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Will the Expected End of QE Lead to a Bond Meltdown?

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Yesterday, bonds fell sharply due to stronger-than-expected housing price and consumer confidence reports. That reflects the belief that the economy is mending, and as a result, the Fed will deliver on its promise to dial back and then end QE. Ten year Treasury yields rose to the 2.10%-2.11% level. Various commentators claim that rates will zoom higher either right over that point or at 2.25%. Russ Certo of Brean Capital claim’s there’s a “technical vacuum” at 2.11% that will lead 10 year rates to gap up to 2.25%. And Bruce Krasting wrote over the long weekend about an apparently widespread concern among investors, that convexity in mortgage-backed securities market could produce a nasty feedback loop, or convexity vortex, at 10-year Treasury yields of around 2.25%.

The guts of his argument, starting with a quote from a hedgie buddy:

Some familiar with it say the vortex is 19 bps away..2.2% on ten year treasury, 3% on the CMM..if breaks, MBS holders subject to extension and duration risk. Would now have to increase convexity hedging. Would lead to price gaps and significant selling. With shortage of treasuries due to bernank and co. and low liquidity, could be very disruptive.

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries (ten-year paper). The higher rates go (and the speed that rates are increasing) forces more and more of the convexity selling.

Krasting did say this source was a perma bond bear, so he consulted a perma bond bull, who remarked:

I don’t disagree – I would guess we have a huge concentration of mortgages that would go out of the money at 2.25% 10yr UST, slowing prepays, extending servicer portfolios, bringing on longer duration UST selling ……

So we have bulls and bears agreeing. Must be true, right?

Maybe not. First remember we’ve had some dire bond market calls in the past produce some short term perturbations but none of the expected follow-through. The freakout over the S&P downgrade of US Treasuries saw the bonds increase in price shortly after the event took place. Reader AU, commenting on the Krasting post, recalled November-December 2010. The QE2 FOMC meeting coincided with the midterm elections, and bond prices fell in the following weeks. There were similar concerns that convexity would beget more selling, but after the correction, prices settled down.

I consulted our house mortgage maven, MBS Guy, who was skeptical of the convexity-driven meltdown thesis:

Vortex is a great fear mongering word. But a few basis point move just isn’t that severe in any scenario. Yes, some bonds will go down in price and that will cause portfolio shifts. That’s really pretty normal. Investors aren’t guaranteed falling rates forever.

Also, the key to really answering this question is knowing how much MBS was issued at the lowest rates and what percentage this represents of total outstanding. I believe it is probably less that 10% – I don’t have the numbers but every research desk on the Street does.

As a note, I’ve always been a skeptic on the risks of MBS convexity. I think it is one of the great exaggerated risks of the market the fear of which is based largely on the Fed rate raising episode of 1994.

Three factors that will be some counterweight to a slowdown in rate-refi’s:

1. Home purchases are increasing, and if refi’s slow, banks are very likely to loosen underwriting to increase originations. New purchases aren’t likely to be enough to offset the refi slowdown, but enough to change the dynamic Krastinh is describing.

2. As property values increase, more borrowers will be above water again, which will allow them to finally refi at more attractive rates providing a counterbalance to in the money refi’s

3. There’s a $900 billion or so non-agency market that is far more credit sensitive than rate sensitive. Much of this market is adjustable rate, and most pays at above market margins. In theory, these bonds might even increase in value if refi’s slow down (although the prepay rate has been very slow for these borrowers already).

I would note also that this stuff really highlights how unnatural the 30-year fixed rate mortgage is. I don’t see why we should be working so hard to perpetuate its existence when it is the cause of so much potential instability.

Marshall Auerback also pointed out that the danger isn’t the Fed but the state of the economy:

The real problem is the withdrawal of fiscal support. If the market begins to fall, everybody will say that this has been exacerbated by the threatened end of QE, even though I think it is more to do with the sharply declining US budget deficit, which is sucking more and more income out of the US economy.

