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Hello. Lots of reader comments on Wednesday’s article on Actual Returns, some of which I quote below. Also, some ideas for fixing the Treasuries market and a word on the Fed.
Today is my 50th birthday. I party by taking two weeks off to recharge my middle-aged batteries. The next newsletter will appear, grimly, on Friday the 13th. During my absence, can I suggest two other excellent FT newsletters? Swamp Notes on American Policy and City Bulletin on British Finance. Good things from my smartest colleagues.
What is the correct analogy to what the Fed is doing?
The Federal Reserve, it seems, wanted to use its Wednesday meeting to make almost nothing. He seems to have succeeded. In the written statement, the phrase “the economy has moved towards these goals” was about the only novelty. This tiny droplet of hawkishness sent a very delicate ripple through the markets, in the form of a slight flattening of the yield curve and a small drop in Tip yields. We are waiting until Jackson Hole.
James McCann, deputy chief economist at Aberdeen Standard Investments, described the delicacy of the Fed’s movements thus: “[Jay] Powell’s job right now is like trying to turn a cruise ship into a bathtub. This means he has limited choices and a little wrong move could create big waves.
I think the analogy is not extreme enough. I think of the Fed as the family in the movie A quiet place, who are hunted down by vicious monsters incredibly sensitive to sound. So far, the Fed has managed to do its job by tiptoeing and communicating with hand gestures. But the public knows someone will end up spilling dishes.
Redux of real rates
The letters to readers on real rates had two common themes. One was that I was naive. Of course, QE skews real rates, several readers have said; exactly. In a time of fiscal debauchery, removing the real interest rate is the only way to make the national debt burden bearable. This point of view is not limited to mumbling conspiracy theorists. One reader pointed out this comment from Deutsche Bank’s Jim Reid:
With debt so high, real returns are likely to remain negative for the rest of my career as the authorities have to control funding [of] this increasing leverage. I am even more convinced of this post-pandemic. . . positive US real returns for any length of time would likely trigger debt crises around the world, so we’re probably stuck with the regime. However, you can still have negative Real Yields and higher Nominal Yields. Most of the major debt reductions seen in history have seen such a large spread through higher inflation. In some ways we are seeing it now.
Thomas Mayer of the Flossbach von Storch Research Institute made a similar statement via email:
I suggest we go back to the pre-1980s financial crackdown. Reinhart and Sbrancia [in The Liquidation of Government Debt] produces excellent research on this. They explain: “One of the main objectives of financial repression is to keep nominal interest rates below the level that would otherwise prevail. This effect, other things being equal, reduces government interest charges for a given debt stock and contributes to deficit reduction. However, when financial repression combined with inflation produces negative real interest rates, it also reduces or liquidates existing debts. It is a transfer from creditors to borrowers. In a free market, no sane creditor would volunteer for such a transfer. So, if you watch it, the market must be manipulated by a very large borrower who has the power to do it.
The second group of correspondents argued that real returns are not so much an indicator of growth as of risk, whether it is inflation or financial stress. Here’s Jack Edmondson from OU Endowment Management:
Sometimes it helps to see the magnitude of the negative real return as the price that some market participants are willing to pay to hedge against the results of inflation, and not just to reflect the central anticipation of inflation. . . . For example, it makes sense to pay a large negative real return to own an inflation-linked bond if you think inflation could be very high, or indeed, even if you thought there was even a small chance of very high inflation.
Explained another way, the real return can be thought of as an insurance premium for a distribution of the results beyond the implicit equilibrium rate.
My colleague Martin Sandbu (whose business newsletter you should subscribe to, Free Lunch) made a related point:
We must ask ourselves if changes in attitudes towards risk are a good explanation for the price behavior of Tips. Here’s what I think: Investors / “markets” get a sense of the overall (real) growth prospects of the economy and therefore the real returns they can expect to get in various investments. They also have some idea of the uncertainty of this outlook. The more uncertain they are, the more they will demand a (real) risk premium between safe and risky assets, even with completely constant inflation expectations.
How would you test this? By looking at a measure of the risky real rate of return, and then comparing it to the returns on advice for a measure of the (real) risk premium. If my hunch is logical, we should have seen this increase.
And, voila, here’s a chart from a few days ago, showing the spread between stock returns (risky expected returns) and real (risk-free) returns widening in recent months (see the little red arrow):
Fixing the Treasury Bill Market
The Group of 30 is a very serious group of financiers – from Timothy Geithner to Mervyn King – with a very pretentious name. On Wednesday, they released a series of recommendations to improve the functioning of the US Treasury market.
This reform is necessary, according to the group, was demonstrated by the events of March 2020, when everyone wanted to sell their treasury bills for cash, liquidity disappeared, bid-ask spreads exploded, the moon turned blood red, etc. The group’s main recommendation is that the Fed be prepared at all times to trade treasury bills for cash with a wide range of market participants, not just banks and brokers. Centralized clearing would also be a good idea.
This all makes sense to me, but two things in the report struck me as funny. The group says it’s better to have a permanent pension facility than having the Fed just come in and buy tons of treasury bills whenever there are problems, because
if the functioning of the market can only be supported by frequent and large-scale purchases of Treasuries by the Federal Reserve, market participants may come to believe that fiscal concerns rather than macroeconomic objectives are driving the purchases.
Ahh, guys? There are a lot of smart people out there already thinking this (see discussion of real returns, above).
Second funny thing. The authors write that,
The root cause of the increasing frequency of episodes of stressed treasury market dysfunction is that the total amount of capital allocated to market making by bank affiliated brokers has not kept up with the very rapid growth in outstanding debt. negotiable Treasury debt, in part because of the leverage requirements that were introduced as part of the post-global financial crisis banking regulatory regime.
I’ve never really taken that line of thinking, perhaps because I’ve heard so many bankers talk about it over the years, but also because market maker liquidity has always been the umbrella that you don’t. use only when it is not raining. It’s just me though. The funny thing is, the group turns out to disagree either, at least not in the cases that really matter:
Even if much more capital had been allocated to market making, the Treasury market could not have functioned effectively in March 2020. . . The underlying economic uncertainty created by the pandemic and the associated massive and widespread ‘money rush’ by holders of Treasury securities was so extreme that no market structure could have provided the capacity to absorb. widespread selling pressures.
I don’t care about small liquidity crises. They train on their own and are probably a good reminder for everyone to be careful. I care about the big guys, and in the big guys market maker capital is not a big help.
Reading the report also made me wonder about a larger problem. Several major market players have told me in recent weeks that they are not worried that the Fed’s tightening and tightening will lead to a market “crash”, for the simple reason that there are currently masses of liquidity. , and as long as liquidity is plentiful. , you can’t have big chain reaction market meltdowns. This is sort of the idea behind the Group of 30 report (although they are careful to point out that there are kinds of crises that even a large Fed pension facility cannot prevent). Is it correct? We may find out in the next few months.
A good read
Someone calls a mechanic. The Fed has transmission problems.
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