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The Beginning Of The End Of Calm Bond Markets

Via Kevin Muir of The Macro Tourist blog,

Although the market is convinced the Federal Reserve will get aggressive with their rate hikes, I am not sure market participants have thought this through. Let’s not forget the Federal Reserve is sitting on the largest balance sheet in history.

This portfolio is the result of years of Quantitative Easing. It was made riskier with the Fed’s “Operation Twist” that extended the duration of their balance sheet by buying long dated securities while selling shorter ones.

The Federal Reserve has been transformed into a gigantic hedge fund, lending long and funding at the short end. Until now, the Fed has raised rates so slowly, their portfolio’s yield has handily produced more income more than their liabilities. So much so that since the credit crisis, the Federal Reserve has remitted almost $600 billion to the US Treasury.

A little back of the envelope calculation shows the Fed’s portfolio is yielding a little more than 2% - still a long way from the current sub 1% overnight rate.

The Fed’s balance sheet is a mix of US treasuries and mortgage back securities. They hold a whack of different maturities, and as they mature, the Federal Reserve reinvests the proceeds into treasuries, and increasingly, into even more mortgage back securities. It is easy to think the Federal Reserve has ceased to prop up the fixed income markets through quantitative easing, but they are still active - especially in the mortgage market.

The next crisis will not emanate from risky assets, but instead, will occur when Central Banks lose control of the bond market. I don’t believe the speculative excesses are occurring in the private sector. They are happening in government balance sheets. Risky assets are expensive, but they are not nearly as stupidly priced as supposedly “risk free” sovereign bonds.

And although I have long been a big bond bear, I recently listened to a terrific RealVisionTV interview with Ben Melkman that put my jumbled arguments to shame. Ben’s bearish argument was so brilliant, I had to write about it.

It took them long enough, but last summer Central Banks finally realized they had hit a wall and there were limits to their ability to stimulate economies solely through monetary policy. The negative rates in Europe and Japan proved way more destabilizing than any of the economic textbooks would have predicted (although not to the surprise to anyone with half a brain - but that rules out most Central Bankers). Since then there has been a reluctant acceptance of the need for more fiscal stimulus (or at least less fiscal tightening) and when combined with a worldwide global economic uptick, it has become obvious the days of extreme monetary policy are coming to an end.

The ECB is already tapering, and the next surprise will most likely come in the form of this tapering accelerating in the months to come, not the other way round. The Bank of England is scheduled to end its BREXIT induced quantitative easing, and the new government does not appear to be a fan of Carney’s balance sheet expansion, so it is doubtful it is coming back anytime soon.

And as for the big daddy of them all, the Federal Reserve is guiding towards rate hikes at the fastest rate since the credit crisis.

Which brings us back to the monster Federal Reserve balance sheet. $4.5 trillion is a big number. Even the crew at Goldman would probably need an extra drink to quell their nerves as they let that ride.

As the Federal Reserve raises rates, this balance sheet will become less and less profitable, until at a certain point, it would actually turn into a loss.

I won’t bother scaring you with some sort of doomsday scenario where the Federal Reserve goes bankrupt. It ain’t happening. Fed officials have already contemplated that possibility and a few years back, changed the rules to take that possibility off the table. From the FT:

Effective January 1, 2011, as a result of the accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U.S. Treasury. Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U.S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board’s H.4.1 statistical release. The liability for the distribution of residual earnings to the U.S. Treasury will be reported as “Interest on Federal Reserve notes due to U.S. Treasury” on table 10. Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the U.S. Treasury were included in “Other capital accounts” in table 9 and in “Other capital” in table 10.

Before the above accounting change, any unremitted earnings that were due from the Fed to the US Treasury would accrue in that ‘other capital’ account. Now however, they’ll be shown in a separate liability item called ‘interest on Federal Reserve notes due to US Treasury.’ So instead of any future Fed losses showing up as a reduction in Fed capital (‘other capital’) — they’ll now show up as negative interest due to the US Treasury. The Fed will still send most of its profits to the Treasury on a weekly basis, but will postpone remittances if the new line item becomes negative.

