Is China selling its Treasuries?
Combine two data points
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The August fall in Treasury holdings in the Federal Reserve Bank of New York’s custodial accounts (the data is released weekly here); and
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The very modest increase in China’s reported holdings of Treasuries this year, and an outright fall in the second quarter, in the TIC data.
You can combine them and tell a story that China is starting to sell its Treasuries.
I don’t buy it. Not really.
China – along with some of the oil exporters – is still adding to its reserves in a quite significant way. China’s reserve growth (like Saudi reserve growth, but surprising, unlike Russian reserve growth) stemmed far less from capital inflows than from its current account surplus. Financial market turmoil has reduced inflows into the emerging world – and generated outflows from places like Russia – but it hasn’t reduced China’s large surplus, or for that matter the large surplus of the major oil exporting economies.
So China still likely has about $40b or so a month to place somewhere. If China wants to transfer say $80b to its new investment fund, it doesn't need to sell anything. All it needs to do is to park two months of the central banks' dollar purchases in the international banking system.
Now it is true that China doesn’t seem to be putting a lot of its rapidly growing reserves into the Treasury market. Relatively speaking, it has been buying more Agencies and corporate bonds this year, and fewer Treasuries.
But a bit of caution is in order even here. Someone is holding a lot of Treasuries in London — UK holdings have increased by about $135b in the past 12 months. And for the past two years, a lot of the UK’s supposed Treasuries really turned out to belong to China (look at the adjustments in the historical data). The high-frequency US data clearly doesn’t capture all Chinese Treasury purchases. China is likely buying fewer Treasuries, but not quite as few as the TIC data suggests.
It is possible – as Macro man notes – that China has been building up very liquid short-term assets (think deposits or bills) rather than buying longer-term Treasuries as it prepares to launch its investment fund. Chinese holdings of t-bills should eventually show up in the US data, but Chinese bank deposits probably wouldn’t.
It is even possible that SAFE recognizes a good trading opportunity – the only time China can sell Treasuries without disrupting the market is when the market really, really wants Treasuries. That is the case now. China could be taking some profits on its Treasury holdings (note the rise in Japan’s reserves, that all stems almost entirely from the fall in US interest rates which increased the market value of Japan’s portfolio – China has similar gains) and locking in slightly higher yields on only marginally more risky Agency bonds. If that is what it is doing, good for it – its actions are fundamentally stabilizing. It is selling what the market wants to buy what the market doesn’t want. Lucia Mutikani of Reuters quoting Tony Crescenzi:
"Central bank debt trading desks are quite heavy and recognize that yields have gone up significantly recently, creating a trading opportunity to gain a little more yield," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York.
All that said, though, I personally would bet that central banks other than China are responsible for the fall in the FRBNY’s Treasury holdings over August.
Here is what I suspect has been going on.
Over the course of 2007, three things have been happening.
First, some central banks with large existing holdings of Treasuries have been slowly reducing their Treasury holdings – whether by selling into the market or by not rolling over maturing bonds – and adding to their Agency holdings (and perhaps otherwise diversifying as well). Korea and Japan are the obvious examples. If nothing else was going on, that would tend to lower Treasury holdings.
Second, those central banks that are adding to their reserves rapidly have been buying more Agencies and fewer Treasuries – China is the most obvious example (Russia is, strangely enough, buying more Treasuries than in the past … but that isn’t saying much, since it previously held an “all Agency” portfolio)
And third, the overall pace of global reserve growth picked up sharply. In the first two quarters of the year, I suspect it will be about $300b a quarter – a $1.2 trillion pace – though that estimate hinges on the q2 IMF data and some expected revisions to the q1 data.
The result – central banks were buying a lot more of everything, including Treasuries. So their Treasury holdings were going up, just not as fast as their holdings of other assets. In some parts of the Treasury market, there actually aren’t many outstanding bonds left for the central banks to buy.
August though was a bit different. Global reserve growth slowed, particularly in places where global reserve growth reflected large capital inflows. International investors took profits and took money off the table. Money even flowed out of a few markets – Russia most notably.
Absent those inflows, the trend move out of Treasuries and into Agencies looked a bit more prominent. And I suspect that central banks needing liquidity sold their most liquid asset – Treasuries. That is a good thing. Right now the private market wants Treasuries.
But the fall in the Fed’s custodial holdings exceeds Russia’s need for liquidity – and even if you add in a few other countries, my guess is that the fall is a bit bigger than can easily be explained by a slowdown in global reserve growth.
So a few central banks that previously held long-term Treasuries sold – and either bought Agencies or moved into bank deposits.
That could include Japan and Korea. This would be a great time for both to accelerate their long-standing plan to diversify away from Treasuries.
And it also might include various European central banks. Remember, a lot of European banks right now have an enormous need for dollar liquidity (all their conduits) ….
I hadn’t thought of the European angle, but Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York, did. Reuters:
"half of the decrease (in Treasury holdings) relates to the purchases of agency securities. The rest of it may be that central banks are looking to hold dollars, rather than investments because there has been a shortage of dollars in the European banking system."
It makes sense to me.
