Why We Don't Need GSE Reform, Or How I Learned to Stop Worrying and Love Fannie and Freddie

It was 2005 and my Uncle was deeply bearish. The housing market was booming but he thought everything was overpriced.  Worse still, Fannie Mae and Freddie Mac had insured over five trillion dollars of US mortgages, and should housing prices descend from there stratospheric levels, the US taxpayer was potentially on the hook.  

"But aren't Fannie and Freddie private companies?" I asked as a bright-eyed seventeen-year-old while my dad flipped burgers on the grill.  

"Yes."  He replied.  

"And no. Investors have always assumed that since both companies were chartered by Congress, the Federal government would rescue them if they got into trouble." 

Back then I knew nothing about funding advantages, interest rate risk, fully sovereign currencies, or retained portfolios.  But three summers later, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were placed into "conservatorship" by then US Treasury Secretary Henry Paulson.  At the time, I didn't understand the implications of this bold but necessary move.  Today, I realize that conservatorship were the best thing to ever happen to the GSEs, and that seven years later, in 2015, we don't need GSE reform so much as a formalization of legal arrangements which preserve the current status quo.  

Nominally Private:

In testimony before the Financial Crisis Inquiry Comission, former Fed Chairman Ben Bernanke descibed Fannie and Freddie as 'nominally private.'  Specifically: 

Fannie and Freddie were nominally private corporations, but they enjoyed cost advantages from the implicit federal guarantee on their liabilities; these cost advantages allowed them to act as a duopoly in a number of businesses [....] Fannie and Freddie were permitted to operate with capital that was both of low quality and of inadequate size to buffer the risks in their portfolios. In addition, their balance sheets were allowed to grow rapidly.  

While Bernanke does not explicitly draw the connection, much of the growth of the balance sheets at the GSEs was specifically because of the strong market demand for their guarantees, a fact not lost of GSE executives.  In fact, so confident were the GSEs that they could access the money markets that they frequently began the business day with a negative cash balance which was made up by intraday borrowing.  Only a government entity could ever expect to have such seamless access to the money market.  

The truth of the matter is, both GSEs could never has grown as large or operated with the levels of margin that they did without government involvement.  However, under the system of allowing the GSEs to issue publicly traded shares and operate largely as normal corporations, we ended up with the worst of both worlds.  In essence, Freddie and Fannie were forced to serve two masters.  They were compelled to make as much money as possible for shareholders, which meant exploiting their government granted privileges to the fullest.  While their implicit government backing meant that profits would be privatized and losses would be socialized. 

Monetary Policy:

But even more bizarrely, both GSEs even gained the power to engage in de facto monetary policy. With the ability to borrow large sums on the short term money market at the same rate as the government, both GSEs were able to finance gigantic retained portfolios which at their height had notional values in the trillions. Again, because investors believed Agency debt to be as good as US Treasury debt, there was practically no limit to the amount the GSEs could borrow in order to finance mortgage investments. In essence, the GSEs were swapping short term liabilities (Agency debt) for long term assets (mortgage bonds). This is very similar to quantitative easing, whereby the central bank removes long term government debt from the market place and replaces it with short term assets (usually reserves). The effect of both policies was to markedly reduce long term borrowing costs. In fact, a 2006 report written by the CEOs of both Freddie and Fannie openly brags that large retained portfolios were materially reducing long term interest rates by keeping bond prices high.

Monetary policy ought to be the purview of the Fed, and should be conducted with the goals of economic stability, not profit. Nothing stops the Fed from running up its balance sheet as much as it wants to increase its earnings. And maybe if the Fed had shareholders to answer to, it might let its balance sheet balloon to the tens of trillions. But if Congress ever had the bright idea to make the Fed list on the NYSE, we would have nobody to blame but ourselves if when inflation got too high, the Fed put earnings ahead of price stability.

Instead of feigning outrage or surprise at the over-leverage and gigantic balance sheets at both GSEs prior to the crisis, policy makers should take note that both Freddie and Fannie responded in a highly predictable way to the incentives that they were provided. Their mandate was not to stabilize the housing or mortgage markest, rather, it was to maximize mortgage originiations and securitization to boost profits as their balance sheets, both in terms of direct mortgage investments and insuranced mortgages, grew to truly epic proportions.   

Dual Roles: 

Perhaps a bit of history is important.  In 2008 it was easy to say that Freddie and Fannie never should have been chartered.  A more insightful line of inquiry would be to examine why the government ever got involved in the mortgage business in the first place.

Mortgage lending is tricky for traditional underwritiers mainly because of interest rate risk.  Since banks finance the majority of their assets with demand deposits, writing long term mortgages can result in large amounts of asset liability mismatch.  In layman's terms, it's pretty risk to lend money to borrowers for 30 years while you might need to payback your depositors at moment's notice.  The beauty of securitiziation is that it allows traditional underwriters such as banks to make mortgage loans and then sell off the interest rate risk to investors in mortgage backed securities.  In fact, most so-called portfolio lenders, or those which both originate and retain mortgage loans, offer mainly adjustable rate mortgages.  They don't have the capacity to bear the interest rate risk. Without securitization, and without the GSEs, the 30 year fixed rate mortgage would not exist. 

