The Fed’s Policy Mechanics Retool for a Rise in Interest Rates

It’s easy to take for granted the Federal Reserve’s ability to raise interest rates. Even among the legions who doubt that Fed officials will pick the ideal moment to start increasing rates for the first time since 2008, few question the Fed’s technical competence. The central bank has a long history. The engine is known to work.

So it may come as a surprise to learn that the old engine is broken. When the Fed decides that it’s time to “lift off” — perhaps this week, but more likely later this year — it will be relying on a new system, assembled from spare parts, to make interest rates rise.

There is a general agreement among economists and market analysts that the Fed’s plans make sense in theory. A team led by Simon Potter, a former academic who now heads the Fed’s market desk in New York, has been testing and fine-tuning the details by moving billions of dollars around the financial system.

But markets have a long history of scrambling the best-laid plans.

“If something is going to go wrong, I haven’t been able to figure out what, but there’s a lot of reason for caution,” said Stephen G. Cecchetti, the former chief economist at the Bank for International Settlements. “We’ve never done this before.”

The stakes are huge. The Fed is in charge of keeping economic growth on an even keel: minimal unemployment, moderate inflation. It tends to operate conservatively and to change very slowly because when it errs, the nation suffers.

Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.

The Fed, embedded in the banking system, has also concluded that working through the banks is no longer sufficient to influence the broader economy. It plans to strengthen its hold by working directly with an expanded range of lenders.

Fed officials have repeatedly expressed confidence that the plan will work. “The committee is confident that it has the tools it needs to raise short-term interest rates when it becomes appropriate to do so,” Janet L. Yellen, the Fed’s chairwoman, told Congress earlier this year, referring to its policy-making body, the Federal Open Market Committee.

And if the new approach does not work at first, Mr. Potter said in a recent speech, then his team of monetary mechanics “stands ready to innovate” until it does.

Freezing, Not Draining

The markets desk at the New York Fed has put monetary policy into practice since the mid-1930s. In the decades before the Great Recession, the desk exercised its remarkable influence over the American economy through its control of an odd little marketplace in which banks could come to borrow money for a single night.

The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.

As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.

But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.

One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.

Bank of America, for example, had $388 million in its Fed account at the end of June 2008. Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.

To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves. The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat. So the Fed decided to find another way.

Instead of draining all that excess money, the Fed decided to freeze it.

Paying Banks Not to Lend

For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.

The straightforward part of the plan is persuading banks not to make loans.

In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.

Say the Fed wanted to raise short-term interest rates to 1 percent, meaning that it did not want banks to lend at lower rates. Because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates. “Why would you lend to anyone else when you can lend to the Fed?” Kevin Logan, chief United States economist at HSBC, asked rhetorically.

This is not a cheap trick. Since the crisis, the Fed has paid banks a token annual rate of 0.25 percent on reserves. Last year alone, that cost $6.7 billion that the Fed would have otherwise handed over to the Treasury. Paying 1 percent interest would cost four times as much. The Fed has sent roughly $500 billion to the Treasury since 2008. As the Fed raises rates, some projections show that it may not transfer a single dollar in some years. Instead, the Fed will pay banks tens of billions of dollars not to use the trillions it paid them previously.

At first, Fed officials thought that paying interest to banks would establish a minimum rate for all short-term loans, exerting the same kind of broad influence as the old system. It soon became clear, however, that rates on most such loans remained lower than 0.25 percent. Even banks that needed overnight loans found they could borrow more cheaply. The average rate in July was 0.13 percent — about half of the Fed’s new benchmark rate.

The rest of the financial system is also awash in cash, and lenders — like money market mutual funds — put downward pressure on interest rates as they fight to attract borrowers.

And here’s where the Fed’s plans got a little less orthodox.

The Fed lacks the legal authority to pay these lenders a minimum interest rate on deposits, as it does to the banks. But two years ago, Lorie Logan, one of Mr. Potter’s top aides, suggested the Fed could achieve the same goal by borrowing from these companies at a minimum interest rate.

The resulting deals, known as overnight reverse repurchase agreements, signal a significant break from the Fed’s history of working through only the banking industry.

