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What if ‘Excess Reserves’ Aren’t Really Excess?

March 4, 2019 1 comment

One intriguing recent suggestion I have heard recently is that the “Excess” reserves that currently populate the balance sheet of the Federal Reserve aren’t really excess after all. Historically, the quantity of reserves was managed so that banks had enough to support lending to the degree which the Fed wanted: when economic activity was too slow, the Fed would add reserves and banks would use these reserves to make loans; when economic activity was too fast, the Fed would pull back on the growth of reserves and so rein in the growth of bank lending. Thus, at least in theory the Open Markets Desk at the New York Fed could manage economic activity by regulating the supply of reserves in the system. Any given bank, if it discovered it had more reserves than it needed, could lend those reserves in the interbank market to a bank that was short. But there was no significant quantity of “excess” reserves, because holding excess reserves cost money (they didn’t pay interest) – if the system as a whole had “too many” reserves, banks tended to lend more and use them up. So, when the Fed wanted to stuff lots of reserves into the system in the aftermath of the financial crisis, and especially wanted the banks to hold the excess rather than lending it, they had to pay banks to do so and so they began to pay interest on reserves. Voila! Excess reserves appeared.

But there is some speculation that things are different now because in 2011, the Basel Committee on Banking Supervision recommended (and the Federal Reserve implemented, with time to comply but fully implemented as of 2015) a rule that all “Systematically Important Financial Institutions” (mainly, really big banks) be required to maintain a Liquidity Coverage Ratio (LCR) at a certain level. The LCR is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) by a number that represents its stress-tested 30-day net outflows. That is, the bank’s liquidity is expressed as a function of the riskiness of its business and the quantity of high-quality assets that it holds against these risks.

In calculating the HQLA, most assets the bank holds receive big discounts. For example, if a bank holds common equities, only half of the value of those equities can be considered in calculating this numerator. But a very few types of assets get full credit: Federal Reserve bank balances and Treasury securities chief among them.[1]

So, since big banks must maintain a certain LCR, and reserves are great HQLA assets, some observers have suggested that this means the Fed can’t really drain all of those excess reserves because they are, effectively, required. They’re not required because they need to be held against lending, but because they need to be held to satisfy the liquidity requirements.

If this is true, then against all my expectations the Fed has, effectively, done what I suggested in Chapter 10, “My Prescription” of What’s Wrong with Money? (Wiley, 2016). I quote an extended section from that book, since it turns out to be potentially spot-on with what might actually be happening (and, after all, it’s my book so I hereby give myself permission to quote a lengthy chunk):

“First, the Federal Reserve should change the reserve requirement for banks. If the mountain will not come to Mohammed, then Mohammed must go to the mountain. In this case, the Fed has the power (and the authority) to, at a stroke, redefine reserves so that all of the current “excess” reserves essentially become “required” reserves, by changing the amount of reserves banks are required to hold against loans. No longer would there be a risk of banks cracking open the “boxes of currency” in their vaults to extend more loans and create more money than is healthy for an economy that seeks noninflationary growth. There would be no chance of a reversion to the mean of the money multiplier, which would be devastating to the inflation picture. And the Open Markets Desk at the Fed would immediately regain power over short-term interest rates, because when they add or subtract reserves in open market operations, banks would care.

“To be sure, this would be awful news for the banks themselves and their stock prices would likely take a hit. It would amount to a forcible deleveraging, and impair potential profitability as a result. But we should recognize that such a deleveraging has already happened, and this policy would merely recognize de jure what has already happened de facto.

“Movements in reserve requirements have historically been very rare, and this is probably why such a solution is not being considered as far as I know. The reserve requirement is considered a “blunt instrument,” and you can imagine how a movement in the requirement could under normal circumstances lead to extreme volatility as the quantity of required reserves suddenly lurched from approximate balance into significant surplus or deficit. But that is not our current problem. Our current problem cries out for a blunt instrument!

“While the Fed is making this adjustment, and as it prepares to press money growth lower, they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise.

“Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. It is possible that, as this happens, reserve requirements could be edged incrementally back to normal as well. But those decisions are years away.”