On the other hand, most MBS investors are large pension funds, life insurance companies, or sovereign wealth funds.  These investors usually have long term liabilities. Most life insurance holders won't die for a long time, and most people involved in a pension scheme won't retire for decades.  These investors are therefore perfectly happy to invest in long dated assets.  

The GSEs are a fairly basic arrangment.  Traditional underwriters originate the loans, but again, since they can't take interest rate risk, they sell the loans off to investors.  The GSEs underwrite the process and also insure against the credit risk.  The result is that borrowers have access to long term (30 years) mortgage financing.  In theory, this same set up could be used to create a market for 30 year car loans, or 30 year personal loans, or 30 year loans to buy dishwashers.  Because the credit risk is stripped away, the investors who bear the interest rate risk will be indifferent to the to underlying colateral.

Therefore, because of the implicit government guarantee, Agency MBS have evolved into gross substitutes for US Treasury bonds.  The GSEs serve dual roles for different groups.  They help home buyers by providing long term fixed rate financing.  But they also help satisfy investor demand for long term government liabilities by effectively enlarging the size of the Treasury market. Indeed, after Treasurys, the Agency MBS market is the biggest and most liquid bond market in the world. 

The dual role of the GSEs can only be achieved with government involvement.  No entity other than the US Treasury itself on Agencies explicitly backed by it can provide risk free dollar denominated securities to worldwide investors.  Similarly, satiating this strong investor demand while simultaneously achieving the socially desirable goal of providing flexible borrowing terms to homeowners is a feat of financial engineering that the private sector would never provide.  In no other market do 30 year fixed rate mortgages exist.  Even in the UK, which has one of the most developed financial sectors in the world, mortgage loans typically have balloon payments after three to five years precisely because the British government is not involved in the making of mortgage loans.

Conservatorship:

Many believe that perpetual conservatorship is a step backwards for the GSEs, but in reality, conservatorship merely formalized an implicit structure which was crucial to achieving both of the their dual roles.  As effective public monopolies and quasi-sovereign securities issuers, it was incredibly misguided to involve the private market at all with either Fannie or Freddie.  Neither should have been publicly listed on stock exchanges.  The inevitable result was that both enterprises would put profits ahead of financial stability, and would exploit there public monopolies not to achieve the public purpose of providing safe investment vehicles and access to mortgage credit, but to make money for investors.  

In fact, in the heyday of Fannie and Freddie, both became more and more involved in riskier lending products which in hindsight destabilized the mortgage market and did not benefit borrowers.  Their securities issuance business was soon accompanied by highly leveraged trading operations which traded MBS on the GSEs' own account rather than on the behalf of clients.  That's right, Freddie and Fannie engaged in so called proprietary trading, a practice thought to have contributed greatly to the systemic risk which built up in the financial sector prior to the crisis. 

Going forward, conservatorship provides a perfect model for both GSEs.  Most importantly, it removes the perverse incentives and conflicting goals that the GSEs had before the crisis, namely, the need to please shareholders but also to responsibly use their government granted priviledges for public purpose and not short term profit.  

Conservatorship also provided stability to the credit markets.  Mortgage markets did not stop working in 2009.  In fact, the GSEs have securitized trillions of loans since the crisis.  Had the mortgage market been left the private sector, it would have essentially ceased to exist after the fallout from the crisis.  This in turn would have made the economic downturn even worse.  Given the primacy of housing in the economy, it is nothing short of reckless to leave the goals of homeownership and the financing necessary to achieve it to the vagaries of the market. 

If the GSEs were made explicit agencies of the US government, the risk to the taxpayer would be essentially zero.  This is because the all mortgage debt in the US is denominated in US dollars, of which the US government is the issuer.  Specifically, the cost of government spending is an opportunity cost.  Real resources marshalled for public purpose cannot be put to private use.  However, goverment spending to make financial transactions, such as paying off bond holders, involve no such relagation of private sector wealth to the state.  Therefore, even massive purchases of securities of by the government, even when financed by money creation, is unlikely to cause inflation.  Indeed, after nearly four trillion dollars of quantitative easing inflation is still at historic lows.  To put things in perpsective, the GSEs drew a combined 187 billion dollars from the Treasury.  This event occured after the worse economic downturn since the great depression and on a combined balance sheet of over five trillion dollars of mortgage assets.  Furthermore, all of the money and then some has been paid back to the Treasury.  And even if the losses had been more severe, nothing would have stopped the government from simply creating the dollars necessary to pay the bond holders with little risk of inflation. So much for risk to the taxpayer.

Lastly, an explicitly public model of mortgage insurance would greatly aid the government's ability to engage in counter cyclical credit policies and implement macro-prudential regulation.  Currently, both GSEs collect a fee for insuring mortgage loans.  However, since the government isn't required to turn a profit, this fee could be adjusted to run counter to the business and credit cycle.  In frothy housing markets, the fee could be increased to effectively raise the cost of mortgage financing and stop bubbles before they get started.  In a depressed housing market, the fee could be reduced or even eliminated to help spur recovery.  In any event, counter cyclical credit policies to smooth out the business cycle merit further attention, especially in light of the reactionary and counter-productive cutting off of traditional mortgage credit to qualified borrowers since the crisis.  Such actions arguably slowed the recovery in both housing and the broader economy. 

