
But perhaps that’s because we’re using the wrong yardstick, using as a basis for comparison concepts that are familiar to us in our daily lives. If we change dimensions, the idea of such a quantity becomes a little easier to picture.
If every neural synapse
in the brain cost $1, $400 trillion would get you only enough for a typical NFL
Quarterback. Though to be clear, in the case of the Jets, we’d be
talking about Ryan Fitzpatrick – not, y’know… anybody else.
Spend a dollar
programming every possible chess combination into a supercomputer? You’d only
have enough for an opening of four moves (a “Fool’s Gambit” if you reach
And if you tallied up the total notional outstanding of interest
rate derivative contracts that are about to be significantly altered by coming
benchmark reform… well, that’s why we’re here, you’d have about $400 trillion.
a huge number, even in the scheme of other large markets outstanding. And it’s
due to be transformed – one might argue – beyond a shadow of its former self.
It’s (still) all about funding markets
During last week’s repo
debacle, here’s how the replacement for LIBOR did (more on the distinction
between these two lines below):
Lest you think I’m cherry-picking
by showing an overnight rate versus a 3-month tenor, take a look at what the
“overnight” LIBOR rate did by comparison. The relative shock wave is of similar
Now, in order to combat
these types of violent moves, the Fed has embarked upon a series of Open Market
Operations (OMOs) to provide funding from now until Thursday October 10th. But if you think this
all ends on that date, you haven’t been paying attention.
In other words, this is an issue that is very much front & center – now.
Making LIBOR Great Again
The saga around “the end
of LIBOR” aka Benchmark Reform has been ongoing for nearly a decade. Really
ever since regulators determined that “asking a cabal of bank executives who
could pick up a phone call from their trading desks what they’d like the daily
rate to be…” underpinning the largest derivatives market in the world left open
a little room for bad actors to operate. LIBOR (the “London InterBank Offered Rate”)
needed to be replaced. And the replacement would need to be something that was
observable & representative of conditions in money markets.
Enter SOFR – the Secured Overnight Financing Rate.
This isn’t the place to
get into the minutiae around LIBOR vs SOFR, but a basic understanding is
important. LIBOR is a “forecast of unsecured funding” and SOFR is an “actual
measure of secured funding”. In other words, the key is that LIBOR is
only a guess at where you could borrow without having to provide collateral and
SOFR is where the borrowing actually gets done that’s collateralized by US
Treasuries. I’ve included links at the bottom of this article & an
excellent series of blog posts on the topic, here & here.
Secured vs Unsecured
You might assume that the
SOFR rate (in which you provide collateral) is always lower than the LIBOR rate
(in which it’s just based on a bank’s estimate of where they could get funding,
based on nothing more than a promise to return it). And,
of course, because this is the world we live in – you’d be wrong.
One has to be a little
cynical (or at least an active trader in today’s paradoxical market) to grasp
the distinction. Banks never want to admit that funding is scarce or that
they’d have a tough time tapping capital markets. Bank stocks don’t tend to
like that sort of admission. So, forecasts are based on an information waterfall
that, as best as we can tell, is “where have things been recently?”
PM: “Wherefore art thou Libor?” 6/28/2019
On the other hand,
collateralized funding is not exactly the cheap source of financing you might
have thought. Banks already have plenty of what you’re
trying to offload in exchange for the cash: collateral. Much of this,
however, is required due to the increase in considerations around
capitalization post-crisis. Increasingly, it’s due to the fact that the
Treasury is aggressively ramping up debt issuance.
Why this becomes
problematic is the fact we’re whirling further & further into an
environment where oversupply of collateral is causing these rates to become
more & more volatile – see the most recent episode for a point of
To say that last week’s repo debacle was precipitated by either the KSA or by the timing of corporate taxes & bills supply is a little like saying World War I was caused by Gavrilo Princip. Yes, that’s true – but the conditions had to be right & the stage appropriately set.
It’s a bit like the grade
school chemistry lesson where you drop additional solute into an already
But, this is what
regulators have decided we’re going with & we’re a few details away from
getting a complete picture of what LIBOR’s replacement will look like.
Back to the future, part 1
Accordingly, efforts have
been made to reduce the type of noise we saw last week. Regulators were aware
of the fact this could happen well in advance.