This is a case where the easy conclusion (central bank Treasury holdings are falling, China must be selling) is not likely to be the right conclusion.
I have long argued that there is a risk that central banks are a potential source of financial instability should they stop adding to their dollar holdings at points in time when the market doesn’t want dollars. That still strikes me as a risk – though not a high probability one. There are a set of countries that hold far more dollars than makes economic or financial sense, and at some point they might decide that they don't want to continue to buy even more.
But all indications suggest that emerging market central bank have been a stabilizing, not a destabilizing, force in the markets over the past month.
If the US economy disappoints and the dollar continues to slide though, some will be put to the test. The key to the dollar’s broad stability has been central banks willingness to put a disproportionate share of their reserves into dollar assets of all kinds when the dollar is under stress.
Goldman's fx team and Barry Eichengreen don’t think a financial crisis that originated in the US subprime market will ultimately prove to be dollar positive. I agree.
Update: The fall in Taiwan's reserves in August suggests that it was one of the sellers — though its sales alone cannot be the entire fall. Yves Smith of Naked Capitalism is more inclined than I am to think the recent fall in central bank Treasury holdings suggests trouble. I would note that the fall in Korea and Japan's holdings of Treasuries likely reflects a shift toward Agencies, not a shift out of the dollar — though Korea probably is also trying to reduce the dollar share of its portfolio. And in any case, this is precisely the time when central banks can lighten up on Treasuries without disrupting the market.
Hi Brad,
it sounds right that European central banks have bought dollars massively to make up for the conduit problems, b ut this doesn’t seem to suqare up with the data: the Dollar has fallen relative to Euro since half-August (and the banks that had more problems with dollar liquidity were German banks, which hold Euro).
So in your view, we should expect an overshooting of the Dollar in the following weeks: Europe and Japan buy massilvely for a period, and then (possibly) all together ( perhaps along with China) sell USD and the latter crashes… Or do you mean that ‘buying Ageincies’ has nothing to deal with buying Dollars?
I think that time has finally come for the US spending to slow. If US consumers stop buying, the FED will have to ‘export’ unemployment to the RoW (as in Obstfeld Rogoff). In order this to occur, the Dollar must fall. And in order the Dollar to fall, the FED should cut rates. And not only of 25 bp.
I don’t agree with prof Roubini when he says that Bernanke is afraid of being pointed at as the rescuer of wreckless lenders. I think he will cut rates if he thinks it’s convenient. The problem is that I am not sure whether he is totally convinced — nor am I, honestly — that US is going thorugh an actual and deep recession. Sure, data seem to confirm it (Mishkin said, if housing goes down, the economy goes down as well). But if Bernanke decides to cut rates because the economy is going down, he has to cut rates deeply (>> 50 bp at least). This is an important decision, and it can’t be based on — though educated — guessing.
Bottom line: I think that if USD will fall, it will fall also thanks to Bernanke’s decision (in the light of “exporting” unemployment). I don’t exclude that such a decision may actually push the USD very down (due to a worldwide selling chain). But I don’t think that the first to sell will be the Chinese.
Best
Bernardo
Bernardo — thanks for your comment. I didn’t mean to imply that the ECB has been buying dollars. I wouldn’t be surprised if they had say sold treasuries to increase their dollar bank deposits though … that was the idea, a shift within the dollar portfolio from the very liquid to the even more liquid …
an interesting question is whether the ECB has been lending in $ to European banks or just in euros. I do think a number of European banks have had to sell euros –whether euros obtained from the private market or from the ECB — to buy $ to supply liquidity to their off balance sheet conduits and SIVs.
appreciate the comment.
Bloomberg’s John Berry with his Insider Fed contacts has accurately predicted past Federal Reserve policy changes.
Fed Cut to 5 Percent Without Promising More
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_berry&sid=avsPSp2cXT0U
Sept. 7 (Bloomberg) — If Federal Reserve officials cut their 5.25 percent target for the overnight lending rate when they meet on Sept. 18, it will be by only a quarter-percentage point with no promise of more to come.
I doubt there’s a facility for the ECB or most central banks (except China) to lend to its domestic banks in a non-domestic currency.
Although they probably should in my humble opinion, the China PBoC is probably not selling any US Treasury Bonds. In a previous statement to US Treasury Secretary Paulson, the China PBoC reiterated its official policy stance of not selling US Treasury bonds. Above all policy considerations under the direction of the State Council, the China PBoC is under the “mandate from heaven” to preserve monetary and social stability. The profit and loss consideration on the Central Bank balance sheet is simply not an issue. The China PBoC is not independent but follows and implements orders from Prime Minister Wen Jiabao and the State Council.
i thought the ecb and the fed discussed some mechanism for extending credit in each others currencies after sept 11, given that some of the big banks that needed credit post 9.11 were european owned — but my memory is a bit fuzzy.
and while i don’t want to accuse any one of playing games or the like especially in the absence of evidence, if central banks sell securities and put deposits in a big bank, my understanding would be that such a move would have the effect of increasing that banks liquidity.
in any case, guest is probably right — no ecb credit extension in $.
but the if ecb or others in europe thought there was some chance that they might need to do so, they might opt for more $ bank deposits and fewer $ securities that usual.
this i should emphasize is pure speculation.
the only really confirmed move was a fall in the reserves of say the bank of russia as it intervened to offset the movement of money out of Russia.
and i wouldn’t be surprised if some asian central banks took advantage of strong treasury demand to shift into agencies. that tho doesn’t explain the overall fall in the frbny’s accounts (that fall incidentally stopped in the last week, so it seems highly corelated with the initial phase of real turmoil and major hedge fund deleveraging).