“We’re pushing more activity out of the regulated banking sector, and so monetary policy has to take account of the unregulated sector,” said Jon Faust, an economist at Johns Hopkins University who until recently served as an adviser to Ms. Yellen, and before that to her predecessor, Ben S. Bernanke. “The world is changing, and I think the bigger risk is not changing along with it.”

When liftoff arrives, however, the Fed plans to place this machinery inside the familiar language of the old system. It is likely to announce that it is raising the federal funds rate, the interest rate that banks pay to borrow reserves, from its current range of 0 to 0.25 percent to a new range of 0.25 to 0.5 percent. The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tools.

Mission Control

On weekdays at about 12:45 p.m., the New York Fed’s trading portal, known as FedTrade, plays three musical notes — F-E-D — signaling that Mr. Potter’s shop is open for business. So begins another day of training camp, another test of the Fed’s plans to borrow money from nonbank financial companies.

The Fed’s traders sit at terminals in a converted conference room. Along one wall are five chairs and five sets of computer monitors beneath five historical photographs of the trading desk: men answering phones, men writing bids in chalk on a long board and, in the most recent photograph, from the 1980s, a glimpse of a woman in the background. On another wall is a screen that links the room in New York by videoconference with a backup trading room at the Chicago Fed.

Potential lenders — a preapproved group of 168, including a bevy of money market funds and the housing finance companies Fannie Mae and Freddie Mac — have 30 minutes to offer the Fed up to $30 billion each. At 1:13 p.m., a warning message starts blinking red. At 1:15 p.m., the Fed closes the auction and accepts up to $300 billion in loans at an interest rate of 0.05 percent.

During two years of experiments, the Fed team has adjusted the rates it pays, the amounts it accepts and the time it enters the market, among other variables. Mr. Potter and his lieutenants have also held lunch meetings with investors on the other side of the portal to solicit advice and complaints.

The size of the program poses the most obvious risk. Fed officials limited daily borrowing to $300 billion because they didn’t want to freeze more money than necessary. They also worry about exacerbating market downturns by giving investors a new place to flee. These concerns were heightened by reports that some investment companies were interested in creating money market funds that would be advertised as the safest place to park money — because the money would be parked at the Fed.

Last year, at the end of September, shortly after the cap was imposed, lenders offered the Fed $407 billion on a single day. Demand was so high that instead of asking for interest, some lenders offered to pay the Fed to take the money. The Fed ended up borrowing at zero percent and turning away $107 billion in loans.

A cardinal rule of central banking is that you don’t starve financial markets during panics, and the Fed has been leaning in the direction of doing more. It has already announced that it is willing to borrow at least $200 billion through a parallel program at the end of September this year, for a total of $500 billion. It has also suggested that it may raise the cap during liftoff. “My sense is we’re better off making sure we can maintain control,” James Bullard, president of the St. Louis Fed, said in a recent interview.

Unpredictable Reactions

“This is where the nutty people on the bond-trading desks have control,” joked Alan Blinder, a former Fed vice chairman, when asked if the Fed’s plan would work.

Mr. Blinder’s point was that markets ultimately determined the cost of borrowing money, particularly for longer-term loans like mortgages and corporate bonds. The Fed can be precise in its planning, but the market is unpredictable in its reactions.

Fed officials have emphasized that they do not want the liftoff to surprise investors. “This has probably been the most telegraphed 25-point rate hike in history,” said Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn. “I think when they actually do something, it will be more of a nonevent.”

But there are at least three reasons markets are becoming less predictable.

The rise of an interconnected global financial system has weakened the Fed’s influence over interest rates. When the Fed last raised short-term rates, beginning in 2004, officials were surprised that long-term rates failed to rise because foreign money was pouring into the housing market and other domestic investments. This time, there are plenty of warnings that the weaknesses of other developed economies could once again make it harder for the Fed to raise domestic interest rates.

“Financial market conditions have come to depend increasingly not only on developments at home but also on developments abroad,” William C. Dudley, the president of the Federal Reserve Bank of New York, said in a February speech in which he cautioned the Fed’s control over those conditions had been “loosened.”

