August 1, 2022 | This week The Institutional Risk Analyst is headed for Leen’s Lodge in Grand Lake Stream, Maine, for a week of fishing, discussion and perhaps a poker game. Topic A on the agenda items for debate will be the state of monetary policy in the United States.
Big Lake (August 2020)
First and foremost, let's review last week's FOMC presser. Powell declared victory and proceeded to state that the neutral rate of interest or ”r*” is somewhere close to the current nominal level of Federal Funds (FF). The incredulity in the room was palpable, yet nobody in the media dared to challenged Powell’s statement. He said:
“I'd start by saying we've been saying we would move expeditiously to get to the range of neutral. And I think we've done that now. We're at 2.25 to 2.5 and that's right in the range of what we think is neutral.”
The chart below shows effective FF vs the rate on reverse repurchase agreements (RRPs). In these latter transactions, the Fed lends securities and takes cash out of the market. But hold that thought.
The lack of specificity in the Fed’s statement about r* provides a hint about just how little precision there is in the way the FOMC looks at variables like inflation and interest rates. This lack of clarity, in turn, trickles down into all of the policy decisions made by the Committee. Thus if Powell actually believes that FF is now at r*, then no further rate hikes are required in 2022?
Bill Nelson at Bank Policy Institute rejected Powell’s statement about FF neutrality:
“That is incorrect – the current level of the federal funds rate is not neutral. The neutral federal funds rate is the rate above which monetary policy is restraining the economy and below which monetary policy is stimulating the economy. The neutral rate is usually defined in term of the real federal funds rate – the nominal federal funds rate minus a measure of inflation or inflation expectations. The neutral real federal funds rate is often called r*. The median FOMC participant indicated in the June SEP (Summary of Economic Projections) that he or she judges that the nominal federal funds rate will be 2.5 percent in the long run at which point inflation will be 2 percent. That reading indicates the neutral real federal funds rate is 0.5 percent.”
Fed Chairman Jerome Powell mentioned the phrase “balance sheet” twice during his remarks. None of the senior reporters and columnists in the room asked about the portfolio, which is the single most important factor in monetary policy. Putting Powell on the spot about the vagueness of the Fed's intentions on the portfolio would be seen as unconstructive. Thankfully Jean Yung of Muck Rack asked about the pace of balance sheet reduction. Powell replied:
“So we think it's working fine. As you know, we tapered up into it. And in September, we'll go to full strength. And the markets seem to have accepted it. By all assessments, the markets should be able to absorb this. And we expect that will be the case. So, I would say the plan is broadly on track. It's a little bit slow to get going because some of these trades don't settle for a bit of time. But it will be picking up steam.”
What Powell was saying is that reinvestment of redemptions and prepayments on mortgage securities will end in September and forward trades in the mortgage market will likewise settle by that time. Translated into plain language, the Fed will start shrinking reserves and in theory force investors out of reverse repurchase agreements in September. Dealers will also be expected to shoulder 100% of the duration of Treasury and agency MBS issuance. Powell then defined the timeframe:
“So I guess your second question was getting-- the process of getting back down to the new equilibrium will take a while. And that time, it's hard to be precise, but the model would suggest that it could be between two, two and a half years, that kind of thing. And this is a much faster pace than the last time. Balance sheet's much bigger than it was. But we look at this carefully and we thought that this was the sensible pace. And we have no reason to think that it's not.”
Greg Robb of MarketWatch then asked Powell a good follow-up question about the potential for a repeat of the December 2018 taper tantrum, when markets seized up after several money center banks back away from overnight funds markets. Powell’s answer was quite revealing and detracts from the idea that reserve targeting as a percentage of GDP is a good way to avoid similar market hiccups:
“So I think we learned, there have been multiple taper tantrums, right? So there was the famous one in 2013. There's what happened at the December '18 meeting where markets can ignore developments around the balance sheet for years on end, and then suddenly react very sharply. So we just had developed a practice of moving predictably and doing it in steps and things like that. It was just like that's how we did it. And so we did it that way this time. We were careful to take steps and communicate and all that kind of thing. Yeah, we were trying to avoid a tantrum. Because they can be quite destructive. They can tighten financial conditions and knock the economy off kilter. And when it happens, you have to, really in both 13 and 18, really had consequences for the real economy, two, three, four months later. So we were trying to avoid that.”
We noted earlier that the Fed is modeling future market liquidity requirements vs GDP. Economists love to argue about mysterious quantities like liquidity or unmeasurable notions such as r*, yet the fact is that the FOMC ultimately relates everything to interest rates or gross domestic product. More complex notions are completely beyond the comprehension of members of Congress and the investment advisory profession.
The purely domestic focus of the Humphrey-Hawkins law encourages this childishly simplistic view of the dollar political economy, a view significantly that excludes the rest of the world. For example, when Chairman Powell stood up last week and spoke about the neutral rate of FF, he never once acknowledged that the 10-year Treasury note had rallied almost 50bp in yield since the last FOMC meeting. Why is this key benchmark falling in yield? Because of the global shortage of risk-free collateral created by QE.
Few people among the Big Media that “cover” the Fed have any idea about the bond market, risk-free collateral or the dollar. Notice in the chart below that sellers of fixed dollar cash flows are paying up handsomely in swaps, but outside of 30 years dollar cash flows trade at far lower yields than Treasury collateral.