The impact of QE is more ambiguous: To reiterate what I have said many times in the past, quantitative easing involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly. So it’s unclear to me that it’s had any kind of beneficial impact and, to the extent that it has engendered risk speculation in the commodities complex, it’s actually derogated from economic growth.

Now some readers may point out that Wall Street was all agog over the data releases on Tuesday, and therefore Marshall’s concerns are overblown. But go look at them more closely. Even though consumer confidence spiked higher, it’s now up to 76, with 100 as the base line from 1985. I have got to tell you 1985 was not a hell-bent-for-leather economy. In fact, Reagan broke with his free market ideology that year to press for the implementation of the Plaza Accord to tank the yen and help American manufacturers. And if you look at the component of consumer confidence, more people expected the number of jobs to decrease rather than increase, saw business conditions as poor rather than good, and saw jobs “hard to get” rather than “plentiful”. The only area where sentiment was net positive was on income expectations, where the proportion expecting gains in the next six months was 16.6%, versus the 15.3% that anticipated a decrease.

Similarly, even though the year-to-year gains in the Case Shiller index exceeded 10%, there are two things to keep in mind. First is that buying is concentrated in low-priced homes (and at least in NYC, we are also getting tail-winds from foreign investors, as the Russians in particular are loath to buy in Europe with austerity creating political instability). I heard a report from a gent in Atlanta who had a lovely-sounding home in Atlanta (on a golf course, great condition) that all of one person had looked at in its full year on the market. He said everyone wanted to buy out of foreclosure. Second, even though housing is relatively strong, it’s still not at an absolute level that is robust enough to drive a recovery as it has in the past. And Scott asks how does one reconcile a housing rally with falling lumber prices?

So while Krasting argued that the vortex risk might not be as severe as imagined because the Fed would resume QE if the bond markets became unhinged, you may see the Fed resume QE (assuming it does wind it down sooner rather than later) because it realizes it has misread the real economy. The central bank seems to be suffering of a combination of confirmation bias (needing to believe its patent medicine is actually working) and concerned about political blowback if it does not seem keen to unwind QE (even though Audit the Fed was cut back from its original scope, it still got further than the Fed liked, for instance). Of course, it is also possible that the Fed is playing the same game that Penelope played with her suitors, pretending action is imminent and keeping them drunk in the meantime. And perhaps nervous investors are channeling this myth, since her paramour-wannabes got slaughtered for taking advantage of her hospitality for so long.

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58 comments

  1. 4D

    I can’t comment on the specifics of treasury market convexity, but I would argue global financial markets are all essentially short volatility and heading into a major gamma spike.

    They talk about the Fed put, but its suddenly dawning that its the Fed that’s going to be doing the putting, and the markets know the expiry just got a whole lot closer yesterday.

    On the 10-year yields they are at a 14-month high, and the two-year top is 2.45, so it wouldn’t be at all surprising if there was indeed a huge convexity here.

    1. 4D

      Apologies for replying to myself,but the more i think about it in option terms, the scarier it looks.

      The “Fed put” from QE is actually a step-up risk reversal with an indefinite expiry, but one that has to come sooner rather than later.

      The Fed official’s softening up the market to the prospect of tapering has now pushed the markets into the foothils of that gamma spike. As data gets better bond longs have to hedge for a move higher until the point data deteriorates again, then it will swing back again, whiplashing them again. That is convexity.

      If the data stays strong bond selling might be orderly, maybe not, but higher rates sure won’t be good for stocks in the longer run.

  2. vlade

    The big question, which I saw asked only at FTA in relation to Japanese banks (but we’re all Japanese now) was what would rates going up do the VaR limits of various desks.

    VaR methodology (unless implemented carefully) can be sensitive to the levels of rates. Extremely simplified (but likely true for quite a few second/third tier banks), you can have either relative or absolute size shocks in VaR. Relative shocks work well for low rates, absolute work well for high(er) rates. If you try to go relative in high rates, you’ll get VaR breaches and vice versa (not to mention the havoc it can play if you do inflation VaR, or in general have rates that can go negative).