The Fed’s audience also increasingly consists of computer programs that will start buying and selling securities before people have time to read the first words of the Fed’s policy statement, creating the potential for new kinds of chaos.

On Oct. 15, for example, automated trading programs drove up the price of 10-year Treasuries in a burst of buying so intense that a government report later found the machines bought more than 10 percent of the securities from their own firms. Then, just as quickly, the computers turned around and drove prices back down.

The 12-minute spree was among the largest price movements ever seen in one of the world’s most liquid markets, yet the government report found no clear cause.

Finally, investors say regulatory changes are keeping some large traders on the sidelines, making it harder to buy and sell, even in the highly liquid market for Treasuries. That can exacerbate market movements because when people are in a hurry to buy or sell, they tend to chase the best available offers. “The depth of the market is not what it used to be,” said Tad Rivelle, chief investment officer for fixed income at TCW, a Los Angeles investment firm that manages some of the world’s largest bond funds. “You can get the same trades done, but it takes more time.”

Other observers, however, urge a broader perspective.

“People are very concerned about those 12 minutes last year,” said Mr. Cecchetti, now a professor of finance at the Brandeis International Business School. “I’m very reassured by the fact that there were only 12 minutes.”

Moreover, Mr. Cecchetti said that removing some liquidity was a good thing because much of that liquidity was a result of public subsidies for the banking system that had encouraged undue risk-taking.

“Does it mean that there’s going to be more high-frequency volatility? Sure,” he said. “It means the Simon Potters of the world are going to have to be much more careful about what they’re doing. But that seems to me to be kind of O.K.”

Volcker’s Messy Lesson

Mr. Potter has worked at the New York Fed since the late 1990s, but he spent most of his career there in the research department before taking over the markets desk in 2012. He became more involved in the practical side of the Fed’s work during the financial crisis. In a 2012 speech at New York University, Mr. Potter said the experience — particularly during a four-week period at the peak of the crisis — had impressed upon him the limits of theory, the need to understand what investors are thinking and the value of flexibility in policy making.

“For economists who did not have the opportunity to observe the panic up close as I and most of my colleagues had, the developments in this four-week period must have been bewildering, given how widely events on the ground and theory diverged,” he said.

That perspective may come in handy. The last time the Fed shifted the basic mechanics of monetary policy was in the early 1980s, when Paul Volcker was its chairman. That campaign is remembered as a triumph of central banking. Mr. Volcker succeeded in driving inflation down toward modern levels, ending a long period in which governments had floundered helplessly to prevent rising prices.

But Mr. Faust, the Johns Hopkins economist, says the messiness of Mr. Volcker’s triumph is often overlooked. The Fed’s initial plans did not work and were revised and did not work and were revised again — and still didn’t work.

He said the Volcker episode was a reminder that monetary policy is not figure skating. The Fed is likely to flail, he says, but it will be measured by its success in getting interest rates to rise, not by the grace of its performance.

“If you’re into the internal plumbing, I suspect there will be times when that looks messy because this is new,” Mr. Faust said. “But central banks can raise interest rates, and they will. And as long as that happens, from the standpoint of the broader economy, everything is fine and the rest will be forgotten or become a footnote of history.”

Source: http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.htmlhttp://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html

Fed risks using wrong tool to tighten

The Federal Reserve has been sending strong signals that it is preparing to raise interest rates for the first time since 2006. As the Fed prepares for lift-off, its operational framework and large balance sheet may pose challenges to market functioning.

The Fed’s balance sheet has increased from roughly $1tn at the end of 2007 to well over $4tn at present. This stems from about $3.4tn of purchases of US Treasuries and other bonds under the Fed’s quantitative easing programmes. This took such assets out of market ownership to reside on the Fed’s balance sheet.

This is important because market interest rates are effectively determined in the collateral market, such as the repo, or repurchase market, where banks and other financial institutions exchange collateral (such as US Treasuries, mortgage securities, corporate debt, equities) for money.