I don’t presume to know who is selling what. I do know that the dollar index closed below 80 today; it now reads 79.725. The 80 level has held against all tests for a good 15 years. For you non currency traders out there: the dollar index is a trade weighted basket which is also the basis for a futures contract at the CME. And as a piece of shorthand it is heavily watched, even if not so heavily traded.
Seems to me that the new strength in the yen and to a lesser extent, the Swiss Franc (both pursuant to purported unwinding of carry trades) was the straw that broke the camel’s back. Among the key currencies, we had previously seen strength in the pound, Canadian dollar, and the Euro against the dollar; the new strength in the yen and Swiss apparently broke the index. It now looks like dollar weakness against all of the other major currencies (though today the Canadian weakened a bit, presumably because people worry about US economic weakness spilling across the northern border).
What is also interesting to me is that on August 16, when the money markets seized up and the stock markets fell, investors ran to Treasurys; today dollar instruments got sold when stocks fell. Also, gold, which fell during the August market breaks, closed above 700 for the first time in 15 months (as measured by October gold futures). Finally, I find it interesting that we did not hear from Secretary Paulson today. With traders pushing their short dollar bets, today might have been an opportune time to intervene had the Treasury so chosen. If Paulson stays silent under these conditions that will show traders -at least this one — that the US indeed wants a weaker dollar. For these reasons and also because of the dollar index chart itself, this break feels more decisive to me than the excursions that took us to smaller fractions below 80 in July and August.
That said, the dollar can always rebound off its low as it did earlier this year. One day we will know if today marked the beginning of the end of dollar primacy.
Brad, I believe that the Fed and ECB did a swap post- 9/11 to furnish dollars to the European banking system. The facility is certainly there to do so again.
Am I alone in thinking it odd that the Fed has done relatively little in providing liquidity to money markets when compared to the ECB, which still wants to put rates up?!?!
Also, I wonder if someone like Norway could be a culprit for selling Treasuries, as they run a rather active strategy…and they are in the midst o an asset allocation switch out of bonds and into equities.
Would not the financial crisis in the West be a good opportunity for the Chinese investment office to step in an buy up large slices of failing or near failing companies? Barclays? And others, maybe even Washington Mutual and CFC? Or in the future when maybe Merrill Lynch is on the ropes or Morgan Stanley….if they are?
…while china still whines about its ongoing need for poor developing country status which, if i understand, justifies its on-going requests for and acceptance of World Bank aid. with all the references to china’s corrupt and rickety firms, markets and institutional infrastructure along with its weak brands and its own domestic issues if anyone can point to credible analysis that shows how any Chinese entities could be unaffected by a meltdown of the scale you allude to, or be in a position to ‘buy up large slices’ of assets from any developed power…
or why references to china’s resource investments in countries like africa don’t seem to include any speculation as to how the costs and uncertainties associated with growing resource nationalism will affect china.
Just a wild guess, but the difference in funds provided by the ECB and the Fed may relate to more geographic and numerical dispersion of clearing banks in the Eurozone - more points of ‘hoarding’ and therefore more funds required to be spread around, in order to achieve a similar overall funds clearing effect.
But that’s the point…the money market in the US isn’t clearing, and the Fed isn’t doing a whole lot about it.
“…the U.S. currency’s prospects relative to its European counterparts are anything but bright… A stronger euro… will also make European companies less competitive on world markets… Futures prices indicate that traders figure there is a 54% chance that on Sept. 18 the U.S. Federal Reserve will cut the target for its federal funds rate… by half a percentage point to 4.75%. Such cuts, though, might depress the dollar, especially if the European Central Bank resumes raising rates. Yesterday, the ECB left its key rate unchanged at 4%, pending a review of the market turmoil’s impact on growth… “Adding aggressive rate cuts to these measures would make the market conclude that the Fed has created a massive capital- market safety net”… That would lure investors into riskier investments and drive the euro above $1.40…” http://www.bloomberg.com/apps/news?pid=newsarchive&sid=abUD8XlPQKc4
“…A major shift by stabilization funds to stocks from bonds should boost both the yen and Japanese equities. That’s because the yen accounts for just 3.2% of global official reserves, while Japan’s stock market represents 11% of [MSCI]. Diversification is a long-term negative for dollar assets, especially bonds. Yet don’t expect the U.S. currency or Treasuries to suddenly plummet. If Asian central bankers dumped their dollar-denominated assets, the value of their holdings would sink in tandem with the dollar and the securities. Also don’t forget the U.S. has the world’s biggest, most- liquid securities markets. What’s more, it makes no sense to risk pushing your biggest customer into recession…” http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLHk5v0M8OYI
I disagree. The market is clearing in terms of the fed funds rate, which is well below target. It was above target before the Fed intervened.
