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June 19, 2023 | “All propaganda is lies, even when one is telling the truth,” George Orwell concluded after working for the British Broadcasting Company (1941-1943). “I don’t think this matters so long as one knows what one is doing, and why.”
Orwell's time as an editor at BBC followed a period working as a colonial policeman in Burma. "“In a time of deceit telling the truth is a revolutionary act,” he said years later. Chairman Powell and the Federal Open Market Committee need to accept that they cannot raise fed funds further without causing serious financial problems for banks and other institutions. Time for truth.
Readers of The Institutional Risk Analyst know our views on Fed interest rate moves, but last week’s market action really begs the question as to the credibility of FOMC policy. Until the Committee completes the circle and starts to actively sell mortgage backed securities (MBS), the markets simply don’t and won’t believe that Powell and the FOMC are serious about raising interest rates to fight inflation.
The big takeaway from last week’s FOMC meeting is confusion on the part of the Committee members and the markets about the direction of interest rates. Komal Sri-Kumar wrote last week:
“Credibility is a terrible thing to waste. I wrote in January about at least two instances when Powell either turned dovish when hit by a cratering stock market (December 2018), or persisted in forecasting “transitory” inflation to justify his vastly expansionary policies (2020 - 2022). Market’s belief that he is a soft touch when it comes to inflation reduction explains why equities have rallied despite his seemingly tough message at the press conference.”
Why does the Fed need to sell MBS from the system open market account (SOMA)? Because only by releasing that massive duration locked away inside the sterilized confines of SOMA back into the markets can the FOMC get long-term interest rates above 4%. Adjusted for option-adjusted duration, the Fed's $2 trillion MBS position is larger than its portfolio of Treasury debt. Ponder that Chair Powell. Selling bonds is also a tangible manifestation of FOMC policy, distinct and apart from the speculations of the media & economist chorus about the target for fed funds.
Finally, selling bonds and pausing further fed funds rate increases will not put additional pressure on banks and will actually increase asset returns. The FOMC should not mistake the current calm in the bank funding market for a solution to the illiquidity and losses created by raising short-term interest rates over 500bp in a year. The chart below shows bank deposits through the first week in June vs the Treasury General Account. Bank deposits fell $80 billion in a single week. Total runoff for the rest of 2023 could be more than half a trillion dollars even if the Fed does not raise the target rate for fed funds again.
It has always been strange to us that an institution like the Fed, which is explicitly devoted to managing emotional intangibles like expectations about inflation, does not appreciate the impact of previously unannounced open-market operations. In the 1980s, the Fed of New York did not pre-announce bond or currency market operations. We did system RPs for breakfast or late lunch, sometimes before the market opened in New York or just before the close. The Fed manipulated currencies and changed expectations because the markets were surprised.
At present, the Fed is boxed-in by the economist/media rat pack, which focuses attention on the Fed’s intentions regarding the target for federal funds to the exclusion of all else. By giving the FRBNY’s desk in New York a broad mandate to manage the SOMA portfolio of MBS, the FOMC can sprout a second front for conducting policy and, yes, managing market expectations.
The FOMC could also move to a quarterly schedule for press conferences to calm media hype concerning rate changes. As Chairman Alan Greenspan taught us, the Fed must control the agenda. While the direction of fed funds is pretty cut and dry, the bond trading activity of the New York Fed is conducted away from public and even media scrutiny. And secondary market sales of MBS, unlike redemptions of Treasury paper owned by the Fed, do not put direct pressure on bank deposits.
Chairman Powell needs to take a hint from the author of Animal Farm and pivot, but not to lower interest rates. Instead, Powell needs to shift the narrative from a single-dimensional fight against inflation to a two track approach to lowering inflation and managing investor expectations about the most important price of all, LT interest rates.
Focusing on bond sales and pausing further fed funds hikes gives the Fed a way to push back against a market that seems intent upon forcing interest rates lower. Not raising fed funds for the balance of the year also gives US banks a chance to catch up with the rapid increase in short-term funding costs. Chairman Powell and the other members of the Committee may conceal themselves behind a beautiful and opaque tapestry of “open market operations.”
