There’s just no interest in it.- Andrew Brenner, co-head of structured products, MF Global, on US Treasuries.
The US Department of the Treasury held a $10bn auction of 30-year bonds yesterday, and it wasn’t pretty. Hopes were perhaps high after the - relative - success of a $20bn 10-year Treasury auction the day before. Alas:
Treasuries fell, led by 30-year bonds, after investors shunned the government’s $10 billion sale of the securities amid concern that U.S. debt sales will grow.
The optics here are tricky. On the one hand, yesterday’s auction dips might indicate saturation point in Treasuries. On the other, they might be a temporary blip: one which will be corrected by ongoing - and increasing - demand for low-risk assets as the worst of the recession begins to make itself felt. Gregor Macdonald notes:
It’s clear that much of the world’s capital has been herded into cash and treasuries, and it was just a matter of time before an exhaustion level was reached.
That signal came today, with a very poor auction of 30 Year bonds. Que sorpressa … As always, this trend change will be fought and doubted. And maybe, just maybe, it will indeed take until 2009 before treasury bond auctions are seen as trainwrecks.
All of this is particularly disconcerting for one reason: the Fed’s balance sheet is expanding extremely fast. The Fed released its weekly figures yesterday also. Currently, the Fed has $2.214 trillion in assets, up $139bn last week.
Calculated Risk notes a comment from Richard Fisher, President of the Dallas Fed given in a speech last week:
I would not be surprised to see them aggregate to $3 trillion-roughly 20 percent of GDP-by the time we ring in the New Year.
The main cause of the expansion of the Fed’s assets is use of the TAF which readers may recall, has no limit on its size. Here, from Bank of America, is what the Fed’s bank lending currently looks like:
The question then: where is this money coming from?
The Fed usually expands its lending by increasing the size of its supplementary financing programme: issuing SFP bills and thus raising cash to lend with. But with the current state of the Treasury market, expanding the SFP programme does not look prudent. The Treasury has, consequently, allowed $50bn of SFP bills to run off this week, reducing the outstanding amount to $510bn. Michael Cloherty at Bank of America notes that there is another $30bn of SFP bills maturing on Monday. Whether those are rolled or not should indicate whether the Treasury is actually winding down the SFP:
We will look for confirmation in Monday’s bill announcement -there is another $30bn of SFP bills maturing on November 20th, so if the program is going to continue we would expect the Treasury to announce a rollover of that bill at 11AM on Monday.
In light of Thursday’s Treasury auction, winding down the SFB would indeed be an attractive option, since it would potentially greatly reduce T-bill oversupply.
It doesn’t though, get us any closer to identifying where the Fed’s rapidly expanding balance sheet is funded.
Unless we’re talking quantitative easing.
The Fed requires banks to hold money on reserve. 18 months ago, typical reserves at the Fed were around $7bn. Last week, bank reserves at the Fed were $592bn.
And as we’ve noted before, the Fed is actively trying to increase this number. It has increased the interest payable on those reserves (or rather, decreased the penalty to the Fed funds target), to encourage more deposits.
This policy is remarkably similar to one instituted by the Bank of Japan. A ZIRP (snap!) was supplemented by a policy of encourage huge bank reserve growth at the BoJ. The policy was supposed to do two things: keep the ZIRP realistic and effectively transmit its effects, and encourage banks to lend normally because of the surety of their huge reserves.
And if that means problems to the effective fed funds rate, to hell with it! In a recent paper, the New York Fed has called it “divorcing monetary policy from money”. It makes for good reading. In many ways though, such “liquidity targeting” is not necessarily about liquidity at all. Money injected into the economy through the TAF and other liquidity operations is not as liquid as newly created base supply. Repo fails, for example, have been increasing, as the ZIRP takes its toll on the efficiency of the repo market.
The point being that the Fed’s current liquidity operations might not really be about broad liquidity support at all, but are actually about specific asset price support.
This paper was written by Bernanke in 2004.
Bernanke notes that through expansion of the Fed’s balance sheet and changing its composition, the Fed can target asset prices. One of the only truly effective things it can do, indeed, when it is otherwise constrained in a liquidity trap scenario. Bernanke is theorising here, and he’s careful that it’s just an option, but nonetheless, the described is strikingly similar to current events. Emphasis ours:
Quantitative easing may affect the economy through several possible channels. One potential channel is based on the premise that money is an imperfect substitute for other financial assets (in contrast to the view discussed in the previous section that emphasizes the imperfect substitutability of various nonmoney assets). If this premise holds, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. Lower yields on long-term assets will in turn stimulate economic activity. The possibility that monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history
In other words, traditional monetary policy is assumed as ineffective, and instead, the Fed must target yields by expanding its balance sheet as much as possible and using it to inject liquidity. Liquidity which can be targeted through specific actions - like the TAF etc.
A look at the Fed’s balance sheet currently will tell you it’s very much in the business of supporting liquidity/prices in assets other than Treasuries. The graph below is a month old, but the point still holds:
The purple and red lines show the declining number of treasuries and bills held by the Fed, replaced by securities accepted under the new open market liquidity ops (green and light blue lines).
Of course, all this implies a rather long term dependence by banks on the Fed’s new auction facilities and a complete transformation of the Fed’s role in the market.
But Bernanke knew that in 2004 too.
…the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its open-market operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers.
Little wonder then that so little has been said by the Fed about their strategy.
Related Links:
Prsh-dum Prsh-dum Prsh-dum - FT Alphaville