For example, what was
previously “3-month LIBOR” (i.e. the trimmed mean of daily bank estimates of
where they could borrow unsecured cash for 3 months) will now be a
daily-compounded in arrears SOFR rate (i.e. the daily fixings over that
equivalent period compounded over that same period). Instead of using just one
rate that covers the entire 3-month period which is set at the START of the
period, we’ll take every business day during that period & compound all the
fixings together at the END of the period.
Here’s a schematic
from Oliver Wyman that shows the difference:
Back to the future, part 2
In other words, we’re
going from an “expectations based” benchmark to a “present realized” index.
While that might not exactly violate the space-time continuum, that does cause
Again, the reason for
this consideration is to remove some of the daily “noise” around the fixings.
That’s “noise” due to things like holidays, reporting periods & unexpected
vaporization of liquidity. This is obvious just from a cursory glance at that
historical chart of the daily fixings for the SOFR rate compared to the 3-month
However, LIBOR doesn’t
just have a 3-month term. An overnight term, a 1-month term, a 6-month term
& so on also exist.
Consider what events like
last week’s move in repo did to LIBOR’s replacement, even after the
“smoothing”. Even without looking, you can probably guess it’s not good.
Not exactly “easing”
Let’s play this out. The
LIBOR fixing that was delivered on the morning of June 17th was the one which
covered an “effective” period that started T+2 (June 19th) for 3-months.
Therefore, that rate would pick up all the fixings from last week. That caused
the “rate” from nearly 3-months ago to increase a little over 3 basis points.
Previously, you wouldn’t have cared much about what happens in the 3-months
following your LIBOR fixing. Now, you care quite a bit about any significant
moves in SOFR underlying that might transpire over the ensuing period.
The VaR-Shock to rule them all
What’s even more
important is that the shorter LIBOR rates are the ones that underpin things
like Student Loan Securitizations & Commercial
Mortgage-Backed Securitizations. Well, those happen to be two
areas of the market precariously balanced at the moment.
Here’s what the 1mL rate
& its replacement did…
Consider: the magnitude
of the move works out to a little over 12.5bps – or half of what the Fed just
cut rates by. That’s a pretty big difference – in the opposite direction of
what the Fed’s intending to do as they “ease” policy.
Now, this past week’s
episode won’t do much since LIBOR is still clinging on. It won’t even affect
the proposed spread adjustment, since that will most likely use a trimmed mean
or median observation of the last 5-10 years. Stay tuned: it’s one of the
biggest outstanding decisions remaining.
But, it’s a good example
of how policymakers have designed a replacement benchmark to take over the
largest derivatives market in the world which could deviate from the original.
Best summed up in the words of Job & George Bluth.
Trillion Dollar PNL Implications
In the context of a $400
trillion market it’s a lot. Especially, since you’ve just caused the entire
index to shift up by 12.5bps when it should have been shifting lower as the Fed
“eases” policy. For a 1-month coupon, that difference is $42bn in PNL terms for
just this one episode. That episode lasted only about 3 days.
Over a longer period (a
few weeks, for example), implications are north of a trillion dollars in market
Imagine if regulators enacted by decree an instantaneous drop of
$1 trillion in market PNL from US equities. You’d take notice.
Furthermore, the index
jumped 12.4bps on the day that the 1mL rate moved 1.5bps. A 1.5bps move for 1mL
is barely a half a standard deviation move on the long-term history, going back
to 1998. That 12.4bps move for SOFR? An 8+
standard deviation event.
Regulators take heed
We live in a world where
risk has been increasingly calibrated to historical VaR. That’s a seismic shock
that poses a serious threat to future position concentration.
have told us in no uncertain terms that this is happening. Williams’ speech on
Monday is an example of their determination to enact a shift. But, the Fed
knows in order to make it stick, one must have a reliable fallback instrument.
fallback instruments for a $400 trillion market don’t move 8+ standard
deviations because of a regularly scheduled tax date. Even if it just so
happens to compound a number of other structural issues.
it’s in the Fed’s best interests to lean against such moves. That’s yet another
reason why we should expect OMOs are really Permanent (with a capital “P” =
POMOs). They’re due to extend well beyond the October date that’s currently on
With that, regulators are more than happy to issue one final
valediction to LIBOR.
material may contain indicative terms & there is no representation that any
transaction could have been executed at such terms. Proposed terms are for
discussion purposes only.