It’s obviously not clearing in terms of commercial paper, etc. - but that’s a credit issue. The Fed has to decide at what point the lower effective Fed rate indicates they are just pushing on a string if they reduce it any further - the funds rate (and the t-bill rate) can’t pull down the rest of the credit rate structure in parallel with it.
“Cerberus Capital Management LP, the New York buyout firm that acquired Chrysler Corp., may consider a takeover of WestLB AG, the German state-owned bank being probed for trading irregularities… Cerberus would be the second private investor to buy into a German state-owned bank…” http://www.bloomberg.com/apps/news?pid=20601085&sid=a6XFQ48dorqc&refer=europe
“…Respondents expect that the housing, automotive, and construction sectors will present the most attractive distressed debt opportunities in the coming year… energy was also included in this group… hedge fund managers expect a significant pullback…” http://today.reuters.com/news/articleinvesting.aspx?type=fundsFundsNews&storyID=2007-09-06T121342Z_01_N05239043_RTRIDST_0_HEDGEWORLD-STUDY.XML
“…”Russia is one of the safest credits out there at the moment, partly supported by the windfall from oil…” http://www.ft.com/cms/s/0/a4e24f92-5cac-11dc-9cc9-0000779fd2ac.html
“Sberbank denied Friday reports that it is seeking…$660 million from oil company RussNeft in early loan repayments…” http://en.rian.ru/business/20070907/77319761.html
http://www.econbrowser.com/archives/2007/08/what_does_the_c.html
August 20, 2007
Some analysts, and perhaps the market, seemed to view Friday’s cut in the Federal Reserve discount rate as a first step in lowering interest rates generally. That view may prove to be correct, though I’m inclined to look first for an explanation in terms of the narrow tactical challenges of managing current liquidity needs …
…The banking system as a whole usually holds only a small amount of reserves in excess of what is required. A bank that ends up with extra reserves would find it advantageous to loan Federal Reserve deposits overnight to a bank with a deficit in what is called the federal funds market. The interest rate on these overnight loans is usually very sensitive to the quantity of excess reserves in the system, so the Fed could change this rate by adding or subtracting deposits through open market operations. The Fed simply announces the rate it intends to maintain, with the current target being 5.25%, and the announcement is credible because all participants know that the Fed will be adding or draining reserves as necessary to keep the rate near the target.
Not all loans will take place exactly at the target rate, however. These loans are unsecured, and though their very short-term nature makes the risk small, it is not zero. Small banks will often pay a slightly higher rate to borrow fed funds than will big banks, and an individual bank will have a maximum amount it is willing to lend to any given other bank. If a bank has a really big outflow of reserves, or its usual sources for borrowing short-term funds dry up, it may need to offer a rate well in excess of 5.25% in order to maintain a positive level of reserves.
This was the case on Friday, on which the fed funds market opened with some trades at 6 %, some 75 basis points above the rate that the Fed has declared it will defend. So, the Fed used open market operations in the form of repurchase agreements to create new reserves, evidently in the amount of $38 billion. One can put this number in perspective with the following graph of what Federal Reserve deposits usually turn out to be over a two-week period.
This was a HUGE intervention, on a par with the remarkable measures taken September 11, 2001, when the interbank loan market faced severe disruption from the physical destruction of a large number of the key institutions that make these markets. Again this week it seems that banks suddenly desired a huge volume of reserves in excess of the amounts they are required to maintain …
Well - maybe this is closer to the real answer:
http://www.voxeu.org/index.php?q=node/460#comment-93
The European Central Bank’s operation was much larger than the Fed’s. Is there a reason?
The details of the European Central Bank’s (ECB) operating procedures are very different from those of the Fed, and I won’t go into the details here. Nevertheless, I can provide the simplest explanation for the size the ECB’s operation. When the ECB announced its intention to provide funds on Thursday 9 August 2007 (a day they would not normally operate at all) they said that they would accept all bids at or above their 4% target. The result was that banks asked for and received €95 billion ($130 billion). Unlike the US, where banks are not paid any interest on their excess reserves holdings, in Europe a bank that has excess can redeposit it at the ECB at a 3% interest rate. That makes it far cheaper for European banks to err on the holding of too high a level of reserve balances.
from the same vox piece: “On an average day, the gross quantity of interbank transfers is $4 trillion… This includes $1.6 trillion in funds that are transferred for the purpose of settling purchases and sales of various bonds (primarily US Treasury securities).
Looking at these numbers, we see that first, the increase in reserves on Friday increased banking system reserves by more than 75%. More importantly, it increased the size of reserve accounts by a factor of 4. Second, the increase was more than 10 times the normal level of excess reserves (although for complex reasons it is hard to know today exactly how much it will add to average excess reserves). Finally, note the rather amazing fact that during normal times the banking system uses $12 billion to engage in $4 trillion in daily transactions. That is, on average a dollar in a reserve account is used more than 300 times PER DAY. Because reserves do not pay interest, banks have a big incentive to economise on their use - this is pretty efficient. (This is also the reason that excess reserves are so low.) That banks do this every day suggests that they know how to do it; but the fact that they use the funds so many times means that if anyone starts hoarding reserves, there is the potential to disrupt the system…”
Also from the same source, and dedicated here to people who insist on preconceived answers to their own questions:
“My definition of an educated person is that you have some idea how ignorant you are.”