In sum, had the status quo existed before the crisis, Fannie and Freddie never would have gotten into trouble in the first place, and the government would have been better equipped to fight the ensuing recession.  Furthermore, private shareholders would never have been unfairly enriched by exploiting government granted advantages.  And finally, without Fannie and Freddie, the mortgage market would have completely collapsed in the wake of the crisis which would only accelerated and prolonged the downturn.  I'm all for private markets and private industry, but eliminating the GSEs or reprivatizing them is just nuts. 

  







 

Introducing Fellman Economics

Every one needs a change of pace once and again, and your humble correspondent is no expeception.  After nearly three years of sucessful blogging and FX trading, I have decided to rebrand my blog to reflect its new more broad direction. 

Attentive readers will note that I have branched out in many different areas, covering the broader capital markets, the US budget process, and even immigration reform.  This rebranding will reflect this new direction.  FX Fusion is now Fellman Economics!

To be sure, there will still be lots of coverage of currencies and exchange rates. But over the years, and especially after picking up my Master's degree in economics, this blog has evolved into a more general source of news and commentary about the economy.  My aim here is to acknowledge this natural evolution for me as an economist, writer, and investor. So sit back and relax.  More great content to come! 

Commetary: CBO Still Dead Wrong on the Budget

CBO has released another one of its long term budget outlooks.  It’s a 132 page document choke full of graphs and figures to help Congress make fiscal policy.  A lot more is going on ‘under the hood.’  Thousands of man hours went into developing the methodologies to make the projections.  I neither endorse nor dispute the quality of these projections.  Sadly, it’s not necessary.  That’s because CBO lays out its basic assumptions and framework through which it views the task of fiscal policy makers.  It’s a laughably incomplete and obsolete set of principles which still sees the world on a gold standard, propagates myths about the banking system, and ignores history. 

The best way to dispatch this whopper of a report is simply focus on exactly what CBO says.  Specifically, three bullet points early in the document lay out why Congress should care about the long term path of the debt and the deficit.  We’ll cover them in order:

“The large amount of federal borrowing would draw money away from private investment in productive capital over the long term, because the portion of people’s savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital, and therefore lower output and income, than would otherwise have been the case, all else being equal.” 

 

Again, here we see the tired long refuted idea that banks act as intermediaries between borrowers and savers.  In reality, because modern central banks play an accommodative role in providing sufficient reserve balances to the financial system, banks create new purchasing power ex nihilo.  Indeed, the old model of banking described in the textbooks is mythological. 

 

It is true that the sale of government securities does indeed reduce the aggregate reserve balance of the banking sector, but the Federal Reserve can and does act to ensure that Treasury Auctions do not interfere with monetary policy.  Usually, this means engaging in defensive purchases of existing Treasury assets to ensure that the reserve drainage caused by Treasury Auctions does not disrupt the banking system by making short term interest rates rise. 

 

Furthermore, although the Treasury is selling assets and the Fed is buying them, the consolidated government is really just executing offsetting open market operations.  Thus, both short term interest rates and therefore the cost of credit creation are not affected.  

 

So long as the Fed has an accommodative policy in terms of providing such reserves as are necessary to allow the banking sector to both settle payments and create credit at the stipulated cost (the Fed Funds Rate), no amount of government spending or debt could ever crowd out private sector borrowing or investment.

 

“Federal spending on interest payments would rise ,thus requiring the government to raise taxes, reduce spending for benefits and services, or both to achieve any targets that it might choose for budget deficits and debt.”

 

No. The government does not face a tradeoff between making interest payments and paying public benefits.  Because the US government spends in its own currency, no binding constraint exists on nominal spending.  The cost of government spending is an opportunity cost.  The real resources (man power, output) assigned to the government for public purpose cannot be put to private use.  However, government payments to purchase financial assets or pay interest do not remove any real wealth from the private sector.  The first order effect of these transactions is therefore not to raise the price level in the real economy.  Nothing stops the US Treasury from continuing to paying interest by issuing more securities, just like the Fed is currently paying interest on reserves by issuing more reserves!  Yet again, the CBO makes lazy assumptions, seeing all government payments as equal both in terms of their inflationary effects and therefore assumes that all spending must ultimately be financed with taxes.

 

“The large amount of debt would restrict policymakers’ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, those challenges would tend to have larger negative effects on the economy and on people’s well-being than they would otherwise.The large amount of debt could also compromise national security by constraining defense spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.”

 

This last point has been made before by the CBO, and it’s still a pot-pourri of partisan hat tipping.  It’s painfully obvious that the words ‘people’s well-being’ are aimed directly and Democrats while reference to national defense is geared towards Republicans.  In any case, if we ever let the national debt constrain the war fighting capacity of the country, we might as well give Texas and California back to Mexico and then surrender to the Russians.   In a stunning rewriting of history, CBO believes that the US government, or any government for that matter, has ‘constrained’ its spending during wartime.  In reality, every major war fought by the United States has been financed by the printing press. 