OTC Derivatives Risk Disclosures:
clearly the terms of any OTC derivative transaction you may enter into. You
should carefully review these terms with your counterparty.
understand the nature of your exposure. Consequently, you should be satisfied
that such transactions are appropriate. In addition, you may be required to
post was written by me & the material is my own, except where sourced. I am
not receiving compensation for it.
Who Could Have Known: What The Repo Fiasco Entails
approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one
night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is
5% above that which she is earning in the bank. Shockingly, your friend says she
can’t. Given the risk-free nature of the transaction and excellent one-day
profit, we can assume that our friend may not be as wealthy as we thought.
On Monday, September 16th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.
The Plumbing of the Banking System and
Interbank borrowing is the engine that
allows the financial system to run smoothly. Banks routinely borrow and lend to
each other on an overnight basis to ensure that all banks have ample funds to
meet daily cash flow needs and that banks with excess funds can earn interest
on them. Literally, years go by with no problems in the interbank markets and
not a mention in the media.
Before proceeding, what follows is a
definition of the funding instruments used in the interbank markets.
Fed Funds are
uncollateralized interbank loans that are almost exclusively done on an
overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
agreements) are collateralized loans. These transactions occur between banks but
often involve other non-bank financial institutions such as insurance companies.
Repo can be negotiated on an overnight and longer-term basis. General
collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage
collateral that backs certain repo loans. In a GC repo, the particular
securities backing the loan are not determined until after the transaction is
agreed upon by the counterparties. The securities delivered must meet certain
On September 16th, overnight
GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which
theoretically should keep repo and other money market rates closely tied to it.
The billion-dollar question is, “Why did
a firm willing to pay a hefty premium, with risk-free collateral, struggle to
borrow money”? Before the 16th,
a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of
financial institutions to lend money via the repo markets. On the 16th,
many multiples of that premium were not enticing enough.
Most likely, there was an unexpected
cash crunch that left banks and/or financial institutions underfunded. The
media has talked up the corporate tax date and a large Treasury bond settlement
date as potential reasons. We are not convinced by either excuse as they were
easily forecastable weeks in advance.
Regardless of what caused the liquidity
crunch, we do know, that in aggregate, banks did not have the capacity to lend
money. Given the capacity, they would have done so in a New York minute and at
much lower rates.
To highlight the enormity of the aberration,
consider the following:
Since 2006, the
average daily difference between the overnight GC repo rate and the Fed Funds
effective rate was .025%.
deviations or 99.5% of the observances should have a spread of .56% or less.
8% is a bewildering 42 standard deviations
from the average, or simply impossible assuming a traditional bell curve.
What was revealed on the 16th?
The U.S. and global banking systems
revolve around fractional reserve banking. That means banks need only hold a
fraction of the cash deposits that they hold in reserve accounts at the Fed. For
example, if a bank has $1,000 in deposits (a liability to the bank), they may
lend $900 of those funds and retain only 10% in reserves. This is meant to
ensure they have enough funding on hand to make payments during the day and
also as a buffer against unanticipated liquidity needs. Before 2008, banks held
only just as many reserves as were required by the Fed. Holding anything
more than the required minimum was a drag on earnings, as excess reserves were
unremunerated at the time.
Quantitative Easing (QE) and the need
for the Fed to pay interest on newly formed excess reserves changed that. When
the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed
securities and credited the selling bank’s reserve account. The purpose of QE1 was
to ensure that the banking system was sufficiently liquid and equipped to deal
with the ramifications of the ongoing financial crisis. Round one of QE was logical
given the growing list of bank/financial institution failures. However, additional
rounds of QE appear to have had a different motive and influence as banks were
highly liquid after QE1 and had shored up their capital as well. That is a
story for another day.
The graph below shows how “excess”
reserves were close to zero before 2008 and soared by over $2.5 trillion after
the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the
hundreds of millions. The amount is so small it is not visible on the graph
below. The reserves produced by multiple rounds of quantitative easing may have
been truly excess, meaning above required reserves, on day one of QE. However, on
day two and beyond that is not necessarily true for any particular bank or the
system as a whole, as we are about to explain.
Data courtesy: St. Louis
The Fed, having pushed an enormous
amount of reserves on the banks, created a potential problem. The Fed feared that
once the smoke cleared from the financial crisis, banks would revert to their
pre-crisis practice of keeping only the minimum amount of reserves required.