If, in fact, the implementation of the LCR is serving as a second reserve requirement that is larger than the reserve requirement that is used to compute required and “excess” reserves, then the amount of excess reserves is less than we currently believe it to be. The Fed, in fact, has made some overtures to the market that they may not fully “normalize” the balance sheet specifically because the financial system needs it to continue to supply sufficient reserves. If, in fact, the LCR requirement uses all of the reserves currently considered “excess,” then the Fed is, despite my prior beliefs, actually operating at the margin and decisions to supply more or fewer reserves could directly affect the money supply after all, because the reserve requirement has in effect been raised.

This would be a huge development, and would help ameliorate the worst fears of those of us who wondered how QE could be left un-drained without eventually causing a move to a much higher price level. The problem is that we don’t really have a way to measure how close to the margin the Fed actually is; moreover, since Treasuries are a substitute for reserves in the LCR it isn’t clear that the margin the Fed wants to operate on is itself a bright line. It is more likely a fuzzy zone, which would complicate Fed policy considerably. It actually would make the Fed prone to mistakes in both directions, both over-easing and over-tightening, as opposed to the current situation where they are mostly just chasing inflation around (since when they raise interest rates, money velocity rises and that pushes inflation higher, but raising rates doesn’t also lower money growth since they’re not limiting bank activities by reining in reserves at the margin).

I think this explanation is at least partly correct, although we don’t think the condition is as binding as the more optimistic assessments would have it. The fact that M2 has recently begun to re-accelerate, despite the reduction in the Fed balance sheet, argues that we are not yet “at the margin” even if the margin is closer than we thought it was previously.


[1] The assumption in allowing Treasuries to be used at full value seems to be that in a crisis the value of those securities would go up, not down, so no haircut is required. Of course, that doesn’t always happen, especially if the crisis were to be caused, for example, by a failure of the government to pay interest on Treasuries due to a government shutdown. The more honest reason is that if the Fed were to haircut Treasuries, banks would hold drastically fewer Treasuries and this would be destabilizing – not to mention bad for business on Capitol Hill.

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The Neatest Idea Ever for Reducing the Fed’s Balance Sheet

September 19, 2018 14 comments

I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.” First, some background.

It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index.” But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.

This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.

I just didn’t say five years from when.

We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.

A similar approach was used with CDOs (Collateralized Debt Obligations). A collection of corporate bonds was put into a trust[1], and certificates issued that entitled the buyer to the first X% of the cash flows, the next Y%, and so on until 100% of the cash flows were accounted for. Since the security at the top of the ‘waterfall’ got paid off first, it had a very good rating since even if some of the securities in the trust went bust, that wouldn’t affect the top tranche. The next tranche was lower-rated and higher-yielding, and so on. It turns out that with some (as it happens, somewhat heroic) assumptions about the lack of correlation of credit defaults, such a CDO would produce a very large AAA-rated piece, a somewhat smaller AA-rated piece, and only a small amount of sludge at the bottom.

So, in 2004 I thought “why don’t we do this for TIPS? Only the coupons would be tied to particular subcomponents. If I have 100% CPI, that’s really 42% housing, 3% Apparel, 9% Medical, and so on, adding up to 100%. We will call them ‘Barclays Real Accreting-Inflation Notes,’ or ‘BRAINs’, so that I can hear salespeople tell their clients that they need to get some BRAINs.” A chart of what that would look like appears below. Before reading onward, see if you can figure out why we never had BRAINs.

When I was discussing CDOs above, you may notice that the largest piece was the AAA piece, which was a really popular piece, and the sludge was a really small piece at the bottom. So the bank would find someone who would buy the sludge, and once they found someone who wanted that risk they could quickly put the rest of the structure together and sell the pieces that were in high-demand. But with BRAINs, the most valuable pieces were things like Education, and Medical Care…pretty small pieces, and the sludge was “Food and Beverages” or “Transportation” or, heaven forbid, “Other goods and services.” When you create this structure, you first need to find someone who wants to buy a bunch of big boring pieces so you can sell the small exciting pieces. That’s a lot harder. And if you don’t do that, the bank ends up holding Recreation inflation, and they don’t really enjoy eating BRAINs. Even the zombie banks.