Financial agents that settle daily margins may post cash or collateral; this forms the core of the financial plumbing. Such “pledged” collateral is generally received by banks not only via repo markets but also from securities lending, prime brokerage agreements with hedge funds, and derivative positions. The largest suppliers of pledged collateral are hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The repo rate is an important market signal and should move in tandem with the fed funds rate; hence the need to have good plumbing.

In 2007, the collateral market was $10tn in size; now it is only $6tn. A further reduction lies ahead, threatening to rust the financial plumbing, as the Fed prepares to raise interest rates.

There are two ways the Fed can tighten monetary policy to control interest rates once it has raised them. The first is to use and expand its so-called reverse repo programme, which soaks up large sums of money from non-banks such as money market funds, but does not release collateral from the Fed’s balance sheet back into the market.

The second is to sell US Treasuries, which similarly mops up cash while also supplying collateral.

The reverse repo programme is currently capped at $300bn per day, but the Fed may raise this cap to ensure reverse repos mop up enough cash to maintain a floor on interest rates. Reverse repos work by persuading non-banks to remove dollars deposited with banks and place them with the Fed, in exchange for collateral such as Treasury bonds. So the Fed becomes the new counterparty to the non-bank, while the bank gets “balance sheet space” as the deposits move to the Fed.

Crucially, this process does not release collateral to the market as the operational structure of the reverse repo facility puts practical restrictions on the reuse of collateral. Thus, none of the collateral within the reverse repo programme can be used to post at central clearing houses, in the bilateral derivatives markets, in the bilateral repo market or delivered against short positions.

The consequence of a sizeable reverse repo programme would be that money becomes scarcer as it is drained from the market, thus raising the repo rate, while collateral becomes proportionately more abundant and therefore cheaper. Thus, by targeting the size of the programme, the repo rate can be made to track the fed funds rate; however, this will result in the repo rate not being a market rate.

A better option would be to keep the reverse repo programme size at its present level and sell US Treasuries . These bonds could be sliced and diced for repos and related collateral usage. While the Fed can control the amount sold, collateral gets reused, which is not under the Fed’s control, so the repo rate may not equate to the fed funds rate. However, selling of US Treasuries can be fine-tuned, to reduce a large wedge between two rates.

It is crucial to ensure that the market plumbing does not get rusty through the use of a large reverse repo programme. A deep and liquid collateral market provides price signals (like the repo rates) that would be weaker under a large programme.

For effective monetary policy transmission, all rates should move in sync with the fed funds rate and this requires good plumbing.

Manmohan Singh is the author of Collateral and Financial Plumbing and a senior economist at the International Monetary Fund; views are his own and not those of the IMF

Source: http://www.ft.com/intl/cms/s/0/0d72eaa8-885f-11e5-9f8c-a8d619fa707c.html

China economics

China’s economy has always been a knotty issue. Assessing what is going on in a real economy with more than 1bn people is not easy. On Thursday, the central bank cut interest rates for the second time in two months. The benchmark lending rate will be lowered by more than the deposit rate and banks have the option of offering loans at a bigger discount to that benchmark. This is about boosting lending and should in principle be good news for investors in commodities.
But the reality is that demand for commodities and machinery this year has not been about end use. China’s copper imports surged by more than half in the first five months, and steel demand was robust. Yet industrial production growth slowed to just 10 per cent. Soya bean imports were strong at the same time as consumption growth moderated. Both trends are due to the fact that anything with monetary value that can be stored has been used as collateral to secure loans. Traders have then fed those funds into the shadow banking system to be lent out over the short term for higher returns.

 

 

Construction machinery makers such as Zoomlion and Sany Heavy have felt the impact of these trends. Despite the slowdown in fixed asset investment, their sales are soaring. Cash-strapped customers need machines for collateral to secure loans just to stay afloat. Half of the machines Zoomlion sold (on credit) in the first quarter have never been turned on, Jefferies notes.

The need for short term financing also shows up in the mix of formal lending. While total loan demand has not fallen, it has shifted to short-term borrowing. Industry is using short-term money not for productive investment but to roll over debt and fund working capital. This is not sustainable.

