So I’ve been asked what I’d do to get Ireland past this latest funding crisis.
Answer: I’d announce that in the case of default new Irish govt debt is freely transferable and can be used for the payment of taxes to the Irish govt.
This should facilitate funding for the near term.
Believe it or not I’m still getting a lot of questions about how QE works,
so I’ve reorganized the discussion some:
First, recognize that, in fact, reserves, functionally, are nothing more than 1 day t bills.
And, for all practical purposes, the difference between issuing 1 day t bills and 3 month t bills is inconsequential.
So since currently the shortest thing the Treasury issues are 3 mo bills,
I can say that:
QE- the Fed buying longer term treasury securities- is functionally identical for the economy to the Treasury having issued 3 month t bills instead of those longer term securities the Fed bought.
Now the more tricky part.
The yields on the approx. $13 trillion of various Treasury securities and reserve balances continuously gravitate towards what are called indifference levels.
That means that for any given composition of reserve balances at the Fed and Treasury securities (also Fed accounts), there is a term structure of interest rates that adjusts to investor preferences at any given time.
So, for example, with govt providing investors with the combination of $2 trillion in reserves and $11 trillion in various Treasury securities, the yield curve will reflect investor preferences given the current circumstances.
That means if investors expect Fed rate hikes, the front end of the curve would steepen accordingly. And if instead they expect 0 rates for a considerable period of time, the curve would flatten for the first few years to reflect that.
If the Fed then buys another $1 trillion of securities, reserves go to $3 trillion and there are $10 trillion longer term Treasury securities outstanding.
And to actually purchase those reserves, the Fed would have to drive the term structure of rates to levels where investors voluntarily are indifferent with that mix of offerings, given all the other current conditions.
The Fed doesn’t force anyone to sell anything.
It just offers to buy at prices (interest rates) that adjust to where people want to sell at those prices.
So even if the Fed owned a total of $10 trillion of securities, and there were only $3 trillion left outstanding for investors, if investors believed the Fed was going to hike rates by 3%, for example, the term structure of rates on Treasury securities would reflect that.
What I’m trying to say is that QE does not mean rates will actually go down. The yield curve is still a function of investor expectations.
But the yield curve is also a function of ‘technicals.’
This means the quantity of 30 year securities offered for sale, for example, can alter the yield of that sector more than it alters the yields of the other sectors.
This is because, in general, there tends to be fewer ‘natural’ buyers of 30 year securities than 3 month bills.
For most of us, we are a lot more cautious about investing for 30 years at a fixed rate than for 3 months at a fixed rate.
And it takes relative large moves in 30 year rates to cause those investors to shift our preferences to either buy them if govt wants to issue more, or sell them if the Fed wants to buy them back.
On the other hand, there are pension funds who ‘automatically’ buy 30 year securities regardless of yield because they are matching the purchases to 30 year liabilities.
So altogether, the yield curve is function of both investor expectations for interest rates and the ‘technicals’ of supply and demand (desires by issuers and investors).
And while there might be no amount of 3 month bills the Treasury could issue that would materially drive up 3 month t bill rates, relatively small amounts of 30 year bonds do alter the yields of 30 year securities. Insiders would say the 30 year market is a lot ‘thinner’ than the 3 month market.
So what is QE?
QE is nothing more than the govt altering the mix of investments offered to investors.
The Fed buying longer term securities reduces the amount of longer term securities and increases the amount of reserves (one day securities)
Interest rates, as always, continuously gravitate to reflect current investor expectations of future Fed rate changes and current ‘technicals’ of supply and demand.
QE changes the technicals, and possibly expectations, and results in a yield curve that reflects those current conditions.
So all QE does is alter the term structure rates, as investors express preferences for the term structure of interest rates, given the securities and reserves of the varying maturities offered by the Fed and Treasury and all the current conditions.
That brings us back to the question of what QE means for the economy, inflation, value of the currency, etc.
Which comes down to the question of what the term structure of rates means for the economy, inflation, the value of the currency, etc.
QE is nothing more than a tool for changing interest rates by adjusting the available supply of securities of various maturities (technicals). And it’s not a particularly strong tool at that.
It’s the resulting interest rates that may or may not alter the economy, inflation, and the value of the dollar, etc. and not the quantities of reserves and Treasury securities per se.
And it is clear to me that the FOMC does not fully understand this.
