Northern, WI 5/15/12 (StreetBeat) -- Interest rates, specifically those at the long end of the curve in the US and Germany, are quite low. Ten Year maturities are yielding below the prevailing rate of inflation in both countries, that shouldn’t happen. In the previous decade the 10 Year US Treasury yield was usually one hundred and fifty to three hundred basis points over the Consumer Price Index Core rate. Before now, only in the aftermath of the Lehman Brother collapse in the final months of 2008, did this spread fall under 100 basis points, and then only briefly. It should be that the yield of long end debt is a premium to inflation, based on the current annualized rate of prices and the expectation for inflation rates in the future. Other factors may play into the calculus, but this is the key fundamental. Not to say that these markets will not fluctuate with the ebb and flow of the economy or provide a hiding place in turbulent times, but I think that something important has happened at the margin of the market that makes economic fundamentals less important now than ever before. The yield of the US and German 10 Year debt is low because of the obvious problems on either side of the Atlantic. But in my opinion the yields on this debt are at or near record lows because for many buyers of long term debt there is no alternative to these instruments. If an institution needs duration, needs an asset to offset a liability and needs the approval of investment committee to get it done, there is nowhere left to turn. There is a lack of good collateral and in many important respects US Treasuries and the German Government debt are the last ones standing.
This is how I think we got here.
The shadow banking system is the popular term used to describe the web of securitization, derivatives, and repos on these instruments, created and traded mainly by non-bank financial institutions. Shadow banking grew exponentially early last decade. It went from a nominal presence at the turn of the century into a multi-trillion dollar pile of collateral by mid-decade.
This shadow system was so large and efficient that it essentially broke the Fed’s monetary transmission mechanism. As I wrote in the TWA from 9/29/08; “The Fed’s use of monetary policy to slow down or speed up the economy, and thereby achieve their mandate for sustainable economic growth, stable prices and high levels of employment, depends greatly on something know as the monetary transmission mechanism. In order to change the target rate of the Fed Funds the Fed will either add money to, or take money out of the system. They then depend on the banks that are affected by changes in the monetary base to charge more or less for loans and, by so doing, move the dial on economic growth in the desired direction; in a nut shell, this is the monetary transmission mechanism.” But the shadow bankers were able to create, through securitization, credit and therefore money outside of the Fed system. The Fed’s role as the determinant of liquidity levels, the so called liquidity fulcrum, became marginalized. Manmohan Singh and Peter Stella explained this concept in a recent essay on central bank reserve creation; “Due to this shift, the liquidity fulcrum of the pre-crisis US financial market was composed only partly of central bank liabilities—and it was a very small part. More importantly, the magnitude of the liquidity fulcrum was determined not by the monetary policy authorities but instead by market practice. The nature and volume of assets determined by the market to be acceptable collateral is the key.”
The FTalphaville blog elaborated on the argument presented by Singh and Stella; “That’s to say, ‘shadow banks’ and ‘non-banks’ were arguably responsible for a lot more lending in the system than previously thought. Or to put it another way, banks were sourcing a lot more of their liquidity (for lending activity) from shadow banks than from pure customer deposits. But while the availability of depositor-created liquidity is easily controlled by the central bank, shadow banks dictate their own reserve limits as well as how much they can lend, all on a bespoke basis. The Fed’s actions thus hold very little sway over their liquidity distribution preferences—which on top of everything are channeled to banks via the ‘real-world’ repo market. The market whose rates the Fed tries to influence, but which it can never guarantee.”
The Fed noticed, which is not to say completely understood in practice or for its ramifications. To Greenspan the inability of the Fed to influence interest rates further out the curve was just a “conundrum” that could probably be blamed on the Chinese appetite for US Treasuries. Bernanke may have had inkling it was something else. At the December 2006 FOMC meeting the new chairman asked Governor Warsh for his “view about the meaning of this liquidity issue?” In the transcripts from that meeting Governor Warsh did a back of the envelope outline of shadow banking and briefly warned of how it was infringing on the Fed’s monetary domain; “So I think liquidity really means a couple of the things you’ve noted. Obviously, I, like you, think that these monetary aggregates are not providing us with much insight. Moreover, regarding your initial point, we would have a hard time drying up this liquidity, if that’s what we attempted to do, given the global nature of the sources and the uses of funds.”
Well, as it turns out, Warsh was right. The Fed could not dry up the shadow banking liquidity; it had to whither on its own accord and it did. And now the problem is that even as they need to irrigate with more liquidity the Fed has found that conditions remain parched, in part because the drought in shadow banking was a magnitude greater than Fed’s ability to drench it.
Additionally, you have to add the rehypothecation chains to the shadow banking collateral calculation. The original security was re-used as collateral in other transactions many as three or four times in the US and a multiple of that amount in Europe. But once the value of the original securities began to decline in the recession so too did their re-use as collateral decline. Manmohan Singh wrote about this in an IMF paper called Velocity of Pledged Collateral: Analysis and Implications; I referred to this paper in TWA 1/9/12: “As a result of these factors Singh estimates that the rehypothecation chains have fallen to a churn rate of 2.4 times by the end of 2010, meaning there has been a reduction in collateral totaling $4 to $5 trillion; a fall from the end of 2007 peak of $10 trillion down to about $5.8 trillion. ‘This decline in leverage and re-use of collateral may be viewed positively from a financial stability perspective,’ wrote Singh in his paper on velocity of pledged collateral. ‘From a monetary policy perspective, however, the lubrication in the global financial markets is now lower as the velocity of money-type instruments has declined.’ The way Singh sees it the ‘velocity of collateral’ is analogous to the concept of the ‘velocity of money’. When there is too much velocity or grease, as was the case in the years leading up to Lehman, the markets are apt to slip and slide on the excesses. But when there is too little velocity the system could grind to a halt. ‘Collateral is the grease that oils the lending system,’ said Richard Comotto of the International Capital Market Association to the Financial Times in an article on Singh’s research. ‘If the grease starts to freeze or run out, the loan cogs won’t run as well.’”