As interest rates moderate and access to loans from the formal banking system improves, China’s commodity carry trade is becoming less attractive. The peculiarities of commodity demand in China mean that looser monetary policy can never be a buy signal.

Source: http://www.ft.com/intl/cms/s/3/fd9c2206-c076-11e1-982d-00144feabdc0.html#axzz1zrglDctg

Sovereign bonds: Oat cuisine

FIFTEEN years ago Western government bonds were regarded as being like porridge: stodgy but easily digestible. Investors knew returns would be modest but perceived the asset class as risk-free, an important concept in both financial theory and portfolio construction. And bond markets were seen as all-powerful, capable of imposing discipline on governments by pushing up borrowing costs in the face of irresponsible policies. James Carville, an adviser to President Bill Clinton, spoke with awe of their intimidatory power.

Things are different now. The bond vigilantes seem less frightening. They were asleep at the wheel as debts mounted in the euro zone, waking up in time to provoke the latest crisis but not avoid it. Private-sector bond investors in Greek sovereign debt face losses of around 70%, making the idea that government bonds are risk-free laughable.

The most powerful investors in many government-bond markets are not profit-maximising fund managers but central and commercial banks, which are buying bonds for all sorts of reasons. Other investors need to be like Kremlinologists, guessing what central banks will do next.

The market is also much bigger than it was. According to Bank of America Merrill Lynch, there were some $11 trillion-worth of government bonds in issue at the end of 2001; by the end of 2011, that figure had risen to more than $31 trillion (see chart 1). And although some euro-zone countries have been cut off from the markets, the story is very different in other places. The British and American governments are enjoying the lowest borrowing costs they have seen for decades, despite big deficits.

The implications of all these changes are still being worked through. The risk-free rate has historically been the rock around which a financial system is built. Other borrowers, such as banks and corporations, pay a premium over their domestic government’s cost of debt. This is still true for companies that are tied to a local economy, such as utilities. But multinational firms can, in theory, move to economies where growth prospects are better and taxes lower. Some, such as Johnson & Johnson or Exxon Mobil, may thus now be seen as better bets than their governments.

Thanks to the European Central Bank’s lending activities, banks in several European countries can also now borrow more cheaply than their governments—a heavy irony given that it was the banking sector’s problems that ushered in the current sovereign-debt crisis. Indeed, investors have learned that simply studying the ratio of government debt to GDP is not enough. Both Ireland and Iceland entered the crisis with very low ratios. But the collapse of their banking sectors meant that private-sector debt was assumed by the government, causing the ratio to balloon.

Modern bond investors have to worry about other contingent liabilities, too—the pensions promised to public-sector workers, say, or the rising costs of Medicare as America’s baby-boomers retire. Governments might easily decide that such promises have a better claim on tax revenues than the rights of foreign creditors. The negotiations in Greece have shown that official creditors deem themselves to have a greater claim on a government’s revenues than private-sector creditors. The more official aid a country receives, the bigger the eventual write-off private bondholders may suffer.

The rise of official creditors is not new. It was first noticed in the 2000s when Asian central banks began to plough their massive foreign-exchange reserves into Treasury bonds. Alan Greenspan, the then chairman of the Federal Reserve, talked of the “conundrum” that bond yields were falling even as the Fed was pushing up short rates, a shift from the usual pattern.

The reason was that central banks were pretty indifferent to low yields, being content to park their reserves in the relative safety and liquidity of Treasury bonds as a way to manage their currencies’ level versus the dollar. More recently, central banks have been buying up their own government’s debt through quantitative easing (QE). It is debatable whether yields are set by economic fundamentals or by the anticipated buying patterns of central banks.

Of course, central-bank policy has always had an effect on the bond markets. One way of viewing long-term bond yields is as a forecast of future short-term rates (sometimes there is an additional premium for tying up your money). On that basis, says Eric Lonergan, a fund manager at M&G, the current level of Treasury-bond yields is quite rational. The average of American short rates over the past ten years is around 2%, almost exactly the level of the ten-year Treasury-bond yield now.