If they did, they’d be in discussion with the Treasury about cutting issuance.
And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted. Which is what they did in the WWII era. And how they target the fed funds rate.
With today’s central banking and monetary policy with its own currency, it’s always about price (interest rates) and not quantities.
So it was buy the rumor, buy the news, then watch it all fall apart a few days later.
QE was a major international event, with the word being that the ‘money printing’ would not only take down the dollar, but also spread ‘liquidity’ to the rest of the world through the US banking system, via some kind of ‘carry trades’ and who knows what else, or needed to know. It was just obvious…
So the entire world was front running QE in every currency, commodity, and equity market.
And the Fed announcement only brought in more international players, with money printing headlines screaming globally.
Then the ‘risk off’ unwinding phase started, reversing what had been driven by maybe three themes:
1. There were those who knew all along QE probably did not do anything of consequence, but went along for the ‘risk on’ ride believing others believed QE worked and would drive prices accordingly.
2. A group that thought originally QE might do something and piled in, but began having second thoughts about how effective QE might actually be after learning more about it, and decided to get out.
3. A third group who continue to believe QE does work, who got cold feed when they started doubting whether the Fed would actually follow through with enough QE, also for two reasons.
a. the FOMC itself made it clear opinion was highly polarized, often for contradictory reasons
b. the economy showed signs of modest growth that cast doubts on whether the Fed might
think something as ‘powerful and risky’ as QE was still needed.
Reminds me some of the old quip- the food was terrible and the portions were small-
(QE is questionable policy and they aren’t going to do enough of it.)
So risk off continues in what have become fundamentally illiquid markets until some time after the speculative longs have been sold and the shorts covered.
Next question, what about after the smoke clears?
A. The dollar could remain strong even after the initial short covering ends- the modest GDP growth is slowly tightening fiscal, and crude oil prices are falling, both of which make dollars ‘harder to get’
It’s starting a kind of virtuous cycle where the stronger dollar moves crude lower which strengthens the dollar.
Also, the J curve works in reverse with other imports as well. As imports get cheaper, initially
the rest of world gets fewer dollars from exports to the US, until/unless volumes pick up.
The euro zone is again struggling with the idea of the ECB supporting the weaker members with secondary market bond purchases, as ECB imposed austerity measures are showing signs of decreasing revenues of the more troubled members. Seems taxpayers of the core members are resisting allowing the ECB to support the weaker members, and the core leaders are groping for something that works politically and financially. All this adds risk to holding euro financial assets, as even a small threat of a breakup jeopardizes the very existence of the euro.
Japan is on the way to fiscal easing while the US, UK, and euro zone are attempting to tighten fiscal.
Falling commodity prices hurt the commodity currencies.
B. Interest rates are moving higher as spec longs who bought the QE rumor and news are getting out.
But it looks to me like term rates could again move back down after this sell off has run its course.
The Fed still failing on both mandates- real growth is still modest at best, and the 0 rate policy is deflationary/contractionary enough for even a 9% budget deficit not to do much more than support gdp at muddling through levels, with a far too high output gap/unemployment rate.
And falling commodities, weak stocks, and a strong dollar give the Fed that much more reason not to hike.
C. A mixed bag for stocks.
Equity values have fallen after running up on the QE rumor/news, further supported by the dollar weakness that came with the QE rumor news, with the equity sell off now exacerbated by the dollar rally which hurts earnings translations and export prospects.
But a 9% federal deficit is still chugging away, adding to incomes and savings of financial assets, and providing for modest top line growth and ok earnings via cost cutting as well.
Fiscal risks include letting the tax cuts expire and proactive spending cuts by the new Congress which seems committed to austerity type measures.
Low interest rates help valuations but reduce the economy’s interest income.
China acting more like the inflation problem is serious. Hearing talk of price controls, as they struggle to sustain employment and keep a lid on prices, in a nation where inflation or unemployment have meant regime change. Looks to me like a slowdown can’t be avoided with the western educated kids now mostly in charge.
>
> (email exchange)
>
> On Wed, Nov 17, 2010 at 1:05 AM, Paul wrote:
>
> Very interesting — but I have a question:
>
> What if the deficit causes “saving” increase in financial assets held by
> foreigners (via the trade imbalance) rather than US domestic households?
>
Hi Paul!