 

In short — Fed losses will now be offset against future Fed remittances to the Treasury. And the US central bank seems to have made it impossible for it to ever record a negative capital position, at least on paper. It’s a rather clever, if devious, solution to the Fed’s inability to use its own earnings to build up capital against future losses.

 

Why do we care?

 

Well — the change means we can forget the Fed ever having the kind of accounting loss that would force it to go cap-in-hand to the US Treasury for a capital top-up — thereby averting the independence problem. (It’s worth noting too, that the European Central Bank has already had to do this via its national central banks).

Although Fed officials have ensured they will be able to continue operating with “negative equity”, let’s not forget they are still human. The $600 billion they “made” during the past decade has been remitted to the Treasury, and it’s been “spent.” There is no special hold back fund.

If the Federal Reserve becomes cash flow negative, regardless of the past large remittances, the howls of protest from Washington and the rest of America would overwhelm any rational discussion.

So ask yourself what are the chances of the Federal Reserve raises rates high enough to cause themselves losses? Pretty low.

Then ask yourself if you are the Federal Reserve, and the economy is gaining strength with inflation already at your target and the job rate at full employment (on the surface at least), how do you slow it down?

The answer seems pretty obvious. Instead of cranking rates higher, you reduce the size of your balance sheet. Reduce your risk of creating a big loss on the Fed’s balance sheet, while still withdrawing monetary stimulus.

The first step will be to announce the Fed will no longer reinvest the maturing notes and interest earned. I expect this will happen sooner than the market anticipates.

Who knows if we ever get to the point where the Fed actually sells, but it won’t matter. Even the removal of the reinvestment will be enough to affect the fixed income market.

The Fed is currently buying more mortgages than treasuries. When they step away the private sector will be forced to replace this buying.

This will occur at a time when rates are rising. And we all know what happens to mortgage back securities in times of rising rates - homeowners don’t refinance and the duration extends. Owning mortgages is in essence a short volatility trade.

So when the Federal Reserve was buying mortgages they were selling interest rate volatility. By stopping their buying, the Fed will no longer be dampening down vol. Private sector agents will be forced to hedge by selling more bonds (or pay for swaps - which is a story for another day and also a great trade in the making) as rates rise.

What is the end result of the Fed’s behaviour?

Short rates will not rise as much as the market expects. They will still increase, but there is a fair amount already built in. The Fed will be hesitant to create a negative cash flow situation by getting out ahead of the curve.

Instead, the Federal Reserve will reduce the size of their balance sheet. This will cause volatility in the longer end of the curve.

The short end will be artificially stable and too low, while the long end will rise and be more volatile.

I hate owning equity volatility, but I would buy long end fixed income volatility all day long. This great monetary science experiment will only come to a crashing halt once Central Banks lose control of the bond market. Everyone is busy buying the hedge from the previous crisis. I would rather try to figure out the next one, and buy a hedge for that market dislocation.

Don’t forget the specs are already short the front end of the curve.

There is little value being short this portion of the curve. In fact, in any sort of economic downtick, the short covering rally at the front end of the curve will be vicious.

Yet the long end has been kept extraordinarily flat due to the world wide yield grab last summer.

As Central Banks reduce their buying, the absurdity of this pricing will become blatantly obvious, and the long end will have one of the largest declines on record.

And even if I am wrong and the global economy rolls over, the US front end of the curve has so much optimism embedded in it, the 5/30 spread will still steepen.

I am buying US 5 year notes against being long US 30 year bond puts. I think it is a great risk reward trade. I don’t buy the idea the Fed will tighten nearly as much as the market anticipates, and when they instead reduce their balance sheet, the curve will steepen and get much more volatile.