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Recapping Last Week's Conference Call: Ferry Poses the Questions, Foster Looks for Answers


Looking for evidence of tightening in the yield curve.


On Thursday, Minyanville's Michael Sedacca hosted a conference call with myself and Kevin Ferry, talking all things fixed income and monetary policy. This was not like an interview you see on television, where pundits see who can scream the loudest to get across their market opinion. This was the type of discussion you might have on an investment committee or among traders at the local watering hole.

What makes this such a value-added conversation is that it inevitably sparks an analytical angle that is not part of the consensus narrative.

While I urge you to listen to entire the hour-long conference call I wanted to highlight one particular exchange that I took away as perhaps the most important concept that is not being widely discussed. Around minute 17:00 we get into discussion about the Fed raising interest rates and Kevin lays out the only questions investors should be considering. (I did my best to transcribe)

The real question is now that we are fully priced for the Fed, at least priced or mispriced, fully anticipating the concept of the Fed moving in the first quarter 2015.. The question that we should be asking is.. How would they move?  Why would they move? And how will this happen now that they have reestablished the fed funds rate as their operational tool..

They are basically admitting that they can't control the supply and the price of money, the quantity and the price at the same time. And so they are offering to create a spread between those two things. With the reverse repo facility that has affectionately been called the Death Star and the funds rate... and that's really the message that they were trying to get out at the last meeting...  I was under the impression that a spread of a couple of basis points might be necessary, but to imbed a spread of twenty?

I interject:

They basically, I don't know if this is because they were really afraid of the disintermediation aspect that Dudley talked about [in a speech recently]...  but clearly they have no intention of taking the reserves out of the banking system... 


They're going to have to let 'em leak out and run down... That's the key.
And so what Michael is asking was do we agree with the idea of rates going up in the first quarter [of next year]... 
And I was like well if the market was demanding it...   the difference for all the talk about the fed meeting or the last two fed meetings about when they might tighten. The question that should be asked or the idea that is being discussed at the meetings is...  Show me the place in the term structure of interest rates in the United States of America that is demanding the Fed hike the rates...  And it's just not there folks...

Boom! I cannot stress how important this is for what's happening in the markets today and will happen in the markets if this is still the case next year when the Fed commences rate hikes.

I commented later in the call that I thought there was way too much focus on when the Fed would begin raising interest rates and how that would impact bond yields. There is this notion the Fed is behind the curve and it will need to tighten sooner than expected surprising markets. Last week I argued against this assessment. In Investors Say the Fed is Behind the Curve; What Does the Curve Say? I concluded:

The curve doesn't flatten because of a reach for yield or because investors want to buy 2.50% 10-year year coupons. The curve flattens to stimulate the economy. The curve flattens because the Fed is too tight. The curve flattens because inflation risk is low. The rules haven't changed.

How can the policy already be too tight?

The yield curve and bond market must also be analyzed in the context of the new Basel regulatory regime, which is due to have a significant impact on bank balance sheets and liquidity. Under Basel III guidelines banks are required to have a liquidity coverage ratio (LCR) that can support cash withdrawals in a 30-day stress scenario. This means banks must hold a certain percentage of high-quality liquid assets (HQLA) that are risk-free and easily converted into cash. Banks must meet these guidelines beginning in 2016 when Basel requires 60% of their respective LCR gradually increasing 10% per year until they are required to hold 100% in 2019.

According to a report by Nomura from the bank in April, the current estimated cash outflow to meet Basel is $2.5 trillion and banks currently hold $2.6 trillion in HQLA, so they are already in compliance. There is just one caveat. A material amount of HQLA is excess reserves. As Nomura notes in their report:

  • The total estimated cash outflows over a 30-day period were $2,520bn, but domestic banks had HQLA of $2,650bn. These numbers are indicating that, on average, domestic banks have enough liquid assets on their balance sheets to meet the Basel LCR requirements.
  • However, domestic banks had about $1,160bn excess reserves as of December 31, 2013, which were largely because of the asset purchases by the Fed (for reference, total reserves in 2006 and 2007, before the asset purchase programs started, were around $17-18bn). If the excess reserves are eliminated from HQLAs (for instance, if banks replaced them with loans), domestic banks would fall short of their HQLA target by $1,030bn.
  • Another important point is that no less than 60% of estimated net cash outflows need to be supported to by Level 1 liquid assets. Currently, domestic banks meet the Level 1 liquid asset requirement primarily because of the presence of "excess reserves." If excess reserves are removed from Level 1 liquid assets, domestic banks may fall short of the target for Level 1 liquid assets by about $720bn.
This is material because of the timing with banks needing to increase LCR and the timing of the run-off of the Fed's portfolio which is financed by these excess reserves. As bonds in the Fed's portfolio are paid down, excess reserves are netted out and will decline on bank balance sheets. In 2016 the first slug of Treasury bonds pays off and by 2019 when banks will be required to hold 100% of the necessary LCR and the Fed's portfolio will have paid off an estimated $1.5 trillion. These HQLA will have to be replaced or bank balance sheets will have to contract (or a combination of both). Both of these events will have an impact on the bond market and the economy.

A dollar holding a HQLA is a dollar that is not available to extend credit. As excess reserves are retired, money that was previously allocated to credit assets will then need to be allocated to HQLA for LCR requirements. Thus in aggregate the shrinking of the Fed's portfolio will constitute a massive tightening of credit conditions. Is this tightening of credit what the yield curve is reflecting?

As Kevin says, nowhere in the term structure is the yield curve asking for the Fed to raise interest rates. Perhaps this is because the tightening is already pending through the natural decline in excess reserves. It's impossible to know whether the yield curve is reflecting the demand for HQLA or the contraction in credit conditions. What is evident, though, is that the curve is suggesting monetary policy is already tightening before the Fed attempts to raise interest rates. If these conditions persist it sets the stage for a yield curve inversion at a very low level and a dangerous policy error.

Twitter: @exantefactor
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