Rates are likely to remain low for some time. The Fed recently indicated that it expected rates to stay near zero until late 2014. Add in the effect of QE and the Fed may be the dominant influence on yields all the way out to bonds with maturities of five years. There is talk of a third round of QE from the Fed, and the Bank of England was set to add to its £275 billion ($437 billion) pile of gilts at a February 9th meeting, held after The Economist went to press.

Rates low, bond mountains high

Analysts argue about the precise impact of QE on yields but the presence of an ever-willing buyer must have some effect. In particular, it must make private-sector investors cautious about betting on higher yields. “Bond crashes become very unlikely, unless they are accepted by central banks,” says Patrick Artus of Natixis, a French bank. “Long-term interest rates could remain very low for a long time.”

Less clear is how central banks will ever dispose of these bond mountains. In practice, it makes no difference whether central banks try to sell their holdings or simply let the bonds mature (since maturing bonds have to be refinanced). Either way the private sector will have to absorb the extra supply on top of the new bonds being issued that year. If central banks are correct in arguing that QE has driven bond yields down, then logically a reversal of QE might drive yields up, in effect tightening monetary policy. It may be a long while before the economy is sufficiently robust to absorb the impact. Large central-bank holdings of government bonds may be a semi-permanent feature of the landscape.

Central banks are not the only distorting presence in the market. In Britain pension funds have been eager buyers of long-dated securities as a way of matching their liabilities (a promise to make pension payments for 25-30 years is equivalent to a debt). Since many pension benefits are linked to inflation, this has sparked a particular enthusiasm for inflation-linked debt. Insurance companies are also heavy buyers of government debt, in large part because of solvency requirements that push them into owning “safe” assets.

And then there are the banks. One feature of the early days of the euro was convergence. Short-term interest rates are the same across the zone. Since government-bond yields are related to expectations for future levels of short rates, bond yields equalised across the region. This was immensely beneficial for countries like Italy and Greece, which saw their borrowing costs fall. It also meant that banks happily owned regional, rather than merely national, government-bond portfolios.

Now that trend is reversing. Banks are suddenly conscious of the credit risk involved in holding another country’s bonds. When the crisis broke French banks were “encouraged” to hold on to their Greek bonds by their government and suffered losses as a result. Now it seems they are willing to buy only their own government’s bonds, and those of Germany; they are far less keen on holding Italian or Spanish debt. “It is almost if the euro zone has already broken up,” says Andrew Balls of PIMCO, a fund-management group.

Domestic banks, however, may well figure that holding the debt of their own sovereign is a “double or quits” bet. If their government defaults the banking system will collapse anyway, so they might as well own its bonds. That incentive has been reinforced by the ECB’s provision of virtually unlimited three-year loans. As President Nicolas Sarkozy of France has hinted, banks can borrow cheaply from the ECB and invest the proceeds in government debt, earning a higher yield in the process.

This is an approach to boosting bank profitability that has been tried before. In the early 1990s the Federal Reserve held rates very low (by prevailing standards) to help the banks recover from the savings-and-loan crisis. Banks were able to earn a “carry” by borrowing at 3% and buying ten-year Treasuries yielding almost 7%.

The carry trade is not the only reason why banks might buy government bonds. In the wake of the 2007-08 crisis, when banks were suddenly cut off from the wholesale markets, regulators have been urging banks to own a “liquidity cushion” of safe assets. Banks can use government bonds as collateral for loans with each other, and with central banks.

The result has been a big expansion in banks’ sovereign-bond purchases, very handy when governments have lots of bonds to sell. In Britain, data from the Debt Management Office show that banks and building societies owned just £26 billion-worth of gilts in the last quarter of 2008; by the end of 2011 they owned £131 billion, or around 10% of the total (see chart 2).

How would you like your loss?

The role that credit risk is now playing in the euro area highlights another great change in the government-bond markets: the influence of exchange-rate regimes. For decades countries struggled to cope with the constraints of fixed exchange-rate systems, whether the gold standard or Bretton Woods, in part because this approach would reassure foreign creditors. “Who would be prepared to lend with the fear of being paid in depreciated currencies always before his eyes?” asked Georges Bonnet, a French finance minister of the 1920s.

