Updated: Dec 8, 2021
December 18, 2021 | Several years back, at a conference in Cancun, Mexico, sponsored by the Association for Private Enterprise Education, we were gently chided by none other than John Taylor, for suggesting that then Fed Governor Janet Yellen was not sufficiently worried about inflation. "Are you suggesting that Dr. Yellen is not concerned about inflation?" he growled.
Years later, our worries about now Treasury Secretary Janet Yellen’s weak focus on price stability appear to have been prescient. Of note, Yellen finally acknowledged that inflation was a problem last week when she said it was time to stop characterizing inflation as temporary. Sadly, Janet Yellen remains an inflationist for whom full employment is the only mandate in Humphrey Hawkins.
The former Fed Chair really did not address inflation head on in her public statements last week. Instead, Secretary Yellen punted and suggested that the Omicron variant of the coronavirus could prolong the problem of rising prices. But she failed to call out the primary causes, namely idiotic fiscal policy from the Congress and a compliant attitude from the central bank.
There are many reasons for surging demand-pull inflation in the US, first and foremost the grotesque expansion of the Fed’s balance sheet since 2018. But more than the size of the central bank’s subsidy for the Treasury’s fiscal largesse, the implementation of the Fed’s radical policy agenda has done significant damage to private markets and counterparties.
The chart below shows the Fed’s tactical position as we enter 2022, with a long book of Treasury securities ($6 trillion) and agency MBS (over $2 trillion) on the left scale and a short-position via reverse repurchase agreements (RRPs) of $1.5 trillion shown on the right scale.
As we noted since our missive this summer (“G-30 Liquidity Panic: Standing REPOs and Centralized Clearing”), the FOMC has been attempting make some modest alterations to US market structure before moderating monetary policy. Now policy is changing despite the Fed's earlier plans.
In particular, the creation of “standing” RRP and forward repurchase facilities were seen by the Fed staff as a tools to moderate and manage a process of tapering securities purchases without causing a liquidity crunch. The forward repurchase facility, in particular, is a means to provide cash directly to end users by circumventing JPMorgan (JPM) and the other large banks.
The sudden surge of visible price inflation globally has forced Chairman Jay Powell’s hand early in Fed terms, this even though the FOMC is months behind the markets and consumer expectations in terms of fighting inflation. The abortive transition away from LIBOR is coming at a particularly bad time for the short-term money market, but the social engineers on the Board’s staff in Washington are not concerned with mere legalities. They are busy saving the world.
Another big idea from the Fed that has yet to be implemented is centralized clearing of US Treasury securities. We noted in a previous missive that the Group of Thirty made the suggestion at the behest of the Fed and Treasury, who both have the same problem, namely too much Treasury debt. The fact that Congress, rained trillions of dollars more in unnecessary liquidity onto the US economy in 1H 2021 distorted balance sheets and income statements for years to come.
It is important for investors and risk managers to understand that many of the market structure problems that the Fed now seeks to fix, starting with the unnecessary elimination of LIBOR, are a function of earlier policies implemented by the Board of Governors and related acts of folly by the Congress. President Joe Biden may own the inflation problem politically, but the swelling debt of the US Treasury starts with the poorly considered tax cuts enacted by Congress under President Donald Trump.
The good news, of sorts, for Chairman Powell and his remaining colleagues on the Fed Board is that further spending legislation from Congress has a decreasing probability of success in 2021 and may simply die in 2022. A moderation in the Treasury’s debt issuance, combined with a sharp drop in new agency mortgage bond issuance, will tend to keep the bond market tight even as the FOMC tapers purchases for the system open market account (SOMA). Powell et al may be late to the inflation party, but they can still salvage the tactical situation if Congress remains in gridlock.
The Fed’s liquidity calculous changes, however, if the economy slows and Congress decides to come together for another multi-trillion-dollar fiscal giveaway. This is one reason, we suspect, why the DTCC published a white paper in October pushing back on then Fed-Treasury proposal for centralize clearing of all US government debt. Like the SOFR replacement for LIBOR, the Fed’s social engineers are trying to use the model for cleared OTC swaps as a new paradigm for the Treasury market. That model may not work. But no matter, economists can just assume it will work.