That would mean we would get the additional benefit of enjoying a larger trade deficit, which means for a given size govt taxes can be that much lower.
Or, if we get sufficient domestic private sector deficit spending, govt deficit spending can remain the same and we benefit by the enhanced real terms of trade supported by the increased foreign savings desires.
Except of course policy makers don’t get it and squander the benefit of a larger trade deficit/better real terms of trade with a too low federal deficit (taxes too high for the given level of govt) that sadly results in domestic unemployment- currently a real cost beyond imagination.
Fundamentally, exports are real costs and imports real benefits, and net imports are a function of foreign savings desires.
So the higher the foreign savings desires the better the real terms of trade.
Also, with floating exchange rates, the way I see it, it’s always ‘in balance’ as the trade deficit = foreign savings desires.
Best!
Warren
Dudley, a former Goldman Sachs economist, also rejected the widely held view that the Fed is really printing money. “What we’re doing is, when we buy Treasury securities, we are increasing the amount of reserves in the banking system.
Promising!
For those reserves to actually create money, the banks actually have to lend those reserves out.
:(
The problem with the U.S. economy now is that there is insufficient lending and he doesn’t expect the Fed’s purchase program to solve that problem because there are ample reserves in the system. He expects the current program to help the economy by lowering interest rates for businesses and consumers.
Ok, he mostly gets it. Like when one of the slow kids in class gets something close enough to right and gets a passing grade.
(If anyone reading this knows him personally, try sending him a copy of my book, thanks)
Something that’s never happened even once in the history of the world with fiat money and floating fx policy.
Greenspan: High US Deficits Could Spark Bond Crisis
November 14 (Reuters) — The United States must move to rein in its massive budget deficits or it faces the risk of a bond market crisis, former Federal Reserve Chairman Alan Greenspan said Sunday.
“We’ve got to resolve this issue,” Greenspan said of the ballooning U.S. debt levels.
He spoke about the issue as a panel, chaired by former White House chief of staff Erskine Bowles and former U.S. Senator Alan Simpson, is due to deliver a report on debt and deficits by Dec. 1.
A draft report made public last week offered a series of politically tough tax and spending choices that would seek to reduce the debt by $4 trillion by 2020.
The report received a lukewarm reception from some politicians and outright condemnation by others, including House of Representatives Speaker Nancy Pelosi, who pronounced the ideas “simply unacceptable.”
Greenspan, who spoke on NBC’s “Meet the Press,” said he believed “something equivalent to what Bowles and Simpson put out is going to be approved by Congress. But the only question
is whether it is before or after a crisis in the bond market.”
He said the risk is that the deficit, which hit $1.3 trillion this year, could spook the bond market. That would result in long-term interest rates moving up rapidly and could lead to a double-dip recession.
Looks like a big ‘risk off’ day coming up.
The authorities are embodying uncertainty at a time when it’s ‘their move’
Where things go is not about market forces, but about what politicians and their appointees do next.
The competence of the G20 is looking much like that of the FOMC, and it’s not a pretty sight.
We can do nothing but ‘wait and see.’
For example, will they or won’t the fund the euro members?
The mixed message is both no, and they will do what it takes to ensure solvency.
And taxpayers don’t want to pay for it, whatever that means.
And the same time the US authorities are being exposed as, to be kind, being on the sidelines.
President Obama has both nothing of substance to add to the debate, either in the euro zone or domestically.
The Fed itself said QE does nothing but modestly lower rates (Bernanke speech, Carpenter paper) which hopefully boosts asset prices which hopefully adds to aggregate demand. Hasn’t worked in Japan, (even with the net exports we also aspire to) but hopefully here. And skeptical markets that fear the Fed is engaged in ‘irresponsible money printing’ are coming around to the reality.
The sustainability commission has reported and recommended ways to reduce the deficit and ensure unemployment rises and our standard of living falls.
The theme continues- by fearing we are the next Greece, we are turning ourselves into the next Japan. Including burdening ourselves with an export driven economy.
So on an otherwise quiet post holiday Friday I look for a risk off rush to the sidelines, and a continuation of illiquidity in general.
The highlighted part is what I was getting at previously.
The idea that QE does nothing is now reasonably well distributed.
Those holding positions include a lot of managers who highly suspect QE does nothing.
But they believe others who do believe QE is ‘inflationary money printing’ will keep driving prices.
