Monday, December 17, 2012

The Fed leverages up

Ben Bernanke, head of the world's largest hedge fund (aka The Federal Reserve), last week announced that next year he plans to borrow another $1 trillion dollars—on top of the $1.5 trillion he's borrowed over the past four years—in order to fund the federal government's CY 2013 deficit and give his shareholders (aka taxpayers) a profit to boot. This plan is otherwise known as QE4.

His is a unique business, since he can force the market to lend him money—he simply buys what he wants and pays for it with his "bank reserve checkbook." By the end of next year, the Fed will own $1 trillion more bonds, and the banking system will have $1 trillion more reserves, whether it wants them or not. Bernanke can also dictate the rate at which he borrows money; for the foreseeable future that will be the rate the Fed decides to pay on reserve balances held at the Fed, currently 0.25%. Those who end up with the reserves will have essentially lent the Fed money on the Fed's terms.

To be more specific: Next year, Bernanke plans to make net purchases of $540 billion of longer-term Treasuries, and $480 billion of MBS. He will fund those purchases by issuing $1.02 trillion of newly-minted bank reserves. In effect, the Fed will be swapping reserves (which are functionally equivalent to 3-mo. T-bills, the paragon of risk-free assets, but which currently pay a slightly higher rate of interest) for bonds. Since money and bank reserves are fungible, Bernanke's planned purchases should effectively cover Treasury's deficit next year, which, perhaps not coincidentally, looks to be about $1 trillion.

It's important to note here that when the Fed issues $1 trillion of bank reserves, it is NOT "printing money." That's because bank reserves are not cash and they can't be spent anywhere: like pajamas, they are only for use "in house," since they are always kept at the Fed. Bank reserves do have a unique feature, of course, that other short-term assets don't: they can be used by banks to create new money, and in fact, acquiring more reserves is the only way that banks can increase their lending, because banks need reserves to back their deposits. Since banks now hold $1.6 trillion of reserves, of which only $0.1 trillion is required to back current deposits, banks already have an almost unlimited ability to make new loans and thereby expand the money supply. A year from now they will have an even more unlimited ability to do so.

That banks haven't yet engaged in a massive expansion of lending activity and the money supply is a testament only to the risk-averse nature of bank management and the risk-averse nature of the public, which now holds $6.5 trillion of bank savings deposits (up 64% in the past four years) paying almost nothing. As the above chart shows, in recent years the M2 measure of money supply has grown only slightly faster than its long-term average.

To put it another way: The Fed's massive provision of reserves to the banking system has not resulted in an equally large increase in inflation because the world's demand for money (cash, bank deposits, and cash equivalents like bank reserves and T-bills) has been very strong. Banks, in short, have been content to sit on $1.5 trillion of "excess" reserves because they worry that making more loans and increasing deposits might be a lot riskier.

The rationale for hedge funds is to exploit arbitrage opportunities, buying one thing and selling or borrowing another. Even small differences in prices can become lucrative, thanks to the use of lots of leverage. If done successfully, arbitrage can contribute to market efficiency, which in turn can contribute to the health of an economy. Whether the Fed will accomplish the same thing with QE4, however, is an open question. Will banks lend a lot more next year, even though they have an essentially unlimited capacity to lend today? Will increased bank lending fuel genuine economic growth, or will it just fuel more speculation? No one knows. We are in uncharted waters; what the Fed is doing today has never been done before.

When faced with issues of daunting complexity and with little or no guidance from the past, one can only begin by trying to reduce things to their simplest form. Here's what I think is a simplified description of what the Fed is planning: Next year the Fed will be purchasing a total of $1 trillion of 10-yr Treasuries and current coupon MBS. 10-yr Treasuries currently yield 1.75%, and current coupon MBS about 2.25%, so the Fed will earn roughly 2.0% on its purchases, while paying out 0.25% on the reserves it creates to buy those bonds, for a net spread of 1.75%. By the end of next year, the Fed will be raking in $17.5 billion per year in profits on their $1 trillion swap, and that will make the Fed the envy of all other hedge fund managers.