Now we get to the really cool part.

So the Fed holds about $115.6 billion TIPS, along with trillions of other Treasury securities. And they really can’t sell these securities to reduce their balance sheet, because it would completely crater the market. Although the Fed makes brave noises about how they know they can sell these securities and it really wouldn’t hurt the market, they just have decided they don’t want to…we all know that’s baloney. The whole reason that no one really objected to QE2 and QE3 was that the Fed said it was only temporary, after all…

So here’s the idea. The Fed can’t sell $115bln of TIPS because it would crush the market. But they could easily sell $115bln of BRAINs (I guess Barclays wouldn’t be involved, which is sad, because the Fed as issuer makes this FRAINs, which makes no sense), and if they ended up holding “Other Goods and Services” would they really care? The basis risk that a bank hates is nothing to the Fed, and the Fed need hold no capital against the tracking error. But if they were able to distribute, say, 60% of these securities they would have shrunk the balance sheet by about $70 billion…and not only would this probably not affect the TIPS market – Apparel inflation isn’t really a good substitute for headline CPI – it would likely have the large positive effect of jump-starting a really important market: the market for inflation subcomponents.

And all I ask is a single basis point for the idea!


[1] This was eventually done through derivatives with no explicit trust needed…and I mean that in the totally ironic way that you could read it.

Sometimes I Just Sits

December 1, 2015 6 comments

An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”[1]

The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.

That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)[2]

More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.

The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.

I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.

pmi

To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.

domdebt

Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.

In 2016, if the Fed goes forward with tightening, we will see:

  • Lower corporate earnings
  • Rising corporate default rates
  • Rising inflation
  • Lower equity prices; higher commodity prices
  • Banks vilified. I am not sure why, but it seems this always happens so there will be something.

All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.

To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.

The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.

[1] This story is attributed variously to A.A. Milne and to Punch magazine, among others.

[2] Cotton is +3% or so versus 1 year ago.

The New Fed Operating Framework Explained with Cheese

October 8, 2015 2 comments

This will be a brief but hopefully helpful column. For some time, I have been explaining that the new Fed operating framework for monetary policy, in which the FOMC essentially steers interest rates higher by fiat rather than in the traditional method (by managing the supply of funds and therefore the resulting pressure on reserves), is a really bad idea. But in responding to a reader’s post I inadvertently hit on an explanation that may be clearer for some people than my analogy of a doctor manipulating his thermometer to give the right reading from the patient.

Right now, there is a tremendous surplus of reserves above what banks are required to hold or desire to hold. With free markets, this would result in a Fed funds interest rate of zero, or even lower under some circumstances, with a substantial remaining surplus.[1] In this case, the Fed funds effective rate has tended to be in the 10-20bps range since the Fed started paying interest on excess reserves (IOER).

So what happens when there is a floor price established above the market-clearing price? Economics 101 tells us that this results in surplus, with less exchange and higher prices than at equilibrium. Consider a farm-price support program where the government establishes a minimum price for cheese (as it has, actually, in the past). If that price is below the natural market-clearing price, then the floor has no effect. But if the price is above the natural market-clearing price, as in the chart below where the minimum cheese price is set at a, then in the market we will see a quantity of cheese traded equal to b, at a price of a.

cheese

But what also happens is that producers respond to the higher price by producing more cheese, which is why the supply curve has the shape it does. In order to keep this excess cheese from pushing market prices lower, the government ends up buying c-b cheese at some expense that ends up being a transfer from government to farmers. It can amount to a lot of cheese.[2] This is the legacy of farm price supports: vast warehouses of products that the government owns but cannot distribute, because to distribute them would push prices lower. So the government ends up distributing them to people who wouldn’t otherwise buy cheese, at a zero price. And eventually, we get the Wikipedia entry “government cheese.” https://en.wikipedia.org/wiki/Government_cheese

Now, this is precisely what has happened with the artificial price support for overnight interest rates. Whatever the clearing interest rate is with the current level of reserves, it is lower than the 0.25% IOER (and we know this, among other ways, because there are excess reserves. If the price floating to the actual clearing price, then there would be no excess reserves, although the mechanism for this result is admittedly more confusing than it is for cheese). So the Federal Reserve is forced to “buy up the surplus reserves” by paying interest on these reserves; this amounts to a transfer from the government to banks, rather than to farmers in the cheese example.