    Depending on how VaR is implemented, even a slow move upwards could mean VaR limit breaches meaning that desks would have to reduce positions – not at exactly the same time all of them, but give or take.

    Note: I’m not going to discuss VaR per se, whether it’s good bad or ugly. It’s there right now, and will play role in bank’s reaction function and that’s it.

  3. Can't Help It

    Same horse show. The market will drop a couple of percent and Hilsenrath or some other Fed goon will step up to the podium and say something equivalent to “we are going to keep this going forever”. Market will rally. Rinse and repeat.

    1. Jim Haygood

      Probably so. Sentiment toward bonds is negative enough now to fuel a contrarian bounce. The inflation guy, Mike Ashton, thinks the alarms are overblown:

      William Dudley, president of the NY Fed and probably the second most-powerful voice at the Fed, said that the decision to taper will take three or four months. If Dudley is talking in terms of 3-4 months to even decide on a taper, and some meeting participants are still questioning whether more asset purchases could be warranted, there’s simply no reason to be concerned about a change in policy for quite a while.

      It is not at all clear to me that a taper will even be announced in 2013, much less effected.

      Now, the sad part of all this is that the Fed’s unwind plan simply isn’t going to work to restrain inflation. Remember, draining excess reserves should have no effect at all on the supply of transactional money (e.g., M2).

      The Fed needs first to drain something like $1.6 trillion in excess reserves (I have kinda lost track) before their actions have an impact on a variable that matters. Simply wanting to restrain inflation isn’t enough.

      http://mikeashton.wordpress.com/

      Meanwhile, Barclay’s index of the 10-year T-note total return has dropped 3.42% since the end of April, representing a capital loss of two years worth of interest income so far this month. Shame about the widows ‘n orphans …

    2. jake chase

      All the talk summarized in this post comes from gamblers playing with other people’s money and using enormous leverage to eek out a few basis points of profit on the funds they run (and outsized bonuses for themselves). Such people always sound highly intelligent, right up to the minute before the shit hits the fan and wipes them out.

      1. monday1929

        Jake cuts to the chase, as usual. The CRASH will be refreshing if only for its capacity to unmask the “sophistication” for what it really is.
        A house of cards, built with a crooked deck, does not depend on “convexity” to fall- a small breeze, already wending its way, will do the trick.

        1. nonclassical

          ..will the CRASH be severe enough to re-set economies??? …doubtful…sooooo…?

          1. psychohistorian

            Some of us are waiting to see BoA go down. Will that happen is this coming round?

    3. DP

      Agree, we’re going to get QE as far as the eye can see. Isn’t the Fed on record guaranteeing ZIRP rates out at least another couple of years? It won’t take much of a rate hiccup to make it evident again that the notion of an economic recovery is an illusion.

  4. George Hier

    I’m sorry, can someone link me to a good primer on Treasury yields? I thought I was decently read up on things like derivatives and overleveraging and so forth, and now all of the sudden the phrase of the day has switched to “10 year Treasury Yields” as the thing to watch. And I’m just kind of left in the dust scratching my head, wondering what everyone knows that I don’t. I mean, granted, it’s been a couple years since that high school micro and macro econ class, but I’m way out in left field wondering if everyone else is playing a different sport entirely.

    A google search for “us treasury 10-year yields” brought up this page from the US Treasury, and I notice that the 10-year column is indeed making quite a noticeable trend for the last month. But then I start pulling up previous years, and the humdrum economy of 2003′s got numbers around 4.00, and 2001 is mostly above 5.00, and happy tech bubble time 1998 is around 5.50 . So what’s so disturbing about the numbers going from 1.60 to 2.15? Why is 2.25 so pants-wettingly terrifying? Am I missing something here?

    1. financial matters

      Good question. A similar one was why did a 10% correction in housing prices in 2007 lead to the global meltdown that we are still suffering from. A lot of these rates are hugely leveraged with derivative bets. An increase in interest rates on the ten-year treasury could be helpful to keep money market funds afloat as it is difficult for them to go out and find safe positive yield. But with the complex derivative market out there it’s hard to tie the economy into fundamentals.