These profits, of course, are automatically remitted by the Fed to Treasury. Happily for taxpayers, those profits will completely offset Treasury's cost of borrowing, at least for the next several years. Here's the math, also in simplified form: First, let's assume that Treasury is funding its deficit with 7-yr Treasuries (that's a decent approximation, since last year they told us that they were going to lengthen the average maturity of outstanding Treasuries, which at the time was about six years). The yield on 7-yr Treasuries is currently about 1.25%, so Treasury will pay 1.25% on $1 trillion, and receive back from the Fed 1.75%, leaving a profit of about 0.5%, or $5 billion. Bottom line, we will all benefit from next year's deficit financing! (Note that the key to the profit is the Fed's decision to buy lots of MBS, which yield more than Treasuries of similar maturity.)

A real-world hedge fund attempting to do the same thing would run up against the reality of mark-to-market accounting rules. If interest rates on the bonds it buys rise, the mark-to-market losses on the bonds could easily wipe out the interest it's receiving, threaten margin calls and ultimately result in insolvency. For example, a 1 percentage point rise in the yield on 7-yr Treasuries would result in a 6.7% decline in their price, thereby wiping out over 5 years' worth of coupon payments. Mortgage-backed securities could fall in price by even more. A hedge fund would also be exposed to the risk that its borrowing costs could rise, thus narrowing or even eliminating the net interest spread it's earning.

Happily, Bernanke doesn't have to worry about any of this, since he doesn't have to mark his bonds to market, and he can keep his borrowing costs below the current yield on his portfolio for at least the next 2 or 3 years, given the FOMC's recent guidance (i.e., it won't start tightening until the unemployment rate falls to 6.5%, short-term inflation expectations exceed 2.5%, and/or long-term inflation expectations become unanchored). And of course, the Fed can always make the interest payments on its borrowings because its "bank reserve checkbook" is effectively bottomless.

If this all sounds too good to be true, it is. The Fed may not face the risks that a typical hedge fund does, but that doesn't mean the Fed is not taking on a huge amount of risk at taxpayers' and citizens' expense. Although the Fed need never face insolvency, if mark to market losses got really bad, they could lose their credibility and with that the value of the dollar could be seriously at risk. The Fed's losses might become direct obligations of Treasury, or they might be inflicted on taxpayers and citizens via the sinister "inflation tax." The Fed could eventually repay its borrowings with devalued dollars, leaving the rest of us with deflated balance sheets and deflated incomes. Meanwhile, by allowing Treasury to borrow trillions at no cost, the Fed is acting as an obstacle to badly needed deficit reduction.

Although it may seem paradoxical, the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

More confidence would mean less demand for cash and cash equivalents, and that in turn would mean that a virtual flood of money could try to exit banks (e.g., as people withdraw their savings deposits, and/or borrow more from their banks). If the public attempted to shift trillions in cash into housing, stocks, gold, or other currencies, the consequences would likely be seen in sharply rising prices and higher inflation. Moreover, higher inflation would almost certainly lead to higher interest rates, which in turn would exacerbate the Fed’s mark to market problem and possibly accelerate the whole process. And of course, higher interest rates will result in significantly higher borrowing costs to Treasury, although this will be mitigated to some extent by Treasury's efforts to extend the average maturity of its borrowings.

The Fed reasons that it could deal with declining risk aversion by selling bonds (i.e., reducing bank reserves), not reinvesting principal, and by raising the rate it pays on bank reserves. But it’s not hard to see how things could get out of control: higher rates on bank reserves would likely accelerate the rise in market yields and the mark to market losses on the Fed’s bond holdings, at the same time as its spread eroded. In the meantime, the more bank reserves the Fed creates, the harder it will be to avoid an unhappy outcome.

It’s ironic that the Fed is trying, with QE4, to accomplish the very thing that could be its own undoing. Trying, that is, to encourage more confidence, more lending, more borrowing, more investment, and higher prices for risk assets.