Same with austerity. The idea that it makes things worse is taking hold, but those who believe it is a good thing- that govt borrowing takes away money from the private sector and all that nonsense- still have the upper hand.
But ‘reality’ is working against those out of paradigm, as the dollar is firming and the rest showing signs of coming apart as well.
As for Europe, it all holds as long as the ECB keeps buying bonds in the secondary market in sufficient size to keep shorter term yields reasonable. And comes apart when they don’t.
The problem is politically it isn’t ‘fair’ to spend euro resources on targeted nations, which carries with it the notion that all the others are ultimately paying for it, though they don’t know exactly how that will play out. So you see the core addressing that with loud noises of restructuring, etc. which may or may not happen. But the real possibility is there.
My proposal of the ECB making per capita distributions to all the member nations of, say 10% of GDP in the first round, would not carry that notion of ‘unfairness’
And as long as member nation spending was appropriately constrained politically there would be no inflation or monetary ramifications, apart from better credit ratings and the ability to fund existing deficits at lower risk premiums.
But it’s still not even a consideration, best I can tell.
Fasten Your Seatbelt
November 11, 2010
By John R. Taylor, Jr.
Chief Investment Officer, FX Concepts
‘… Although the world believes that QE2 is there to push the dollar sharply lower, Bernanke argued that his goal was something else. On the day after the Fed’s move, he wrote in a Washington Post editorial piece that QE2 would push up the equity market, bonds, and other risky securities thereby stimulating consumption and economic activity. Even Greenspan did not publicly proclaim his “put,” but now Bernanke has made it the centerpiece of US strategy. Equities are already overpriced, with profit margins at all-time highs and PE ratios far above average. Speculation is now more American than apple pie – but this is a very risky time to practice it. As one highly respected analyst noted about Bernanke’s article, “these are undoubtedly among the most ignorant remarks ever made by a central banker.” As we and many others have noted that QE has shown little or no positive impact on actual economic activity, so the Fed has taken a big gamble, and if it fails as we expect it will have nowhere else to go. With the Republican victory tainted by the Tea Party “starve the beast” mentality, austerity has come to Washington. This next year will be a terrible one for the world’s biggest economy, so we would go against Bernanke on the equity side, but buy government bonds along with him…’
It does look like they are trying to cause markets to discount a very high probability of restructuring.
Any restructuring losses are reductions in financial assets and ultimately deflationary, as former bond holders
have less spending power. Unless the restructuring somehow results in more govt spending on goods and services, which, in this case, it clearly won’t. In fact, it will most likely be followed with additional austerity.
So looks like another whipsaw for the euro- down as people flee the currency over fears of losses due to restructuring
as well as fears of officials willing to restructure doing some other unknown thing that could cause losses, followed by a strong currency once it’s sorted out and considered ‘safe’ from default risk.
France Joins Germany Ganging Up on Bondholders to Share Pain
By Mark Deen and Francine Lacqua
November 11 (Bloomberg) — French Finance Minister Christine Lagarde said investors must share the cost of sovereign debt restructurings, backing a German call that helped send yields on Irish and Portuguese bonds to record highs.
“All stakeholders must participate in the gains and losses of any particular situation,” Lagarde said during an interview yesterday in Paris for Bloomberg Television’s “On the Move” with Francine Lacqua. “There are many, many ways to address this point of principle.”
Irish 10-year bonds dropped for a 13th day, driving the yield up 19 basis points to 8.95 percent and the risk premium over benchmark German 10-year bunds to a record 652 basis points. Ten-year Portuguese yields rose 9 basis points to 7.27 percent, while Greek and Spanish bond yields also climbed.
Lagarde’s comments mark France’s most explicit backing of German proposals to make bondholders contribute in bailouts, which deepened the slump in bonds of the so-called euro peripherals. Risk premiums that investors demand to buy their debt have risen since an Oct. 29 European Union summit when German Chancellor Angela Merkel sparred with European Central Bank President Jean-Claude Trichet over forcing bondholders to take losses in restructurings, so-called haircuts.
“We do have differing approaches,” Merkel told reporters after the summit.
The clash continued during the past two weeks, pummeling European bond markets.