But the euro crisis has shown the perils for international investors of a fixed-rate regime. Denied the option of devaluation, Greece is being forced, in effect, to default on its debts. In contrast America and Britain, with their floating exchange rates, have the freedom to expand their money supplies and depreciate their currencies. Although this may still result in losses for foreign investors, they are likely to be far smaller than the Greek write-offs. As Mr Balls puts it, countries with floating rates are the “least dirty shirt” in the markets.

Emerging markets have also changed their role. Historically, developing countries defaulted often and had high inflation. They had to borrow in dollars and to pay high yields. But now the finances of many developing countries are better than those of the rich world (see chart 3). Brazil and Mexico pay yields of less than 2% on five-year dollar-denominated debt.

It all adds up to a completely changed investment landscape. For the 25 years from 1982 to 2007, owning rich-world government bonds was almost a no-brainer. Yields fell steadily in line with inflation and there was no question of default. Now the market is much more complex. The players are more diverse and their motives more varied. The balance between risk and reward has also shifted against investors. In the past bondholders have not made money buying Treasury bonds on yields as low as 2%. At current levels of inflation, bond investors are getting negative real yields.

That may be the idea. Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia, three academics, have suggested that governments may use “financial repression”—forcing debts down the throats of captive buyers and keeping real rates negative so that inflation eliminates their debts. This trick worked after the second world war. The presence of “forced buyers” in the market such as central banks and commercial banks may enable it to be repeated.

But could governments really pull it off? Or are rich-world bond markets signalling that Japan is the more likely template? Ten-year yields there have been around 1% for much of the past decade, thanks to persistent deflation and slow growth.

This is a vital issue since a sudden surge in bond yields might wreck government finances, economic prospects and the outlook for other asset markets. “The unknown question is how much inflation central banks are willing to tolerate. Until that is settled, one cannot be sure about the outlook for bonds or other asset markets like equities,” says Manoj Pradhan at Morgan Stanley. For a supposedly risk-free asset it all adds up to a lot of risks.

Source: http://www.economist.com/node/21547245

Hose and dry: The ECB fills banks with funds

WHEN economists think of the financial system, it is usually as a frictionless conduit through which money flows to areas of the economy where it is most needed. A better analogy right now might be of a hosepipe with a knot tied in it. The European Central Bank (ECB) is pumping unprecedented amounts of money into one end of the pipe, but how much of that will find its way to the parched real economy is another question entirely.

Start with the liquidity flowing into the euro-area banking system. On December 21st the ECB made available an eye-popping €489 billion ($628 billion) in three-year loans to more than 500 banks across Europe. The money was released in response to an almost total freeze since July in the bond markets that are an important source of long-term funding for banks. Demand for this ECB funding was much higher than expected, signalling just how much stress there is in the system.

The ECB had previously tried to ease pressure by offering one-year loans to banks. Yet this had done little to encourage them to lend to companies or people, since the money banks owed the ECB would have to be repaid before they were due to be repaid by their customers. A shortage of longer-term funding also contributed to an increase in the riskiness of the whole financial system, since banks were being forced to rely ever more on short-term financing that needs to be rolled over.

The flood of money being pumped into banks by the ECB goes a long way towards easing these funding pressures. Analysts at Morgan Stanley, an investment bank, reckon that the new facility adds about €235 billion in additional funding to the banks (since some of the money is being used to replace shorter-term loans) and takes the central bank’s total lending to the banking system to €979 billion. More important is the fact that it only has to be repaid in three years, which takes the average maturity on ECB loans to about 21 months, up from a mere ten weeks before the auction.

This should help insulate most large banks from turmoil in the funding markets. But not all will be protected. Although the ECB has essentially made an offer of unlimited funds, banks are still constrained in how much they may borrow by the quality of the collateral that they are able to hand over. This is because their collateral is subject to an initial “haircut”, or reduction in value. A portfolio of relatively safe government bonds might attract a small haircut, whereas one consisting of loans to small businesses might be reduced in value by 40% or more. A bank focused on this area of business, as many of Europe’s smaller savings banks are, might thus only be able to borrow 60% of the value of its outstanding loans.