It’s no wonder that the market remains so risk-averse, since this is hardly a comforting position we're in. For now, that is probably a good thing. But in the wake of the election results and the Fed's latest decision, I am less optimistic today than I have been for several years.


Public Library said...

Great post. I am sure Benjamin will jump on here with a keep on pumping post. However, I think you are ahead of the game in your thoughts about how this might unwind. We are reaching the boundaries on fiscal and monetary tinkering on a Global scale. Much of it is predicated on directing/predicting human behavior with little data to test the hypothesis. At some point, credibility is lost and when the tipping points occurs, it is usually swift and disorderly. Very hard to play your cards in todays markets.

Jeff said...

What's not to be optimistic about? My taxes are going up some300%, we will add another trillion to the debt, I'm going to have to go through a federal government bureaucrat before I see my doctor, Obama is going to start the process of banning guns in this country, I can no longer buy an incandescent light bulb (which has been around for over a hundred years), I have an “ECO” button in my Mercedes that defaults to ON as mandated by the federal government, 20 kids are dead in Newtown Friday and the nation mourns, and 4000 more aborted on Monday, and 4000 more on Tuesday, and 4000 more on Wednesday, and so on and so on and the nation does nothing.

But I did buy AAPL at $508. Can you believe that Scott Grannis!? Yes, the Apple nay-sayer buys Apple. It’s a love/hate thing!

Gloeschi said...

Erm, Scott, did you read what you wrote? Banks are not lending because demand for money is so high? It makes no sense whatsoever.
Banks don't lend because a) they burnt their fingers b) regulators awaking from their corruption-induced hibernation, demanding higher capital ratios and c) consumers are deleveraging.
The Fed does not print money? Please.

McKibbinUSA said...

Now that the Fed has committed to monetary expansion, how do we exploit that decision to put money in our pocketbooks...?

theyenguy said...

World Stocks, VT, rose 0.8%, to a new rally high as Shanghai, CAF, jumped vertically higher for the second day rising 3.3%. While the National Bank of Greece, NBG, led Greece, GREK, lower.

The biggest risk humanity face as a result of the Fed's QE4, and the ECB’s OMT unprecedented experiment in quantitative easing, that has produced investor confidence and the decline of risk aversion, with World Stocks, VT, rising 12%, and World Small Cap Stocks, VSS, rising 15%, in a risk on Major World Currency, DBV, and Emerging Market Currency, CEW, momentum rally, is that that monetary easing has crossed the Rubicon of debt monetization, and that the world has passed through Peak Credit, on the exhaustion of the world central banks’ monetary authority. This is exactly the case, as a see-saw destruction of fiat wealth is underway, as the Steepner ETF, STPP, broke out on a steepening 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, which drove Total Bonds,, BND, sharply lower today, while Junk Bonds, JNK, Leveraged Buyouts, PSP, and Senior Bank Loans, BKLN, and Distressed Investments like those taken in under QE1, FAGIX, rose to new highs. The rise of the benchmark Ten Year Interest Rate, ^TNX, which rose to 1.76%, means that the bond vigilantes have gained control of the bond market. Ben Bernanke and Mario Draghi’s monetary policies have turned the springs of credit toxic. Charts show that the highest degree of loss of trust has come in global debt is centered in World Government Treasury Bonds, BWX, Emerging Market Bonds, PCY, Mortgage Backed Bonds, MBB, Municipal Bonds, MUB, and High Yield Municipal Bond, HYMB, and even the so called inflation protected bonds, the Long Duration TIPS, LTPZ, have fallen from channel support.

Benjamin Cole said...

Well, I am just a layman, but I think the economics profession needs to sort a few things out.

BTW, I always appreciate Grannis' posts. I am trying to learn. I hope everyone knows I am earnest in this regard.

Okay, so the Fed is on schedule to QE to the tune of $2.5 trillion within 12 months (1.5 plus 1)

Grannis says it is not printing money, it is actually the Fed borrowing money. I no savvy.

My understanding has been it is the Fed printing money (digitizing money) to buy Treasuries.

The Treasuries become owned by the Fed. The Fed passes annual profits along to the Treasury, so the Treasury is the ultimate beneficiary of QE (the taxpayers that is).