- Christopher Hitchens
“Hitchens claims to have detected a new, personalised nastiness in the attacks on him… He welcomes being attacked as a drinker ‘because I always think it’s a sign of victory when they move on to the ad hominem…” Oliver Burkeman, War of words, The Guardian, October 28 2006
Brad: I doubt whether a central bank would sell dollar securities to make dollar loans; they would repo them (perhaps this is what you meant by “sell”). It is conceivable that repo could remove securities from holdings reports, but only if those holdings are reported on a settled basis rather than a done basis. A thirty year treasury is arguably more liquid than a normal bank deposit, because it can be lent to raise cash by the end of the day, especially in Europe a few hours ahead of the US, whereas the standard money market settlement interval is two days. I doubt therefore that central banks would build precautionary bank deposits.
Macro Man: Perhaps the US money market would clear, but not at a rate that makes the previous conduit carry trade profitable. Hard luck!
Anonymous: Good point about the ECB deposit facility.
RE, I am more than happy to see the conduit/SIV trade go bust. However, I’d prefer to see the Fed use ‘all available tools’ before cutting the funds rate, precisely to avoid the reflation of another bubble elsewhere in financial markets.
Perhaps another move lower in the discount rate would be a useful interim step; alas, it doesn’t appear that it will be forthcoming without an accompanying FF cut.
Chinese authorities just recently stopped feeding live horses to the lions at the zoo.
An Indian steel executive believes China is at war with the west. Economics are war in a sense.
By the way, who’s responsible for this stranglehold on the U.S. dollar. The free market system ? Or predatory capitalism ? Certainly the U.S. government and its budgetary chaos are the major contributor. Predator versus Alien. Two wonderful heroes.
“Blackstone Group plans to buy a 20 to 40% stake in chemicals company China National BlueStar (Group) Corp for up to $500 million, marking its first major investment in the world’s fastest-growing major economy. Blackstone, in which China’s first state overseas investment agency recently bought a $3 billion stake, will pay between $400 million and $500 million for the stake in the Chinese company… BlueStar is a unit of China National Chemical Corp, a major Chinese chemicals maker with annual sales of… ($3.98 billion)… BlueStar has more than 30 subsidiaries and research institutes and holds stakes in three domestically-listed firms… Goldman Sachs has taken control of China’s top meat processor, Henan Shuanghui Investment & Development Co , and bought shares in top auto glass maker Fuyao…” http://news.moneycentral.msn.com/provider/providerarticle.aspx?feed=OBR&date=20070906&id=7426181
Macroman — Norway is an intriguing possibility. When I last looked at the Survey data tho, it didn’t seem Norway held all that many treasuries (relatively to the activity they generate in the TIC data), they seemed to hold a slightly more aggressive bond portfolio. (Their monthly activity seems related to some options based strategies, from what I have heard). But you are certainly right that this is a very good time for them to execute the desired portfolio rebalancing.
as for China’s investment fund buying a troubled financial institution. well, it is both a politically risky and a financially risky move — as China would need the capacity to evaluate the firm’s assets and owning a regulated financial firms hinges in some deep sense on the host government. You could argue China’s wealth fund is just doing what Western financial firms did in the aftermath of Asia’s financial crisis — but it would certainly bring all the simmering concerns about Chinese state investment to the fore.
A large minority stake would be much easier … we will see.
france?
Sept. 4/07 - “…GDF-Suez, as the new company is to be called, will have a market value of €90-billion - the equivalent of $130-billion - and will count Groupe Bruxelles Lambert (GBL) among its top shareholders. GBL is the Brussels investment company ultimately controlled by the Desmarais family, through their Power Corp. of Canada empire, and Groupe Frère Bourgeois… the enlarged company, which will be 35 per-cent owned by the French state, will have the market and industrial presence to qualify as a “global energy leader,”… In the power industry, only OAO Gazprom, the Russian gas producer, and Electricité de France, the state-run operator of 58 nuclear reactors, will be bigger… The Desmarais and Frère families have ambitious goals as investors and being passive isn’t one of them. The stated goal of Pargesa, the holding company directly atop GBL, is the creation of long-term value and “to exercise control, or major influence, over the companies in which the Group holds interests.” Already, there is speculation that GDF-Suez, backed by the French government, GBL and the other powerful shareholders, will embark on an acquisition spree after the merger closes next year. Analysts think takeovers are inevitable, if only because the new company will have relatively little debt.” http://www.globeinvestor.com/servlet/story/GAM.20070904.RSUEZ04/GIStory/
Topic: Naive Interpretation of “All Available Tools”
Bernanke’s Fed has changed the rules and the tools.
