Rising Rates, the Treasury Complex, and Banking. The Straight Dope
September 7, 2015
The financial ecosystem is trying to figure out what comes next. The equity market is down 50 points on a given day and the long bond catches a light bid, but nothing like a break-out. When the market is in full short squeeze, the long bond responds by selling off big. Term risk isn’t working in the face of a downturn. It is true that a modest hike in rates is coming soon. And this means trouble for term risk. Why does a 25bps hike in short rates (provided that the Fed can establish control over all four short rates) so far trump the impact of a big move in risky assets?
What is the optimal positioning in a constantly evolving, planetary, financial ecosystem Here's my thinking on the subject.
First, a preamble. Financial markets are fluid complex systems that don’t act the way we anticipate. They interact in a nonlinear way. Nonlinearity is not a mathematical property. It is the lack of a mathematical property. It implies a multitude of forces simultaneously acting. Take three simple quadratic examples:
y = ax^2 + bx + c 1)
y= -ax^2 + bx +c 2)
y = -ax^2 –bx - c 3)
In 1), the forces augment each other positively in their action on y. In 2), the force counteract each other, though in short order the first, -ax^2 dominates the other two. In 3), they augment each other in a negative way.
This simple example effectively explains the unhappy plight of the Treasury complex. The two factors are 1) the safe haven bid for Treasuries as perceived macroeconomic deterioration in China and EM threatens to engulf developed market fundamentals on the one hand and 2) the negative impact of a Fed rate hike on term risk counteracting each other. At the present time, they counteract each other. In the long term, we will seeing the ambiguity of the latter dominate the former, but for now the effect results in a standstill.
These two forces are driving risk appetite in general, not just Treasury yields. Financial markets ultimately reflect nothing more than collective views on the future, buttressed by money being on the line. It’s not about how the world actually works, but how markets think the world works. If the market is wrong, one can either momentum trade the market by front-running it or arbitrage it by waiting for the market to catch-up to reality’s fair value.
The challenge is that the Fed has signalled a readiness to hike rates. Despite the fact that there is absolutely no inflation pressure showing in commodity markets, the Fed is still likely to hike rates. There is a case to be made for imposing some discipline on the labor market bid: in my experience, even hiring new grads is a pricey exercise. But I suspect the rationale has little to do with commodity prices, the labor market, or even frothy asset price bubbles. The likely reason is that the Fed is facing up to the fact that additional monetary stimulus at this point is neither stimulative nor helpful. Given a slowing China and its impact on emerging markets leading the rest of the world into a global recession, they need reload so that future easing is possible when it will actually matter. No matter—as Bill Gross has recently indicated—that it will likely only convert an emerging market downturn into a self-fulfilling global recession.
Rising rates will occur in a financial ecosystem in great flux. The dominance of the dollar as a planetary funding vehicle implies money flows that will dwarf anything involved in past rate cycles. This synchronicity is the ultimate implicit aim of globalization, even as it heals and adapts from the blows of the financial crisis. It has been reengineered by Basel III: bank balance sheets are hampered by liquidity and funding rules and the sheer scale of the system makes it unclear what stresses will be unleashed by a rate hiking cycle.
They will have to hike rates differently than in the past. There are multiple short term rates, sme impacting the banking systems and some impacting the shadow banking system. Together these spheres comprise the entire ecosystem, one subject to policy rates and regulated by Basel III and the other operating in response to reserve repo operations and wholesale funding. So when Volker switched from a regime targeting rates to targeting the volume of reserves, the Fed funds rate prompted exceeded 20%. This was because slowing reserve levels caused a crunch given the pace of lending and creating deposits. This leads to a key insight: What drives demand for reserves is strong loan growth. and loan growth has not caught up to reserve levels. So the Fed can’t just drain reserves on its own. The ecosystem has to respond in a way that accommodates this objective.
Because of the high reserve levels in the market, the response will be sluggish. The size of the fed funds market is about $50 billion, down from $250 billion pre-crisis. The reason is that there are so many there are so many excess reserves due to QE, there is no need for it. Also, $2 trillion + of deposits have left the banking system by switching into money funds. Banks facilitated these outflows by giving up reserves and as a result shrinking both sides of their balance sheets. In turn, money funds increase both sides of their balance sheets. Fed liabilities remained the same in size but different in composition as reserves fell from $2.5 trillion to $ 500 billion and reverse repos grew from $100 billion to $2.1 trillion. Fed funds has become relatively insignificant, but repo and reverse repos get little airtime.
There is a reason for this: few get it . The degree of interest rate sensitivity of players in the shadow banking system is not well understood, and there is a lot of room for model risk as banks calibrate their HQLA portfolios backing shadow banking portfolios. As a result, there is a potential a need for reserves to ensure compliance. This implies Treasury repo from HQLA holdings to cover outflows. In the event that liquidity needs become pressing, outright sales of Treasuries and agencies generate proceeds to cover outflows.
Some takeaways for risk positioning:
Some banks will benefit and others will not. For some, the effect of rising interest margins will be offset by the need to recalibrate portfolios and shrinking balance sheets. JP Morgan and Goldman Sachs are prime examples of banks that are over-reserved with cash sufficient to mitigate any need to adjust balance sheets. They are the choir boys for the re-regulated, better capitalized global banking system.
The rest of the financial system is by no means as well-capitalized. Their collectively diminished capacity to make markets and broke assets will result in greater likelihood of flash crashes and an elevated volatility regime. This is intimately connected to an impaired macroeconomic environment with subdued demand for loans.
The USD will continue to draw reserves from the EUR as the ECB cut deposit rates below zero. As it stands right now, USD has absorbed a huge amount of global FX reserves from the EUR. Since June 2014, FX reserve managers allocated 25% of holdings in the EUR. By June 2015, this level fell to 20%. The USD absorbed all of it. Far from seeing this trend reversing, the expectation is that the demand for USD assets will move from the short-term money markets to the longer term-capital markets. There is little room for central banks or governments to conduct countercyclical fiscal and monetary policy should recession occur. Points of relative value on the Treasury curve are attractive places to hide.