You should realize too that setting the floor rate higher than the market-clearing rate artificially reduces the volume of trade in reserves. The chart below, which comes from this article on the New York Fed’s blog, illustrates this nicely.

6a01348793456c970c019b01bdca9a970d-800wi

Creating such a floor also causes the supply of excess reserves themselves to increase beyond what it would otherwise be. This confusing result derives because while the Fed supplies the total reserves number to the market, banks can choose to create more “excess” reserves by doing less lending, or can create fewer excess reserves by doing more lending. Of course, banks aren’t deciding to create excess reserves per se; they are deciding whether it is more advantageous to make a loan or to earn risk-free money on the excess reserves. A higher floor rate implies less lending, all else equal – and, as I have said in the past, this means the Fed could cause a huge increase in bank lending by setting IOER at a penalty rate. This would create the conditions necessary for these lines to cross in negative nominal interest rate territory, with much higher volumes of credit and much lower levels of excess reserves being the result.

In this environment, and as recognized by the Sack-Gagnon framework that is now the presumed operating framework for Fed policy, raising IOER is the only way to change the overnight interest rates unless the Desk undertakes to shift the entire supply curve heavily to the left, by draining trillions in reserves. But raising IOER, just like raising the floor price of cheese, will create more imbalances: bigger excess reserves, less lending, and a bigger transfer from government to banks.

(Note: this is subtly different from what I have said before, which is that raising IOER will have no effect on the growth rate of the transactional money supply. Depending on the shape of the supply curve, it will reduce lending which in turn may reduce the growth rate of the monetary aggregates that we care about, such as M2. My suspicion is that the supply curve is in fact pretty steep, meaning that banks are relatively insensitive to small changes in rates, and thus loans and hence the monetary aggregates won’t see much change in the rate of growth – or, more likely, any change will be the result of other effects beyond this one such as the effect of general economic prospects on the quality of credits and the demand for loans).

Price supports, as any economist can tell you, are an inefficient way to subsidize an industry. And in fact, I don’t think the Fed is really interested in subsidizing banks at this stage in the cycle: they seem to be doing just fine. But they are taking on all of these imbalances, creating all of this government cheese, because they believe the effects I talk about parenthetically above are quite large, rather than vanishingly small as I believe. And the ancillary effect, by raising interest rates, is to spur money velocity – an unmitigated negative in this environment, as it will push inflation higher.

Now, all of this discussion may be moot since the current betting is that the Fed won’t raise interest rates any time soon. But it is good to understand this mechanism as clearly as we can, so that we can prepare ourselves for those effects when they occur.

[1] It is really hard to say how low interest rates would go, and/or how much surplus would remain, because we have no idea at all what the supply and demand curves for funds look like at sub-zero rates. Most likely there is a discontinuity at a zero rate, but how much of one and the elasticities of supply and demand below zero are likely to be “weird.”

[2] In fact, in high school I won an economics prize for my paper “That’s a Lotta Cheese.” No joke.

They Came to Play

I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.

Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:

“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”

All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB.  This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.

There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.

If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).

ECBdepo

But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.

Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.

If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.

europlusus

The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).

euroinfl10

Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.


[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.

Tempest in a Microsecond

April 1, 2014 3 comments

News flash! High-frequency trading (HFT) is happening!

The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”

Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”

Capture

So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?

To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.

High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.

So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.

But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.

Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.

Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.

And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.

The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.

Don’t Bank on it

February 17, 2014 7 comments

Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.

To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.

Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.

Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.

(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).

So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.

On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.

And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.

However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). roebanksWhat is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).

bankpeMaybe all the bad news is already in the price of bank stocks, but it doesn’t look like it to me.

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