‘Nail in the Coffin’
“Lagarde’s comments mentioned restructuring, and that’s another nail in the coffin” for peripheral debt, said Steven Major, global head of fixed-income research at HSBC Holdings Plc in London. “There’s still a big constituency of investors and traders who have not recognized until now that restructuring could happen.”
The spread between yields of Irish 10-year bonds and German bunds has widened more than 200 basis points since Merkel began her push for burden sharing.
German officials are sticking to their guns amid the bond market rout.
“We do also need creditors to be involved in the costs of restructuring,” Merkel said today in Seoul, where she’s attending a summit of the Group of 20 leaders. “There may be a conflict here between the interests of the financial world and the interests of politicians. We can’t constantly explain to our voters that taxpayers have to be on the hook for certain risks, rather than those who make a lot of money taking those risks. I ask the markets sometimes to bear politicians in mind, too.”
Trichet’s Stance
Trichet says such talk risks exacerbating the situation for indebted nations as they struggle to cut their budget deficits.
“The more you talk about restructuring debt, the harder it is to obtain debt,” Irish Finance Minister Brian Lenihan said Nov. 2. “That is the reality.”
“They are making it more likely that countries like Ireland and Portugal will be forced to restructure their debt,” said John Stopford, head of fixed income at London-based Investec Asset Management Ltd., which oversees $65 billion. “There should potentially be some conditionalities, otherwise it will become a self-fulfilling prophecy.”
The cost of insuring Irish debt gained 20 basis points to a record 617 basis points, according to data provider CMA. Credit default swaps for Portugal added 17 basis points to 494. Fallout from the slump in Ireland and Portugal pushed up the default risk on Spanish debt 12 basis points to 289.
Irish and Portuguese debt has suffered the biggest declines this month among the world’s government bonds. Ireland has dropped 8.6 percent since the Oct. 29 EU summit and Portuguese bonds have shed 5.9 percent.
Portugal Bid
Portuguese Finance Minister Fernando Teixeira dos Santos urged the EU yesterday to clarify how the so-called crisis mechanism will operate.
EU leaders plan to map out by December how a permanent bailout facility might work, and also study how to treat private bondholders and whether to involve the International Monetary Fund. The new system would kick in when temporary measures, set up this year to rescue Greece and protect the euro, expire in 2013.
“We have to make an appeal at the European level for the European institutions to rapidly, with the greatest possible urgency, clarify the terms in which this mechanism will function,” Teixeira dos Santos told reporters in Lisbon.
Lagarde cited several ways in which investors would share the losses in a bond scheduling with taxpayers.
“I’m not specially focused on haircuts,” she said. “We can insist on having in any issuance and in any agreements a collective action clause under which any lender agrees that if something goes wrong, the lender will actually participate in the plan that will solve the difficulty, in the same way that you can have rescheduling over time.”
>
> (email exchange)
>
> On Wed, Nov 10, 2010 at 10:29 PM, Mark wrote:
>
> One more thing I dont get. You say there isn’t more money
> in the system, but there is more “cash”. For instance, If
> I have $10 in t-bonds before QE and you have $10 in cash
> and the government comes and buys my bond from me then we
> both have $20 in cash combined.
>
Right, because as an investor, yields are such where you now favor cash over t bonds.
>
> If we both want to buy a pair of socks the next day we will
> bid up the price of those socks because now there is more
> cash in the system, right? Before I couldn’t buy the socks
> because I owned a bond. Is that wrong?
>
Not wrong, but probably not realistic.
If you wanted socks you could have sold your t bonds the day before, just at a slightly higher yield/lower price.
QE is predominately about yields adjusting to levels where investors in aggregate make investment decisions decide to hold cash rather than longer term securities.
To your point, the question is whether lower rates in general cause what were investors to become consumers.
There isn’t much evidence of this happening anywhere, including Japan, so the next question is why not.
My guess is the interest income channel- lower rates mean less income for the economy in general because the govt sector is a net payer of interest. And QE directly reduces govt interest payments as the Fed earns the interest on the securities it buys, rather than the private sector.
So rates are lower, which might encourage consumption, and might encourage borrowing to consume, but income over all is lower as well.
And, of course, without real asset prices rising lenders are less inclined to lend as they don’t have rising collateral values to bail them out. A 70,000 mtg on a 100,000 condo or house can easily turn into a loss if the borrower defaults, for example, just from fees, commissions, closing costs, depreciation due to neglect.