 

The Continental Congress printed up Continental dollars to finance the revolution.  Abraham Lincoln established the Office of the Comptroller of the Currency to print the dollars necessary to finance the Civil War.  By the Second World War, things had gotten a bit more sophisticated.  The Federal Reserve pegged Treasury rates at 0.375 percent  via massive bond purchases, which were financed by crediting bank accounts with dollars created by an accountant’s pen.  In sum, the power of money creation means that the nominal spending of monetary sovereigns is never constrained.  While it is true that periods of very high to severe inflation followed each of the above episodes, the extent to which the inflation was caused by money creation is unclear.  Surely, the removal of productive capacity from the economy to help with the war effort only exacerbated the inflationary pressure on the economy.  

 

In any event, neither potential inflation nor the national debt could ever prevent the US government from marshalling enough forces to fight a war or defend the nation.   Rest assured, if the Canadian Mounties ever occupied my native Minneapolis, the United States would have the real military assets to dislodge them, regardless of government finances.

 

While the CBO is supposedly highly respected by both sides of Congress, that says more about the sorrow state of political discourse and economic thinking in the twenty first century.  The CBO’s tired and outdated mode of thinking is only adding to the noise and confusion surrounding important issues that face the country when it comes to fiscal and economic policy.

Essay: How QE Actually Affects the Economy

To virtually nobody's surprise, the ECB announced a 60 billion Euro a month asset purchase program.  Queue the peanut gallery. 60 billion isn't enough.  60 billion is too much. Europe's economy is saved.  Hyper-inflation is around the corner.  The ECB is causing a bubble in stocks.  The ECB is causing a bubble in bonds.  The responses ran the gamut and pretty much aligned one-for-one with the political predilictions of the commentators. But perhaps some of the most confused people in the room were economists themselves.  When the story hit the newswires, all the reporters called up their economist sources to give them one liners they could quote.  There was lots of quotes about liquidity, money creation, and interest rates. But most of it was muddled and simply decreased the signal to noise ratio.  The purpose of this essay to speak with authority and clarity on how QE actually affects the real economy.

QE Shifts Portfolio Preferences and Investment Behavior

People seems to have an infatuation with incomprehensibly large numbers so its not surprising that news sources like to use them a lot in headlines.  The number 60 billion and 1.1 trillion littered the front pages of the financial press this morning. No doubt, editors secretly hoped that readers would see the headlines, imagine 1.1 trillion euros being pumped into the financial sector, and wonder how they could get a piece of the action.  Sadly, this is not remotely close to how QE works.  In fact, the ECB is not pumping any 'money' per se into the financial sector at all.  Rather, it removing certain assets from the market place in an attempt to shift portfolio preferences.  The idea is actually very simple.  When the ECB (or the Fed or the Bank of Japan) purchases government bonds, it removes interest bearing assets from the market.  This reduction in supply raises the price of bonds because investors are now forced to compete over fewer outlets to earn interest.  The result is higher bond prices and lower yields.  Inevitably, some investors who were satisfied earning some rate of interest which was available to them before QE happened are now disatisfied with current yields, and thus shift into riskier assets such as stocks or lower grade bonds.  With more investors fighting over the same number of stocks, stock prices rise.  The same is true for corporate debt all the way down the credit quality spectrum. Therefore, by lowering government bond yields, the central bank is able to affect the kind of investments that get made.  Investments in riskier assets is stimulative to the real economy via a variety of factors. Namely, firms are now able to issue debt more cheaply, which makes expanding operations more attractive.  The required returns for capital investments is now lower as well.  For example, say a widget company is thinking about building a new factory and reckons it will earn a 10 percent return on its investment.  If government bonds are yielding 10 percent risk free, you can bet the corporate treasurer of the widget company will advocate that the firm simply invest its retained earnings in government bonds.  But if the government could lower the yield on its debt to say 4 percent, that factory may well get built, and thousands of jobs could be created.  Some have also speculated that there is a 'wealth effect' whereby higher securities prices stimulate the consumption of other investors because they 'feel' richer.

QE is not about Liquidity

But wait a minute, don't interest rates fall beacuse the banks are now awash in 'free' money?  No. TThe reserves created by QE are not an important part of the transmission mechanism.   The banks are not able to lend more than they could before QE.  This is because QE typically, though not necessarily, occurs when the short term interest rates are already at zero.  The policy rate, or short rate, through which most modern central banks traditionally implement monetary policy is the effective price of reserves that banks must pay to meet the reserve requirement.  And the central bank can only credibly implement monetary policy if it stands ready and willing to supply these reserves at the stipulated price.  The cost of meeting this reserve requirment is the true constraint on bank lending. Bank credit is thus constrained by the price of reserves, not the quantity of reserves.