September 8, 2007
Abstract. This commentary discusses changes implemented by the Bernanke Fed and how the Fed is now using three distinct tools instead of one. Practitioners who follow monetary events closely may wish to skip the sections on Fed Funds and the Discount Window and go directly to the section on Rule Changes.
It is important to understand that the Bernanke Fed has approached its role in a different way than the Greenspan Fed. Too much TV rhetoric is consumed on harangue in this area and not enough on the distinctions that we have seen in the last month.
The enhanced Fed policy approach evidenced in the last few weeks could have been more transparent. This is a valid criticism of the Fed. Its spokespersons could be more forthcoming in explaining its mechanics and activities to a thirsting audience. The Fed knows that 6% of our nation’s employment and about 1/4 of the profits of America’s publicly owned companies come from the financial sector. That is where Main Street meets Wall Street. That’s why the Fed must explain its changes in mechanics.
We expect that the Fed will show more transparency in the future. Q & A after Fed persons speak is one ways to do it. Chairman Bernanke could allow himself to take questions after his remarks. At the ECB this is routine. If he does not, Congress will most assuredly be asking them.
Meanwhile, let’s try a non-Fed person’s view.
1. The Fed Funds Rate.
This Fed is using several tools and not just focusing on the blunt instrument of the Fed Funds Rate. In fact, we will not see the first use of the Fed Funds rate change until the September 18th meeting. Most practitioners (including ourselves) expect the Fed to cut then and to continue with several additional cuts before yearend. In our view this is a methodological Bernanke Fed and thus we expect a succession of 1/4 point cuts that will take the Fed Funds rate down to 4 ½% before 2008. The evidence supporting a lower Fed Funds Rate is very strong and the risk of inflation has diminished. If for some odd and unexpected reason they don’t cut on September 18th, it will also say something about the Bernanke Fed’s decision on how to use (or not use) the Fed Funds rate.
To this Fed’s credit, they have not panicked like the Wall St. hysteria demanded. TV histrionics that I have personally witnessed may be good “theater” but are not contributing to transparency or education of investors. Furthermore, the practitioners of hysteria either do not know the facts about the results or refuse to acknowledge them.
The Bernanke Fed knows that inter-meeting rate cuts can do more damage than good. See the Dunkelberg, Scott study in 2005, if you don’t believe it. Inter-meeting Fed Funds rate cuts are an asymmetric act. There is no history of an inter-meeting rate hike. There is evidence that inter-meeting rate cuts create a sense of panic and alarm. Obviously an exception is something like the 9/11 terrorist attack. St. Louis Fed President Bill Poole is absolutely right when he says it would take a calamity for there to be an inter-meeting cut.
2. The Discount Window.
Here the Bernanke Fed has reintroduced the Lombard facility into US banking. This tool is aptly named in honor of Walter Bagehot’s book Lombard Street (1873) which described how the central bank can directly loan money to a commercial bank provided that the commercial bank pledges good collateral. Sir Walter wrote that about the Bank of England situated on London’s Lombard St. He penned this outline 40 years before the US Federal System was created.
Discount Window usage in the US has been dormant for years. In 2003 the Fed set a penalty rate on the use of the Window. The decision to make it 100 basis points above the Federal Funds rate for primary banks was arbitrary. We cannot find many Fed references about what the optimal penalty rate should be.
There is plenty of evidence that the Discount Window rate should be higher than the Fed Funds rate and that the Discount Window should be used as a “lender-of-last-resort” facility. To its credit the Bernanke Fed reduced the penalty rate last month when the turmoil started. It also immediately expanded the rules governing the use of the Discount Window. We expect these changes will continue to be made as the new Discount Window processes unfold.
When markets can clear in a normal and routine fashion we would expect the Discount Window to get little use. Why would any bank pay a higher rate for reserves when it can fund itself at a lower cost elsewhere? The Bernanke Fed is trying to get the Discount Window used when times are not normal. It has extended the term from overnight borrowing to a longer option; it has expanded the use of collateral and encouraged banks to borrow with this facility when they need to. It is trying to eliminate the “stigma” attached to using the Discount Window.
To some extent this has worked. One needs only to observe the LIBOR rates to see if they are trading above the Federal Funds rate and below the Discount Window rate. If yes, the banks have little incentive to use the Window. If not, then the banks have the Window available to fall back on if there is a liquidity squeeze in the markets.
Note that the Fed has NOT encouraged the use of poor credit quality collateral. It will not accept it. Discussions about that in the media are false. The Fed is insisting that the collateral pledged be of the highest credit quality. The Discount Window is a facility to provide liquidity when markets have seized up. It is not a way for the Fed to subsidize a lower credit quality. Chairman Bernanke does not want to appear before a Congressional committee and explain that the new Fed operating procedures resulted in a loss by the Fed and that means the taxpayers of the United States have to pay for the Fed’s failure to appropriately police the collateral.
3. Changing the Rules
This one is the hardest elements for many market players to grasp. We will use the example set by Bank of America (B of A) but we will also advise that it has already been applied equally to Chase and Citibank. We do not know if there are others. In this area the Fed has virtually ignored transparency by offering only technical explanations of its actions. In so doing it is increasing the risk of an unintended consequence.