A federal taxpayer liability have been wiped out, through monetization.

Taxpayers are relieved of the $2.5 trillion in debt.

I do have a sincere, earnest question. If I own $10 million in Treasuries, and I say "I want to sell these to the Fed's QE program" then what happens?

I sell to a dealer of some sort who then sells them to the Fed. I get $10 million in cash.

How is this not monetizing the debt? I know invest or spend the $10 million. Maybe I ut it in the bank. Banks are supposed to lend out deposits. Disintermediation?

If so, we have wiped out debt with any impact on inflation?

And yes, Public Library, I am in favor of of very aggressive QE, and a much smaller federal government. I am talking federal outlays as percent of GDP down to 15 percent, and down from there.

The experience with QE so far does not seem to indicate inflationary impact. USA Inflation is dead, was dead in Japan after their QE program of 2001-6 (a program John Taylor of Stanford gushed about).

An interesting chart is the Cleveland Fed Inflation Expectations chart. It has been going down for years and especially so in the last five years---right into the face of QE.

I suspect the real risk to the USA and Europe is not inflation, but Japanization. We will have huge deficits and tight money, and here break out of perma-rcession, Inflation will be dead, but ever there will be fears of inflation, and so "monetary kiss of life" as prescribed by Milton Friedman.

Frankly, I do not know how to invest if this scenario comes true. The experience in Japan suggests that real estate and equities will be very long term losers, and bonds will yield nothing.

Lots of luck, guys.

McKibbinUSA said...

Making money in the next couple of decades will require owners to become more active -- rents must be paid on time, even if the renter has to do the impossible --likewise, CEO's of companies need to pay dividends, even if it means drastically cutting executive compensation and outsourcing 90% of the firm's production activities -- we the owners need to become very demanding when it comes to paying rents and dividends -- I believe that CEO's should be willing to commit to increasing dividends, or offer to kill themselves if they fail -- the US needs CEO's who are willing to offer their lives if they fail to pay exciting dividends to owners -- the most important goal for every CEO should be to pay dividends to owners -- owners in the US need to become much more vocal and demanding of management -- for the record, dividends are horrible right now -- companies need to be disciplined to change that policy -- also, rents are going up, which is good for owners -- more dividends and rents, please...

Benjamin Cole said...

BTW, if you go here, you see that unit labor costs are lower today than at the end of 2008.

This just does not strike me as an inflationary environment. In fact, one would be hard put to find a similar sustained stretch of flat labor costs

If unit labor costs are dead, if commercial rents of all kinds are soft, just where does inflation come from?

Benjamin Cole said...

It may be a matter of semantics, but most economists refer to QE as the creation of money or the printing of money by a central bank to buy bonds or other securities.

It is not central bank borrowing money, as Scott says in this post.

From Wikipedia:

"Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.[1][2] A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions with newly created money in order to inject a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value."

I have to say,I think the Fed is monetizing debit, and I think that is the right thing to do at this juncture.

I don't think a timid mouse of a man like Bernanke, nor all but not of the FOMC, would vote to undertake radical and possibly dangerous policies.

Scott is saying the FOMC has embarked on a radically dangerous path. Does that seem likely?

steve said...

US on its way to mimicing japan NOT greece/spain. runaway spending with pols unwilling to so anything about it. low growth and low inflation or maybe even deflation equals investment peril. seems like every so called sage is calling for lower bond prices. I'll bet we see the long bond trade south of 1% and an anemic stock market within O's second term.

McKibbinUSA said...

By the way, QE3 (purchasing mortgage-backed securities) is a lifeline for Main Street real estate development -- QE4 (purchasing treasuries) is a payoff to Wall Street banksters to gain their support for QE3 -- QE4 is pure extortion money being paid to Wall Street to fund internal bank deals on their own accounts, as well as executive bonuses -- plain and simple...

Scott Grannis said...