The failure of QE to spark a credit explosion in the United States should thus ultimately be the deathknell for the so called money multiplier model of money creation, as well as the so called loanable funds market. On loanable funds, reserves can never be 'used up' because banks lend by crediting the checking accounts of borrowers.  When the newly created checking deposits are spent by the borrower, reserves are transferred from the borrower's bank account to the bank account of whoever the borrower purchased goods or services from. The total amount of reserves held by the banking sector is unchanged. The bank of the payee now invests those reserves at the policy rate.  There is no limit to the number of time these reserves can be lent and re-lent.  The so called 'loanable funds market' does not exist. 

But what about the reserve requirment everybody learns about in Econ 101?  Actually, most advanced economies have no practical reserve requirment.  The US technically has a 10 percent reserve requirement, but that only needs to be met during the so called 'reserve matenence period,' which consists of a day or two every three weeks. The effective reserve requirment in the United States is really only 2 percent.  Canada, Austrailia and New Zealand have formally abolished their reserve requirements.  But even under a reserve requirement, banks can never 'use up' the reserves of the banking system.  This is beacuse in modern times, the central bank is the sole issuer of bank reserves and can create them at will.  Thus if lending ever picks up and the demand for reserves increases, again solely to meet a statutory reserve requirement, the central bank simply issues more reserves such that the price of reserves remains constant.  In essence, the central bank allows the quantity of reserves to float, and fixes the price.  Thus, even under a reserve requirement, the quantity of reserves is never a constraint on bank credit.  The constraint is the price of reserves.  Banks must find willing, credit worthy customers who will take loans at a high enough interest rate to cover the costs of meeting the reserve requirement.  Reserves are thus analogs to tradeable pollution permits.  There have value and a price only because they are required by the government to be obtained in order to engage in some economic activity. 

The quantity of reserves in the banking system is irrelavent, but it is especially irelavent when the price of reserves is zero.  Reserves are only necessary for meeting the imposed reserve requirement.  Returning to the tradeable pollution permti analogy, suppose for second a cap and trade system was fully implemented in the United States and that carbon emission permits traded on open exchanges.  Now consider the economic implications of a price of zero for emission permits.  This would entail that all emittors already held the necessary permits to perform their economic activity of choice, and that there was no bidder for the permits, eg, no one new wanted to engage in economic activity which required carbon emssion.  Now, say the economy is deeply depressed, and the government actually wants to encourage economic activity which results in carbon emission (Eg,factories, taxi cab fleets, ect.)  Would issuing more permits result in more emissions?  No. Again, even at a price of zero, nobody wants to emit more.  Thus, the extra permits will simply go unused, sitting idle and in excess.  A similar situation has been going on in the banking sectors of countries where QE has been implemented.  The price of reserves was already zero. Thus, the demand for reserves was already met, and no bidder existed for reserves.  Therefore, creating more reserves has no effect on credit creation. Banks could obtain reserves at a price of zero before QE, and can obtain reserves at zero after QE.  QE created more reserves, but the banks are price constrained, not reserve constrained.        

QE is never inflationary

Perhaps never is too strong a word.  But nonetheless, QE is very unlikely to ever be inflationary. Again, we all learn PQ=MV in Economics 101.  That is, the price level times the quantity of goods produced is equal to the money supply time velocity of money.  The obsession of human beings with big numbers is rearing its ugly head again. Surely massive injections of reserves must lead to hyper-inflation. However, as we have discussed at length, the banks are not able to do anything after QE they could not do before QE.   

Outside risks to inflation do exist if the private sector responds strongly to lower interest rates and the credit cycle quickly restarts.  But recent experience has shown us that this is unlikely in a depressed economy.  In the United States, bank lending did not begin to grow again until 2014, nearly six years after QE started and ironically the same year it ended.  QE it seems does not lead to credit creation precisely because the quantity of reserves is not a constraint on the banking system. 

A major source of the confusion is that before modern central banking, the quantity of reserves was a constraint on the banks.  Under the gold standard, banks held reserves of gold against their note issues and created loans by printing notes and giving them to the borrower. (In an analogous fashion by which modern banks simply credit the checking accounts of borrowers, essentially issuing 'bank money' or M1) Since notes were backed by some fractional reserve of gold, gold reserves did act as a real constraint on credit creation.  Thus, when credit was tight in the United Kingdom, the Bank of England would ironically raise the rate of interest paid on gold.  This would attract gold from abroad, which would allow the banks to issue more notes and thus fund more loans.  In contrast to today, central banks supply reserves at will, on demand, and at a stipulated price.  Thus, the quantity of reserves is again never at issue, especially when the price of reserves is zero. 

QE does not entail ZIRP

Mario Draghi was one for two at his press conference when talking about the transmission mechanism by which QE affects the real economy. He touched on the portfolio balance channel, but also mentioned the mysterious signalling channel by which QE reassures the banks that interest rates will remain at super low level for a long time, thus reducing the interest rate risk born by the banks.  While any central bank is certainly free to pledge to keep rates low forever, QE does not tie the hands of central bankers when it comes to short term interest rates.  This is because most central banks have the authority to pay interest on reserves.  Therefore, nothing stops the Fed, the ECB, or the Bank of Japan, from simply buying up tons of long term assets financed with reserve creation, and then simply setting a price floor on reserves by paying interst on them.  The result would be a flatter yield curve.  The supply of long term assets would fall, reducing long term bond yields.  At the same time, the short rate would stay constant because of rate of interest paid on reserves kept at the central bank. 