Fact is, with low new issue volume, and even with the mortgage paper being sold by the FDIC and many banks, there is still a massive shortage of risk-free assets that is pulling LT interest rates down. Look at the fact that spreads between the 10-year Treasury note and mortgage rates are back down to the narrowest spread in months. The Fed of New York should be selling into market strength right now.
Pushing LT yields higher will also help with the gradual reduction of the Reverse Repurchase Agreements which are costing the Fed billions in losses every month. The Fed's RRPs peaked over $2.5 trillion in January and have since trended lower to just below $2 trillion last week as funds flowed into Treasury bills. Notice that the series for $8.5 trillion of total holdings (red line) and $2.8 trillion in MBS (green line) are barely declining.
Another reason to accelerate MBS sales is to frankly reduce the impact of the Fed on private markets and the economy. The complexity of the Fed’s balance sheet is now arguably an obstacle to normalizing policy. The Jay Powell hedge fund is losing $1 billion per day.
The Fed’s loans to the FDIC, to finance the resolutions of Silicon Valley, Signature and First Republic banks have recently been disclosed in more detail. To date, the Biden Administration has not disclosed to Congress "the expected final cost to the taxpayers" of the program as required. Is Treasury Secretary Janet Yellen hiding the full cost of the three bank failures from Congress?
“On June 9, the Federal Reserve Board posted information on loans in the ‘other credit extensions’ category in the H.4.1, currently $180 billion,” writes Bill Nelson of Bank Policy Institute. “The new information is available here. The Fed explains that the obligor to the credit extensions is the FDIC. All the loans began as 1) discount window loans to Signature and First Republic, 2) discount window loans to the bridge banks that the FDIC established for SVB and Signature, or 3) a BTFP loan to First Republic. All the loans are now in the receiverships established for each of these institutions; the FDIC is the receiver. The interest rate on the loans is the applicable discount window or BTFP rate plus 100 bp.”
These emergency loans by the Fed illustrate the cost of the bank failures caused by the FOMC’s aggressive interest rate hikes in the first quarter of 2023. These losses and the prospect of more bank failures down the road has made the cost of the Fed’s support for FDIC a highly sensitive topic within the Biden Administration. Nelson suggests that while the Fed may eventually be repaid, the Treasury may ultimately take a loss on these three bank failures.
Of note, the FDIC and Fed interaction with respect to the loans made to FDIC receiverships is being left to the respective agencies and their legal offices. Former Fed Governor and now White House economic czar Lael Brainard and former Fed Chair and now Treasury Secretary Yellen reportedly are being briefed directly on the Fed loans without involvement of career staff.
Another large bank failure might require direct support for FDIC from the Treasury. Also, another bank failure might force the FOMC to drop short-term interest rates. As we've noted previously, in a rising interest rate environment, other banks will avoid purchasing the assets of dead banks. Nelson notes that there is still considerable uncertainty as to when the Fed will be repaid by the FDIC receiverships.
Last week, BlackRock announced that it will not sell Ginnie Mae Project Loans held by the FDIC, Bloomberg News reports. Why? A very low price. These agency commercial mortgage backed securities (CMBS) came from Silicon Valley Bank and Signature Bank, Nomura Securities (NMR) said in a client note. Instead, the FDIC decided to consider “alternative disposition strategies,” according to Nomura.
Pushing up the sale of MBS from the SOMA gives the Fed another tool to continue the fight against inflation, especially if liquidity problems at banks force the FOMC to reduce short-term interest rates earlier than now expected. Banks, the Fed and the FDIC all have the same problem: massive mark-to-market losses on assets that ultimately render markets illiquid. If the FOMC raises fed funds further, bank failures and perhaps even a market access crisis for the Treasury are next.
Markets know that many banks are literally hanging on by a thin thread. A pivot by Powell and the FOMC to stand pat on fed funds and accelerate bond sales will take the crosshairs off the banks and restore the Fed’s credibility with the markets. As George Orwell noted almost a century ago, it all depends on whether we know what we are doing and why.
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