Re "the demand for money." This obviously can be confusing, so let me clarify. I define "the demand for money" as the public's desire to hold cash and cash equivalents (e.g., T-bills, savings deposits, money market funds). This is equivalent to a "long" or ownership position in dollars. When the demand for money rises, people want more cash in their portfolios, not less. Borrowing money is the opposite of wanting more cash in one's portfolio, since it creates a "short" position in dollars. When the demand for money rises, people want fewer loans; people want to deleverage.

Banks are not lending as much as they otherwise could because the demand for money is very strong. People are still building up their cash balances (bank savings accounts are rising at double digit rates) and paying down their debt. Even banks want lots of money (i.e., bank reserves) on their balance sheets.

To be clear, the demand for money is not the same as a demand for more loans; those are opposite positions. When the demand for money rises, the demand for loans must at the same time fall.

Tom Nugent said...

Maybe I missed something but doesn't the Fed receive big interest payments on all those mortgages it holds? I think the Fed gave the Treasury $80 billion in profits from those interest payments last year. Doesn't that withdraw $80 billion from the private sector and replace it with reserves that yield virtually nothing? Is Fed policy contractionary from this perspective?

Public Library said...

Btw USGG5Y5Y breakevens continue grinding higher @ ~3. An over 12+ month acceleration and firmly higher than the pre-crisis levels. Are inflation expectations changing on the margin?

Unknown said...

I propose a new logo for the Fed: picture Uncle Sam
standing in a bucket, lifting himself up by the handle.

Mark Gerber said...

"But in the wake of the election results and the Fed's latest decision, I am less optimistic today than I have been for several years."

It sounds like you are starting to see the bigger picture that I failed to paint with sufficient clarity to convince you of its existence. Now the question is how do investors navigate this federal debt and QE insanity? Does gold look cheap here as insurance against QE insanity?

McKibbinUSA said...

OK, I just had a call with someone I trust -- QE4 (which I view as Wall Street extortion money) is unlikely to cause inflation precisely because all of the proceeds (the Fed trading dollars for treasuries) will find their way into Wall Street safes for use in "behind the scenes" internal deal-making by Wall Street -- the issue is that Wall Street is eager to obtain new sources of liquidity in order to fund its gambling habits on their own accounts -- these trades and deals will not become evident for at least the next decade, but make no mistake, QE4 is hideous -- the ideas is to avoid inflation by sheltering QE4 proceeds from consumers, and instead to keep the dollars active in Wall Street deals internationally -- in other words, Wall Street wins again -- let's hear it for the banksters...

McKibbinUSA said...

PS: Monetary policy appears to be deteriorating globally -- more at:

NormanB said...

Although SG has a take that the negative real return on TIPs coupled with the current Treasury rates means inflation will stay low his fear of future inflation, a weak dollar, etc in this piece plays right into the inflation fear shown by negative TIP rates. Thus his fear of inflation is being shown in this market and shown it a great extent. Will the TIP buyers be correct? I think they will be as the Treasury could (and should) be selling tons of TIPs but they are not. They must fear inflation, also.

Anonymous said...

While the Fed only creates "base money", or, M0, or "high powered money", it is immediately available to the commerical bank like a demand deposit account should be. The commercial bank can use the "reserves" in any way they want to. So the Fed doesn't print money but it is pretty close to becoming money. The commercial bank only has to withdraw "reserves" from the Fed then spent, loan, or invest into the economy. Then it is money.

when a bank withdraws reserves it relieves the Fed from a liability. That liability was created by the Fed "borrowing" money from the bank inorder to buy bonds from the bank.

On the Fed balance sheet, I think this is the accounting:
Fed buys the bonds: Debit asset Bonds, Credit liability Reserves

Bank "A" withdraws the Reserves:
Debit liability Reserves, Credit Capital (net worth)

Net result is a Debit to the asset Bonds, and a Credit to Capital (net worth).

So when the banks start to use those reserves, the Fed's balance sheet improves. I wish I could credit my capital account if in fact that is how the Fed does it.

ronrasch said...

Scott, your blog is a must read. Thank you for your great work. We need to pray for a surprising event that gradually returns us to a path of gradually winds down our debt.

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