A flatter yield curve may be a legitimate policy goal.  In the 1960s, the monetary autorities in the United States wanted to increase short term interest rates but lower long term rates.  The government had dual objectives.  It wanted to raise short term interest rates to support the dollar, which had come under pressure because of the US balance of payments deficit.  But it also wanted to stimulate long term investment.  Thus, the US Treasury hatched a plan whereby it would issue more short term Treasury bills and fewer long term Treasury bonds.  The result was an increase in short rates by about 10 basis points, but a sharp reduction in very long term rates (30 year) by about 47 basis points.  As discussed in the previous post, funding the government with more bills and fewer bonds is the economic equivalent of QE.  This early monetary experiment shows that QE does not entail ZIRP.  In fact, QE even allows for an increase in short term interest rates! 

Conclusion

We have explored QE and its various flavors in the context of the modern monetary system.  I have shown that QE acts via a portfolio balance channel.  I have also demonstrated that it does not increase liquidity in the financial sector nor does it represent 'free money' for the banks. I discussed why QE is very unlikely to be inflationary, though it is not impossible for QE to cause inflation.  Finally, I used a historical example to show why QE does not entail a zero interest rate at the short end of the term structure.  

In sum, the implementation of QE around the world has generated much hype, hysteria, and conspriracy theories and confuses even seasoned economists.  While I cringe every time I hear an economist talk about how QE is important because it 'expands the money supply' I hope this essay will serve as useful guide to both expert and layman alike when they try to wrap their heads around the opaque world of unconventional monetary policy.     
  

Commentary: Falling US Yields Do Not Portend Disaster

In 2014, the biggest economic story was the dramatic collapse of oil prices.  But perhaps more surprising to both economists and bond traders has been the dramatic fall in US yields despite clear signaling from the Fed that rate hikes are coming in 2015. However, cutting edge research from the Bank for International Settlements suggests that the drop in long term yields in the US, and also notably in Australia and New Zealand is not a mystery at all. On the face of it, this research is simple in premise. Just like any other security or commodity, the price of long term assets (and thus yields) are driven by supply and demand, not a "stacking up" of shorter term interest rates.  Thus, the dramatic fall in the supply of long term assets relative to demand, in most cases due to large scale asset purchases by central banks, explains the fall in yields even in the face of rising short rates. 
 
Bernanke’s “Global Savings Glut”
In 2005, the future Fed Chairman Bernanke delivered highly influential lecture on bond yields which sought to explain the so-called “Greenspan Conundrum” whereby aggressive hikes in the Fed Funds Rate beginning in 2004 failed to increase long term bond yields (or mortgage rates).  Bernanke believe that a global glut of dollar reserves from abroad, mainly the result of large US current account deficits, were being recycled back to the US as foreign investors piled into US Treasuries and Agency debt.  While Bernanke made many insightful observations about why high savings rates abroad might contribute to low long term interest rates, he completely ignored the supply side of the equation. A glut of savers could equally be seen as a dearth of borrowers and/or long dated assets.  A key factor missed by both the Treasury and the Federal Reserve was that the supply on long term investment outlets was falling rapidly, and this was the direct result of government policy. Beginning in 2002, the US Treasury department radically shifted course by issuing a large number of short term bills relative to longer term bonds.  In 2006, right before the yield curve inverted, the average weighted maturity on US Treasury securities held by the public stood at a historic low of 43 months. The net supply of new long term Treasury bonds being supplied to the market was falling, and falling fast.
 
Fundamentally, what Bernanke failed to grasp was that there is and will always be a strong demand for long dated Treasury securities.  Regulatory and institutional features are the main drivers of this highly price inelastic demand.  In general, banks are required to hold zero capital against US Treasuries because they are correctly judged as risk free.  Insurance companies, which have many long term liabilities and thus match them with long term assets, are required to hold large percentages of their portfolios’ in government bonds.  Liquidity requirements also play a role. Large financial institutions are required to hold a certain amount of highly liquid assets, and the most liquid bond on the planet is the US Treasury. 
 
Supply Effects Persist
 
Later, Dr. Bernanke would become Fed Chairman, and would exploit supply effects in the Treasury and Agency MBS markets to push down long term interest rates.   The reserve creation brought on by the various rounds of QE was meaningless because the price of reserves was already zero. In contrast, QE removed long dated assets from the private marketplace.  This is the economic equivalent of the Treasury funding itself with more bills rather than bonds.  In sum, QE caused investors already starved for yield to compete for even fewer Treasury bonds, which bid down yields even further. 
Something else happened in 2009.  The deficit exploded because of collapsing tax receipts, and the US Treasury faced a humongous financing task.  However, in what now is recognized to be a highly unproductive course, the Treasury decided to finance the deficit with mostly long term bonds rather than bills.  This may or may not have been consistent with the Treasury’s mandate to achieve the lowest possible borrowing costs for the taxpayer. (A mandate that should be reconsidered) But there is no doubt that it was highly disruptive to the implementation of monetary policy.  Just as the Fed’s was desperately trying to remove long dated assets from the market, the Treasury was boosting the supply of them.  2010 minutes of the Treasury Borrowing Advisory Committee reveal that the Treasury is loathe to acknowledge Fed actions when making borrowing decisions, viewing that as nothing more than another “large investor.”  Strikingly, the supply effect was also noted yet dismissed, 


At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting.  The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities.  The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.
 