Even a massive increase in Treasury issuance was not enough to offset the decline in private sector credit creation. For instance in 2007, on a seasonally adjusted annualized rate (SAAR), total credit market borrowing in the US was $4.5 trillion; including things like corporate debt, securitizations, commercial paper, etc. Of that total the Treasury tapped the credit market for $237 billion; this is according to the Fed’s quarterly statistical report called the Flow of Funds. In 2009 the Treasury borrowing was up to $1.4 trillion SAAR, but the overall figure for credit creation was a negative $580 billion. In other words private sector credit creation went down by about $2 trillion for the year and down by $5 trillion when compared to the pre-recession levels. As of the end of 2011 the net figure for SAAR credit creation was a negative $300 billion, once you take out the Federal Government contribution of $1.07 trillion.
So the point is that in the years before the recession private sector credit creation was rampant; collateral was plentiful, maybe too much so. But since then it has become a mere shadow of its former self and that has implications for the economy. The way Singh described it in his paper on the velocity of collateral, “a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the ‘primary source’ collateral pools in the asset management complex (hedge funds, pensions and insurers etc), due to averseness from counterparty risk etc. The second round impart is from shorter ‘chains’—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.”
Some institutions are natural buyers of longer dated debt; pension funds, insurance companies or banks have a need to hold an asset that offsets their liabilities. In the early years of this century they may have held private sector securities to satisfy that balance sheet requirement. But since the recession there has been a dearth of that paper and there is a heightened concern about the worthiness of the counterparties that are supposed to support those securities. Therefore the duration needy institutions have increased their holdings of Treasuries by a significant amount; where else were they to go? “The quality of the paper may be one reason but it seems to me the key factor is that there is a flight to quantity. If an institution must own an interest bearing security, especially one that is secure, then it needs to buy what is available, and for now that means Treasuries.” That is how I described the fresh demand for Treasuries in TWA 8/3/09. The demand for Treasuries has outstripped the massive increase in the supply, as is evident from the increase in the bid to cover ratios at the auctions even though the auctions are ever more frequent and larger than ever before. The Operation Twist bidding also puts the heightened appetite on display. When the Fed is buying Treasuries the market offers a couple of times the amount the Fed plans to purchase. But when the Fed is selling Treasuries the size of the bid is huge in comparison, several times the amount the Fed plans to sell.
As many Treasuries as there are, it doesn’t seem that there are enough to feed all the hungry accounts looking for good collateral. The evolution of the European debt crisis has exacerbated the situation. Originally the problems with and decline of the shadow banking collateral benefitted all sovereign debt, not just the Treasuries. But try to find an investment committee that will sign off today on an investment in Spanish long term debt. You can trade European sovereign debt, but aside from German Bunds you cannot invest in them. The collateral pie is shrinking fast. Counterparty nervousness is playing a role as well. The use of covered bonds in Europe has grown dramatically in the last couple of years. That’s because the coveted collateral that is used in this sort of transaction cannot be re-used and the owner maintains ownership as opposed to having it pledged elsewhere with no guarantee that the same paper will be returned; one cannot be frivolous with the good stuff. A few steps down the quality ladder and we find that another EU1 trillion of lower graded collateral has been taken off the market with the ECB liquidity program, the LTRO. Even ECB boss Draghi has taken note of the “scarcity of eligible collateral.”
Call it the result of risk on/risk off. Well, the SP is barely five percent off a multi-year high, but the 10 Year yield is 1.80%, well short of inflation.
Call it the Fed’s relentless buying of Treasuries. Well, in mid-May 2007, the month before we first heard about MBS trouble at Bear Stearns hedge funds the Fed owned 15.9% of marketable Treasuries. As of last week the Fed owned 15.2% of the supply. Granted that their holdings are longer dated, but the yield of the 10 Year was 1.86% on the day that Operation Twist was announced and the path followed since then does not reflect a relentless Fed effect. Rates are extremely low but, arguably, not clearly driven lower by the Fed strategy.
Call it a bubble waiting to burst. But before you do you better be sure the supply of reliable, call it safe, collateral other than Treasuries or Bunds is readily available. You should also be able to see a resolution to Europe’s debt crisis on the horizon, and be sure it is not a mirage.
Therefore, I think the very low rates in the Treasuries and the Bunds is the result of the lack of alternatives available to the natural buyers of fixed income. The return of one’s money is paramount to the return on ones money. You may not always get what you want, but if you buy some time with Treasuries and or Bunds you might get what you need; a reliable asset to offset a liability. Not a good deal, but a good deal better than an unwanted haircut. Markets will fluctuate, but until there is an alternative I don’t see how rates will normalize any time soon.
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