Jeffrey Snider, Head of Global Research at Alhambra Investments, did an important piece recently where he discussed the shortage of collateral in the context of the dollar and interest rates (“Collateral Shortage…From *A* Fed Perspective”).
Snider noted that since 2017, Treasury bills have been trading at a premium to risk-free reserves at the Fed, a strange situation that suggests a systemic shortage of this crucial collateral. At the same time, the short-term market for dollar swaps has been trading well-outside of the Treasury yield curve, but beyond 30 years is very tight and well-through Treasury yields. Since only banks may hold reserves at the Fed, the shortage of collateral has fallen most heavily on private market participants. Snider concludes:
“It’s all about the puppet show. Top-level policymakers still, to this very day, believe that they can convince the world to dance to their tune; playing the federal funds “market” as the sole instrument in the accompanying FOMC Orchestra. The intended audience for this pitiful display includes, ridiculously, collateral suppliers and multipliers. That very fact alone gives it away. No one uses nor really cares about fed funds except those in the media who then give the public a distinct monetary impression that is plainly false.”
“Even now, you’ll hear it said that the dollar goes up because of rate hikes to either the FOMC’s fed funds target (pre-2009) or its range plus instruments (like RRP and IOER),” Snider relates. “The Fed does not matter. Only Euro$.”
We agree. For some time now, we have tried to focus the attention of our readers on the growing influence of foreign investors when it comes to the dollar and also the rate of interest in the dollar system. The growing number of disturbances to the offshore dollar system, including the financial implosion of China’s “Belt & Road” effort, the default of HNA and other corporate failures, and the related carnage in the Chinese property market, were early signs of stress. The war in Ukraine, inflation and the rising rates have thrown the non-dollar world into another debt crisis.
And yet, strangely, the FOMC managed to conduct a press conference last week where the word “debt” was never mentioned. Foreign nations and markets were barely acknowledged. All of this is part of the exceptional American perspective that our domestic debt does not matter and the impact of the dollar on other nations, most of whom are short dollars, is of no consequence.
As we noted in our comment to subscribers of the Premium Service last week ("Questions for Chairman Powell"), one reason that the Fed is not willing to allow its balance sheet to fall below about $6 trillion by the end of the decade is uncertainty about how the different pieces of the puzzle – the $9 trillion portfolio, $2 trillion in reverse repurchase agreements, and the Treasury market and cash balances -- will interact. But politics also plays a role.
The FOMC figures that they can manage the politics of losing money on an interest rate mismatch more easily than taking hundreds of billions in realized losses on securities held in the system open market account (SOMA). Thus the FRBNY research team last month assumed no realized losses from the SOMA at all, zero, and thus no sales. Somehow nobody in the Big Media thought this was important?
The $9 trillion in paper held by the SOMA (~ $6.2 trillion in Treasury debt and $2.7 trillion in mortgage backed securities) constitutes a threat to the global economy outside the US. Why? Because when countries and private companies and banks engage in offshore dollar transactions, they need risk-free collateral to back the trade. The low coupon Treasury paper and MBS created in 2020 and 2021, however, is now a ghetto, unsalable paper that is trapped on the Fed’s balance sheet, creating a serious problem in the global market for dollars.
“Given the Fed primarily holds 2.0% to 2.5% coupons on its balance sheet, the ‘Sword of Damocles’ that is active sales hangs over these lower coupons as the Fed postures to embark on this unprecedented route,” writes Gordon Li of TCW, referring to the considerable underperformance of the lower coupon MBS since last year. He elucidates:
“In stark contrast to these developments in lower coupon sectors, current coupon agency MBS have seen nominal spreads widen to levels roughly 35 bps in excess of previous Fed 'Reinvestment-QT' ranges, perhaps suggesting that the ‘pricing in’ of hawkish Fed actions has been overdone this hiking cycle. Valuations in current coupons have been made even more compelling by a sharp decline in dollar prices.”
Given the dichotomy between the Sell Side tendency, which has already begun to chatter about Fed rate cuts before the end of next year, and the rest of the world, which is suffering from a strong dollar, the lack of clarity with respect to the optimal level of Fed involvement in the market is striking. Specifically, should the Fed assume that it needs to aggressively lend out its SOMA portfolio as the process of shrinkage actual begins in September?
Here’s a question we’ll leave with our readers until later this week, when we report on the discussions at Leen’s Lodge: Will the Fed actually be able to “force” investors out of the more than $2 trillion in reverse RPs? “Force” is one of those unfortunate terms in monetary economics. We cannot force people to lend or invest unless we turn America into a copy of Xi Jinping's Chinese prison.
Some believe that the Fed lost control over its own balance sheet at the start of QE. More, how much of a discount to FF will investors tolerate in return for borrowing risk free securities from the Fed? The answer to those questions will better inform the FOMC’s consideration of optimal reserve levels than a modeled output based upon GDP.
After all, the relative demand for risk-free collateral and thus liquidity is largely a function of how JPMorgan (JPM) CEO Jamie Dimon feels about risk on any given day. As we noted recently, Dimon is a seller of risk. Stick that in your model and stir briskly Chairman Powell.