The same minutes even openly acknowledged that the Fed and Treasury are “independent institutions whose objectives may at times appear to come into conflict.” The Treasury's insistence on changing its funding strategy even when it disrupted the implementation of monetary policy calls for a re-examination of the Fed-Treasury relationship.  Specifically, two institutions control the aggregate supply of US Treasuries, the Fed and the Treasury itself.  And, if the supply of US Treasuries is major determinant of long term interest rates and thus a monetary policy variable, coordination, not independence or mutual ambivalence, is required to implement policy objectives.  

Today's Environment

In October 2014, Fed purchases of Treasury bonds finally ended, but Treasury rates have kept falling.  However, yet again a simple supply story can explain this drop. Indeed, in 2010 when the deficit peaked at 10 percent of GDP, net issuance of long term Treasuries topped out 1.2 trillion dollars. Net issuance in 2013 of Treasury notes was 644 billion dollars, while in 2014 this figure fell to 576 billion dollars, a drop of 70 billion.  This dramatic reduction in net issuance is exclusively the result in the shrinking deficit, itself a product of the improving economy.  Therefore, the Treasury began supplying less long dated Treasuries to the market precisely as the Fed has phased out its purchases of Treasury assets.  The net economic result is that the private market is being supplid with less Treasuries, which causes the prices of these very securities to be bid up. 

The fall in Treasury yields is not the bond market's way of pricing in disaster.  Rather, it is simply a reflection of the sharp reduction in the supply of new Treasuries over the past few years. Should the Fed move to raise rates on the short end of the curve, the result will be a flattening of the term structure, not a parallel shift in long term rates.  In fact, we already have a test case for this. The Reserve Bank of New Zealand hiked the overnight rate by 150 basis points in 2014, while at the same time public debt in New Zealand is very low.  This created a scarcity of long dated NZD denominated assets, which many investors are required to hold for regulatory reasons.  The result has been (unsurprisingly) an inversion of the NZD yield curve.  Fixed income investors can rest easy. A shrinking deficit all but ensures a greater scarcity of Treasury notes and bonds.  Flatter yield curve here we come.        

         

Commentary: This Is no Tequila Crisis

Recent events in Mexico have prompted some to liken the current situation to the 1994 Tequila Crisis which ended with hyper-inflation, a collapse of the Mexican Peso, emergency loans from the US to the Mexican Government, and a deep economic contraction.  The Financial Times even ran a story saying that the US, Mexico and the IMF should pre-negotiate terms of an assistance package in case it is needed. (Though to be fair, they admitted such a case is highly unlikely)  Many of these voices come from the fact that two factors which proceeded the '94 crisis are superficially present today.  Namely, '94 was a year of political instability in Mexico and the beginning of a monetary tightening cycle in the US.  It is true that street protests are happening in Mexico over the murder of 43 students in Igula, Mexico, and the Fed will probably hike rates next year. However, noting a few similarities and concluding that Mexico is on the brink is shoddy analysis.  Mexico has worked had for twenty years to learn from the '94 crisis and shore up its defenses so that it can absorb both internal and external shocks.

In 1994, Mexico was on a fixed exchange rate regime.  Thus, any exit of dollars out of the country would force the Bank of Mexico to sell dollar reserves to defend the peg.  This made it extremely attractive for speculators to attempt to break the peso on the hint of any sort of trouble.  When a presidential candidate was assassinated in '94, and the Fed was on the verge of raising interest rates, which would increase the incentive for US investors to repatriate funds from abroad, a perfect storm ensued and the rest in history.  The pre-election spending spree by the Salinas administration also caused some to worry about the government's fiscal position, and began to scare off international investors.


Today the Bank of Mexico has over 190 billion USD in reserves and is committed to flexible exchange rate.  It has the most liquid capital markets among the EM countries, with government yield curve going out to 30 years. Government finances are stable and the Mexican Government has no problem funding itself exclusively on the MXN denominated local market.  Thus unlike '94, it does not depend on external financing, a significant fact given that international investors are more easily spooked by bad news.  Mexico also has a 71 billion dollar flexible credit line(which was renewed this month) with the IMF which serves as a further buffer. 

Central bank independence, which was an initial reform implemented in the wake of the '94 crisis, has served Mexico well.  Since then, inflation targeting from the Bank of Mexico has delivered price stability as well as a strong, strictly regulated and well capitalized banking sector.  2014 is not a replay of 1994. 