On August 20th the Fed granted a waiver to B of A by exempting it from The Fed’s Regulation W. That waiver will allow the B of A to extend up to $25 billion of additional credit to its broker-dealer affiliate. The restrictions of Reg. W were and are designed to protect a bank from losses that may occur in a broker affiliate. The Fed imposed collateral restrictions and policing mechanisms on B of A. It also required that the B of A holding company subordinate its interest to the bank itself. This rule applies whether or not the Fed actually extends any Discount Window loan to B of A. The Fed gave a similar waiver request approval to Citibank and Chase. Even a bankruptcy cannot supersede the Fed’s claim. Obviously the Fed has taken every administrative step it can to protect the bank’s capital from loss.
This means that the bank has approval to lend to its broker affiliate if the broker cannot finance itself. Obviously brokers are at risk in the seizing up we have witnessed. Added risk comes from the hedge funds and other entities that have bought securities from those brokers.
Here’s why. Many of the brokers who sold paper to hedge funds and other agents had to offer some type of “put” or other liquidity provision to the buyer. The broker was interested in the underwriting fee and commissions so it agreed to the terms in order to make the sale. At the time the broker’s mathematical models indicated that this was a minor risk.
All that has changed.
Now the hedge fund has a demand for cash from its investors who want to get there money out. The hedge fund has used its lockout period to delay payment to its investor. Those lockouts are starting to run out of time.
The hedge fund will have to raise cash. It doesn’t want to be forced into selling the security in a market which will penalize it severely. Instead the hedge fund will activate the liquidity provision in its contract with the broker. Now the broker has a problem and the liquidity demand has transferred from the hedge fund to the broker.
The broker needs to get cash in this scenario which is about to be played out many times over the next few weeks and months. The Fed has provided the opening to do so. The broker can take the collateral to the bank and pledge it in return for the loan. Then the broker can pay what it owes to the hedge fund which will have the liquidity to pay the investor. The bank can fund the loan in the market but also has a back up access to the Discount Window if it needs to use the lender-of-last-resort.
So far, so good since nobody defaults. AS LONG AS THE COLLATERAL IS OF THE VERY HIGHEST CREDIT QUALITY AND REMAINS THAT WAY. That is where the rubber meets the road.
Many of these securities are tied to the housing market and housing finance. They are ultimately secured by mortgages on illiquid real estate assets which are falling in price. There is no question that hundreds of billions will be lost because of the adjustment in housing prices. Those losses will impair the credit quality of some of those securities. Some of those mortgage holders or derivative security holders will lose part or all of their money.
The Fed is trying to construct a system in which the markets will function while the losses will not be subsidized. It has attempted to implement rule changes in order to facilitate that outcome.
Will the Fed succeed? We hope so.
Have they run out of tools? No. There are many more steps the Fed can take to keep the markets operating while trying to isolate the losses so that they fall on the parties who gambled and took the risks.
In sum, the Bernanke Fed is using its tools with surgical precision AND it has restored, expanded and embellished the use of the Discount Window. It did all this BEFORE it resorted to the blunt instrument of the Fed Funds Rate. On September 18th, it will use that, too.
For readers who would like to read the full text of the Fed’s approval letter sent to B of A see:
http://www.federalreserve.gov/boarddocs/legalint/FederalReserveAct/2007/20070820a/20070820a.pdf
Serious monetary policy analysts understand that this mechanism is changing the velocity calculations. It has added a way to expand the multiplier of high powered money at a time when it is otherwise contracting. We are researching that new multiplier and how the massive global reserve creation will eventually flow worldwide. We see world reserves growing at a 20% annual rate while the multiplier is halved because of the turmoil. We still see seizing up in the commercial paper market. But we believe the same mechanics described in simplistic terms above can be used to prevent contagion there.
Cumberland Advisors
There seems to be an assumption becoming established that it is OK for the Fed to cut the Fed funds rate if real economic activity is hit by the present financial turmoil. I disagree. Some impact can be expected, and it is probably most efficient for it to be absorbed by the activities that generated it.
A root cause of the turmoil is that it became recognised that finance for some activities, especially housing, has been unsustainably cheap, because of misunderstandings - probably wilful in my opinion, but leave that aside for now - about liquidity, the meaning of credit ratings, and the need for capital to absorb risk. Surely, it is inevitable and healthy that these activities should contract as they adjust to a more sustainable cost of finance.
A better test of whether easing is justified might be whether activity in other, disconnected parts of the economy begins to contract.
re: A root cause of the turmoil
“…Today, intangible assets represent 50%-85% of the market capitalization of public companies…” http://www.iafinance.org/
“…each company makes its own valuation of intangibles, guided only by very general accounting standards…. In all cases, there is little relationship to market value…”Some people think the logic of econometrics was handed down by God, but it’s actually the result of 40 or 50 years of economists and accountants arguing about corporate performance… We’re now at the early stages of evolving that process…” http://www.nytimes.com/2007/09/09/business/09frame.html?ref=business
as intangibles are inseparable from tangibles, all valuations are questionable.