This would leave them an unprecedented surplus of excess funds to buy financial
assets and/or create loans which would vastly increase the money supply with
inflationary consequences. To combat this problem, they incentivized the banks
to keep the reserves locked down by paying them a rate of interest on the
reserves that were higher than the Fed funds rates and other prevailing money
market rates. This rate is called the IOER or the interest on excess reserves.
The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.
From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.
Beginning in 2018, the Fed began
reducing their balance sheet via QT and the amount of excess reserves held by
banks began to decline appreciably.
Solving Our Mystery
It is nearly impossible for the public
to figure out how much in excess reserves the banking system is truly carrying.
Indeed, even the Fed seems uncertain. It is common knowledge that they have
been declining, and over the last six months, clues emerged that the amount of
“truly excess reserves,” meaning the amount banks could do without, was possibly
came on March 20th, 2019 when the Fed said QT would end in October
2019. Then, on July 31st, 2019, as small problems occurred in the
funding markets, the Fed abruptly announced that they would halt the balance
sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from
Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after
it began. The Fed’s balance sheet declined only $800 billion as a result of QT,
less than a quarter of what the Fed added to their balance sheet during QE.
was the declining spread between the IOER rate and the effective Fed Funds rate
as the level of excess reserves was declining, as seen in the chart below. The spread
between IOER and the Fed Funds rate was narrowing because the Fed was having
trouble maintaining the Fed Funds rate within the targeted range. In March
2019, the spread became negative, which was counter to the Fed’s objectives.
Not surprisingly, this is when the Fed first announced that QT would end.
Data courtesy: St. Louis
The third and final clue emerged on September 16, 2019, when overnight
repo traded at 7%-8%. If banks truly had excess reserves, they would have lent
some of that excess into the repo market and rates would never have gotten
close to 7-8%. It seems logical that banks would have been happy to lend on a
collateralized basis at 3%, much less 7-8%, when their alternative, leaving
excess reserves to the Fed, would have earned them 2.25%.
Further confirmation that something
was amiss occurred on September 17th, 2019, when the Fed Funds effective
rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This
marked the first time the Fed Funds rate traded above its target since 2008.
On September 17th, the Fed
entered the repo markets with a $53 billion overnight repo operation, whereby
banks could pledge Treasury collateral to the Fed and receive cash. The
temporary liquidity injection worked and brought repo rates back to normal. The
following day the Fed pumped $75 billion into the markets. These were the first
repo transactions executed by the Fed since the Financial Crisis, as shown
These liquidity operations will likely
continue as long as there is demand from banks. The Fed will also conduct
longer-term repo operations to reduce the amount of daily liquidity they
The Fed can continue to resort to the
pre-QE era tactics and use temporary daily operations to help target
overnight borrowing rates. They can also reduce the reserve requirements which
would, at least for some time, provide the system with excess reserves. Lastly,
they can permanently add reserves with QE. Recent rhetoric from Fed
Chairman Powell and New York Fed President Williams suggests a resumption of QE
in some form may be closer than we think.
Why should we care?
The QE-related excess reserves were
used to invest in financial assets. While the investments were probably high-grade
liquid assets, they essentially crowded out investors, pushing them into
slightly riskier assets. This domino effect helped lift all asset prices from
the most risk-free and liquid to those that are risky and illiquid. Keep in
mind the Fed removed about $3.6 trillion of Treasury and mortgage securities
from the market which had a similar effect.
The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.
Short-term funding is never sexy and
rarely if ever, the most exciting part of the capital markets. A brief
recollection of 2008 serves as a reminder that, when it is exciting, it is
usually a harbinger of volatility and disruption.
In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”
Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.”
Today, a decade after the financial crisis, we see that Bernanke
and Powell have little appreciation for the inner-workings of the financial
In the Wisdom of
Peter Fisher, an RIA Pro article released in July, we discussed the
insight of Peter Fisher, a former Treasury, and Federal Reserve official.
Unlike most other Fed members and politicians, he discussed how hard getting
back to normal will be. As we are learning, it turns out that Fisher’s wisdom
from 2017 was visionary.
“As Fisher stated in his remarks, “The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”
The Wisdom of Peter Fisher
“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President
In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.
Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.
In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.
Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”
The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.
The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.
In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.
As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.
Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.
Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?
The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.
Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.
As Fisher stated in his remarks at the conference, “The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.
The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.
Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.
Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”
As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”
What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”
A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”
Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”
Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.
Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.”
That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.
Fisher fittingly sums up by restating the point he made at the beginning:
“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”
The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.
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