The selloff in recent weeks, and especially since Thanksgiving, has been the product of many factors.  First, oil prices have plunged since OPEC announced that it would maintain production despite the current oversupply. This has caused some to worry about the Mexican economy, given that Mexico is major oil producer.  However, it is important to note that today crude oil accounts for only 10 percent of Mexican exports, as compared to over fifty percent in '94.  Mexico has done a remarkable job diversifying its industrial base.  A report release on Friday showed that manufacturing output increased by 3.9 percent.  Construction, which had been in a terrible slump since mid 2012, surged 5.4 percent, the fourth consecutive month of gains after nearly 18 months of contraction.  In sum, both internal and external demand appear to be rebounding.  Yes, Mexico will earn less from its oil, but that is but a small component of a highly diversified economy. 

Secondly, a broader EM sell off has occurred on prospect of tighter US monetary policy.  This was exacerbated by the Dec 5th non-farm payrolls report which beat expectations by over 100,000 jobs.  Unlike prior episodes, Mexico was unable to escape as the USD strengthened broadly.  

Third, the MXN got hit again by risk-off sentiment last week as concerns over global growth pushed bond yields down.  The usual safe haven suspects rallied, (CHF,JPY) and EM currencies were on the back foot again regardless of idiosyncratic strengths or weaknesses.  It was just more panic selling. 

Fourth, the Mexican peso is the most liquid of the EM currencies and is the 8th most traded currency in the world.  Many speculators have made large bets against the peso as a 'proxy' in order to profit from the broader EM selloff.  This exaggerates the Peso's downward moves at times.  Unfortunately, futures and options contracts do not exist for many other EM currencies, or are illiquid.  This has encouraged many speculators to simply bet against the peso instead of betting against EM assets more broadly. This explains some extreme positioning the options and futures markets, with speculators amassing a record net short position against the peso.  

Fifth, it is crucial to note that the Peso depreciation does not appear to be the result of capital flight.  Indeed, participation by foreigners in the local bond markets is steady at 37 percent.  More evidence that the trouble is coming from offshore speculators in the futures and options markets.          


I will admit it.  The last few weeks have been extremely humbling to say the least.  The extreme positioning has caused a precipitous drop in the MXN. Oil linked currencies, such as CAD, NOK, and RUB have also sold off broadly as oil plunged  The MXN, which in 2013 was able to resist the steep declines seen in the likes of ZAR, TRY, or BRL has had no such luck in Q4 of 2014.  However, the firm rejection of the 15 level for USD/MXN may be a sign the there is finally a marginal bidder for the beleaguered peso.  One strong piece of evidence in support of this view is that despite oil's 4 percent drop on Friday, the Peso held on to most of its gains, and was actually able to close the trading day up after falling as far as 14.94 to the dollar.  While further long dollar positioning ahead of next week's FOMC meeting may crimp the Peso style, I expect the MXN recover broadly in the coming months.  Q1 of 2015 should see a test of the 14 handle, and to end Q1 between 14 and 14.2.  I expect to see USD/MXN ending 2015 between 13.50 and 14.

The Return of FX Fusion

After several significant life changes (for the better!) I am ready to start what I hope will be a steady stream of FX commentary.  Lot's of exciting things have happened in the foreign exchange and capital markets.  I face the future, both in a person and professional sense, with more confidence than ever.  So without further ado, let's get to work! 

 The National Bank of Hungary issued a surprisingly upbeat assessment of internal economic conditions its statement which accompanied its interest rate decision. The base MNB policy rate, or the rate paid on HUF deposited for two weeks at the Central Bank, was left unchanged at 2.10 percent.  The bank referenced relatively robust growth when compared with the rest of Europe, noting growth rates of 3.7 and 3.9 percent in the first and second quarters respectively.  The Bank expects this trend to continue.  Of particular note is the gradual recovery of the consumer sector, as well as the large public investments in infrastructure.  Hungary also continues to benefit from EU development funds intended to bring living standards in less developed member States.   Nonetheless, these funds only amount to 0.3 to 0.4 percent of GDP.

On the inflation front, the Bank believes the low inflation environment in the rest of Europe, as well as falling commodity prices, are responsible to historically low Hungarian inflation despite a relatively strong domestic economy.  The Bank also highlighted the Funding for Growth Scheme, which is similar to the BoE funding for lending program. The Bank also noted the reduction of foreign debt, and the re-domination of EUR and CHF loans into HUF, aided both by the initiatives of the central government and the FGS. Both these developments have reduced Hungary's once problematic external vulnerabilities. 

On FX, the HUF remains a carry trade candidate, but only against the EUR or CHF.  Several factors however should caution investors from jumping in with both feet.  Most importantly, in times of Eurozone stress, the currencies of developing European economies have tended to depreciate against EUR and CHF even despite the factor that these countries are presumably somewhat better insulated from Eurozone troubles precisely because they have opted to retain monetary sovereignty.  Panic selling of risky assets, especially those with exposure to Europe, is the likely explanation.  In other words, it seems unlikely that the market will differentiate between the weaker and stronger EM currencies in the event of adverse shocks.  Secondly, HUF only yields 2.1 percent, one of the lowest rates in the entire EM space.  Third, European weakness will likely be a major theme going forward, and this trade is essentially neutral Europe.  Selling EUR or CHF against KRW, MXN or even COP will both earn more carry, but also allow investors to capture capital appreciation derived from stronger growth of the rest of the world vis a vis Europe.