The DTCC noted: “A number of market participants who do not engage in the swaps market are critical liquidity providers to the US Treasury market.”
Translated into English, if the Fed uses the same insensitive and uninformed perspective that was employed with the let's kill LIBOR fiasco, then the liquidity in the market for Treasury debt may suffer. Only 13% of all Treasury trades are centrally cleared and the remaining 87% of the market have no interest in joining the clearing house. Hopefully the Fed will understand that the central clearing proposal is DOA, but remember these are economists.
Again, take the handcuffs off the banks in terms of trading their own account and the problem is solved. But nobody at the Fed, including the cowardly Powell, dare to tell Elizabeth Warren (D-MA) and other members of Congress the truth about liquidity. Dodd-Frank and the Volcker Rule have reduced liquidity in the market for US Treasury debt. Duh. Liquidity ratios and other rules have essentially taken the banks out of the business of providing cash to the markets.
"Fed leaders are obsessed with avoiding blame for predictable responses to their actions," Professor Edward Kane tells The IRA. He continues:
"When have Fed leaders ever acknowledged that their policies and strategies lie at the root of most of the market evolutions they find themselves worrying about? Volcker cleverly professed to have shifted to targeting monetary aggregates, not because he suddenly became a monetarist. He did so because adopting that targeting scene allowed him to disclaim responsibility for sending interest rates to the moon. The only exception I can think of fell during the postwar era of pegged yield curves, because Fed leaders' goal was to win back their so-called "independence" by blaming Treasury stubbornness for the postwar inflation."
Since the 2010 Dodd-Frank law and the related Volcker Rule essentially got the largest banks out of the business of underwriting Treasury auctions, the market is now dependent upon non-bank funds for liquidity. Right on time, the folks at the Fed and other central banks have decided to attack the nonbank funds that provide liquidity to the Treasury market. You really cannot make this stuff up. But then again, former Treasury Secretary Tim Geithner was involved with crafting the Group of Thirty proposals.
The Bank for International Settlements has declared that investment activity that takes place outside the banking system requires a new, broad-based set of global regulations to tackle inherent instability. There is no mention of the fact that perhaps the US has been issuing too much debt, leading to the very market instability that so troubles the economists at the BIS.
This new policy on nonbanks is being pushed by Claudio Borio, chief economist at the Basel, Switzerland-based BIS. Mr. Borio holds no elective office. He is merely an economist. But he feels the need and, more important, the authority to make huge changes in market structure and private financial institutions, changes that are usually the province of elected officials. The net effect of the actions of the BIS will be to reduce market liquidity even further.
After “a period in which there is aggressive risk taking, you have a build-up in leverage. You think that markets are liquid, whereas in fact under stress they are not going to be liquid,” Borio said in an interview with Bloomberg News. “You can smooth this out by building buffers in good times -- whether that’s in the form of capital, for solvency, or in the form of liquidity, to avoid fire sales -- so that when bad times arrive you will have a bit more room for maneuver.”
Sadly, the “room to maneuver” sought by the gnomes at the Fed and BIS comes at the expense of private markets and investors. Instead of focusing on the mounting debt of the industrial nations, the BIS and Fed want to attack the investors who buy the debt. The chart below is familiar to readers of The IRA and shows the Treasury yield curve out to 30 years and dollar swaps, which trade through Treasury yields.
Placing constraints on market activity generally leads to liquidity crises, as we saw in 2019 and 2020. Yet despite this empirical evidence, look for the folks at the BIS to push the Group of Thirty nations for restrictions on leverage for non-bank financial firms in 2022. This will not end well. It is alarming that the Fed, Treasury and BIS somehow can fail to acknowledge the primary and growing role played by funds in the market for government debt.
Having neutered the big banks after 2008, what did policy makers at the Fed, BIS and Group of Thirty expect to happen? To solve the "problem" of non-banks, take off the shackles from the large commercial banks in terms of market liquidity.
Of course, the economists who work at the Fed and other agencies will never admit error, much less go back and correct a mistake after the fact. As the Fed and other agencies seek to preclude liquidity crises, in fact periods of contagion will grow more frequent as the sources of liquidity become ever more constrained and the public debt of the US grows larger.