RebelEconomist on 2007-09-09 05:27:34
The point is - economic activity is going to contract even with Fed rate cuts.
The Cumberland piece points out that Fed actions prior to rate rates are already consistent with financial sector contraction.
Rate cuts merely calibrate the degree of knock-on contraction in the real economy so that it doesn’t become a depression.
There seems to be an assumption that Fed action is not consistent with financial and real economic contraction. This is too simplistic. There’s going to be massive pain for those who behaved recklessly in any case.
“an interesting question is whether the ECB has been lending in $ to European banks or just in euros.”
I’d be very surprised if it’s been lending in dollars. If it has, it hasn’t filtered down to my level (working in a continental IB).
“an interesting question is whether the ECB has been lending in $ to European banks or just in euros.”
A related question is the degree to which central banks deploy their FX reserves in bank deposits in ” normal time “. This is different than the question of extraordinary “advances” of foreign currency from central banks to their domestic banks in times of stress. The swap arrangement referred to earlier might be an example of the second. But it’s unlikely that an ongoing foreign currency standby facility exists similar to the equivalent of a domestic currency discount window - e.g. while the Fed can’t control Eurodollar flows, it has ultimately control over the provision of additional fed funds supply through the discount window and via open market ops.
“China would need the capacity to evaluate the firm’s assets”
whether recent, pending and future blackstone, goldman sachs and other foreign partner deals may be driven by the need for the involvement of western entities to do that, although their involvement has to increase the complexity given the ‘public’-'private’, cross border nature of these deals in nations with nascent property rights.
“…As many as 10 funds with a combined total of more than Rmb20bn ($2.6bn) to invest, including joint ventures with foreign funds, will be approved for the Tianjin Binhai New Area, a new special economic zone… “will allow China’s own Samsungs and Motorolas to transform themselves from cats into tigers”. “This is one of the principal policy goals of the government right now,”… Beijing has designated Binhai as a special economic zone and has directed financial authorities to use the zone as a proving ground for financial reforms… In late August, the government said it would allow Chinese individuals to buy overseas stocks directly for the first time, but required them to open their trading accounts at the Binhai branch of Bank of China…” http://www.ft.com/cms/s/0/3b280b24-5b48-11dc-8c32-0000779fd2ac.html
“…the state is hoping to attract hundreds of billions of dollars into sectors such as power, rail and roads. United Energy Systems (UES) and gas monopolist Gazprom will between them spend upwards of $600bn to rebuild their processing and transport assets by 2030, much of it being financed by foreign investors and borrowing… Each of the projects has been undertaken in partnership with a private investor, and companies and regions have to raise a significant part of the financing before they can apply to the state investment fund commission for the rest of the money needed to complete a project.
The Kremlin is also trying to involve professional managers and commercial interests wherever it can to ensure efficient, profit-motivated management of all these projects. “We are in contact with the Russian government development agencies to see how we can help add value by bringing in the lessons learned from our international experience of PPP and work with other banks, such as the European Bank for Reconstruction and Development (EBRD) and other commercial banks… What is key in these countries is being able to hedge the interest rate risk over the long term. If this ability is questionable, there is a natural constraint about the maturity you can get for this type of financing, which undermines one of the benefits that PPP deals present: matching the long-term financing with the long-term nature of the underlying assets. You can’t do this if the capital markets are relatively immature; you can’t hedge the interest rates for the life of the loan.” Moreover, playing against Russia are fears of the renationalisation of the oil and gas sector…”
http://www.thebanker.com/news/fullstory.php/aid/5092
Irresponsible and Reckless Federal Reserve Monetary Policy
Analyst: Fed rate cut won’t help markets
Lower interest rates will not bring in money but instead send dollar into a tailspin, says Punk Ziegel banking analyst.
http://money.cnn.com/2007/09/10/markets/bc.apfn.liquidity.aheado.ap/index.htm
NEW YORK (AP) — A widely watched banking analyst said late Sunday the best solution to the crisis plaguing financial markets is to let cash-strapped borrowers default and their lenders go bankrupt, rather than slashing interest rates.
Punk Ziegel & Co. analyst Richard X. Bove wrote in a client report the hoped-for cut in interest rates this month will do nothing to bring money back into the U.S. financial markets. Instead, Bove said, lower interest rates will send the dollar into a tailspin and wreak havoc in the job market.
Bove cautioned that cutting rates will not lure investors back into troubled markets. Investors and banks already have the cash to buy risky loans and investments, he said. “There is no liquidity problem, but a serious crisis of confidence,” Bove said. In fact, cutting interest rates will only encourage investors to borrow dollars at the lower rate and bring the cash to places like Europe, Bove said.
“It is illogical to assume that holders of cash will have a strong desire to lend money at low rates in a currency that is declining in value when they can take these same funds and lend them at high rates in a currency that is gaining in value,” he said. “By lowering interest rates the Federal Reserve will not stimulate economic growth or create jobs. It will crash the currency, stimulate inflation, and weaken the economy and the job markets.”
Bove said the solution to this crisis is to allow people who cannot repay their debts to default and allow the companies that issued bad loans to fail.