A second constraint is that if the collateral the ECB holds falls in value, then banks need to post more. This also happens if there are credit downgrades on the bonds posted as collateral. The ECB’s haircut on sovereign bonds that are rated above “A-” is just 1.5%, but if they fall another notch this jumps up to 6.5%, Morgan Stanley notes. Weak banks in peripheral countries remain vulnerable to a downward spiral in which their holdings of government bonds are downgraded and fall in value, forcing them to come up with ever more collateral to keep borrowing from the central bank. It was this sort of collateral spiral that felled MF Global, a bust American broker, in its ill-fated bet on euro-area government bonds.

Now that banks are getting funding, the big worry is whether they will do more than merely hoard it. The early signs are not encouraging. Over the Christmas weekend bank deposits at the ECB rose to a record €412 billion. That partly reflects a traditional year-end rush to tidy up banks’ balance-sheets but also nervousness about lending directly to others.

Banks also have to present plans in January showing how they will raise an extra €115 billion in core capital to meet a new threshold imposed by the European Banking Authority. This capital shortfall has already prompted asset sales by banks, which would rather shrink their balance-sheets than tap shareholders. The ECB’s auction may make a credit crunch less severe, but it is not enough to avoid one.

Source: http://www.economist.com/node/21542187

Banks in Italy Find an Unusual Liquidity Lifeline

LONDON — The London Stock Exchange is becoming the lender of last resort for many banks in Italy as concerns over the country’s debt levels squeeze liquidity out of the Italian financial market.

With cash increasingly hard to come by, Italy’s banks are turning to CC&G, the exchange’s Italian clearinghouse, for short-term lending. That includes some of the country’s largest financial institutions, including Unicredit and Mediobanca, according to a person close to the situation.

While just two banks received short-term capital from CC&G in 2009, that number has now risen to 15 — half of them Italian and the rest European financial institutions that trade in the country.

Under terms of the deals, the clearinghouse, which acts as a middleman to guarantee trades between financial parties, is offering money to both Italian and European banks with a presence in Italy for up to three days.

The money, which comes from collateral that traders must put up to complete financial transactions, is deposited with the banks to cover shortfalls in liquidity. CC&G earns a profit by charging banks interest on the money that they borrow.

Previously, banks had used the so-called repo market, where banks lend capital to each other on a short-term basis, to meet their financing requirements. But fears about Italy’s ability to repay its debts has pushed up borrowing costs and reduced the ability of banks to access that market.

A spokesman for the exchange said the company was in close discussions with the Italian central bank about any potential problems in the country’s financial sector, and used stringent risk management to decide whether to give banks access to capital.

CC&G also doesn’t technically lend money to banks, but instead deposits the cash with them on a short-term basis. Under Italian law, this distinction makes CC&G a depositor with the banks, and places it ahead of other creditors looking to get their money back if any financial institution should fail.

The legal distinction may still leave CC&G exposed if a lender defaults. And analysts question the sustainability of lending to struggling banks. That’s particularly true as the collateral offered to institutions as short-term financing is often provided by the same bank’s separate trading operations.

Paul Rowady, senior analyst at financial consultancy TABB Group in Chicago, said the global squeeze on liquidity was forcing institutions to look elsewhere, including to clearinghouses, to meet their short-term financing commitments.

He added that central clearing parties might feel secure in lending to banks because it was on a short-term basis and they were eager for extra revenue.

“Financial entities are making money in new and different ways,” he said. “Just because times are bad doesn’t mean they’re not looking for profits.”

And Italy’s turmoil has been good business for the London Stock Exchange. According to the exchange, CC&G reported a 209 percent jump in income to £54.3 million, or $83.6 million, during the first half of the year, compared with the same period in 2010.

The Italian business now represents 14 percent of the exchange’s overall income, compared with just 5 percent in the first half of 2010.

Source: http://dealbook.nytimes.com/2011/11/17/banks-in-italy-find-an-unusual-liquidity-lifeline/