    2. Moneta

      These bonds back derivatives… so if they drop by 4-5%, we can expect margin calls.

    3. Moneta

      We know that margin debt is back to pre-crsis levels… it is fair to expect a black swan to appear out of there….

      OMG, I just used the term black swan… haven’t heard that in a while!

      1. Chauncey Gardiner

        Moneta,

        Re: … OMG, I just used the term black swan.”

        Maybe it’s Ben Bernanke who has been playing 11 dimensional chess: http://seekingalpha.com/instablog/4596961-joseph-stuber/1856021-the-bernanke-agenda-it-isn-t-what-you-think-it-is

        Lots to consider regarding the multiple possible purposes that have been and are being served by QE and increasing excess reserves. Of course, there are always sacrificial lambs.

        With respect to your observation about margin debt, some consider it to be a legacy metric. IMO it remains of interest.

        Thanks.

    4. Ben Johannson

      The short answer is we have a professional class of financial hyperventilators jumping on anything that looks like an opportunity to say they were right in predicting doom for the last five years. None of them understand central bank operations and won’t listen if you try and explain it.

      What they don’t get is the Fed is trying to generate expectations of future inflation by allowing some yields to rise (which is what happens in such an environment as the Fed raises the interbank interest rate). Rather than raising yields in response to inflation, the Fed is hoping that reversing the chain of events and raising yields first will create inflation. Which it likely won’t.

    5. nonclassical

      …might be “convexity”, as originally intoned, is at base of…consult Satyajit Das-
      “Extreme Money”…

  5. Eric

    This is all madness.

    As far as I can see this is the worlds biggest gamble. Namely, will QE get to the bottom of the economy and really help the recovery before they have to turn it off. The answer has to be no it won’t. Therefore, the biggest bubble of assets will form both in stocks and the housing market. When the realisation sinks in that real economy has not been helped, then the coming crash will be enormous.

    The Governments will be mired in debt, there will be a huge divergence in the haves and have nots, and I am afraid there will be no hope of a solution.

      1. Richard Kline

        “When the con goes mad, the mad go pro.” Polished that for yah; Anglo-saxon vernacular is relentlessly monosyllabic. And you’ve got it covered pretty well, I’d say.

  6. Moneta

    A few points:

    1. Rates are at all-time lows and the vast majority can not imagine these going up.

    2. This low rate environment discourages long-term planning so if we want any improvement whatsoever, yields must go up.

    3. In this low rate environment, borrowers who have not locked in these low long rates only have themselves to blame and deserve to get pounded.

    4. Bailouts and mispricing of risk will not last forever.

    5. Corporate profits-to-GDP are at historical highs due to multiple factors: all-time low taxes and rates, low wages, low DD&A, etc. They are due to drop and one ore more of these factors will help contract margins.

  7. washunate

    My superficial understanding is that we are bailing out the banksters by lending them money at low rates and then letting them buy treasury securities that pay higher interest rates. Key to this cash flow is the Fed printing lots of money to buy lots of Treasury securities to keep the price high (the interest rate low).

    There’s really no way the Fed can simultaneously end money printing and perform its tasked role of bailing out the banksters. It’s possible the President and Congress could have a change of heart and tell the Fed they don’t need to bail out the banksters, but that wouldn’t be a monetary event.

    That would be a reclaiming of American democracy from the predator class.

    1. Ben Johannson

      QE actually behaves as a tax on those banks. Yes, the banks buy Treasurys, but the Fed then effectively confiscates the bonds so it can dump more reserves onto balance sheets. Last year the Fed returned over $100 billion in profits from purchasing interest-bearing financial assets from banks; that’s $100 billion less in income than they would have earned otherwise.

      1. financial matters

        But about half of what they are buying is MBS. I can understand this as a way to lessen the impact on sovereigns, pension funds, life insurance companies etc who bought these based on their AAA ratings. But as they no longer have these ratings I don’t see how these can be viewed as a high quality asset and just an exchange of financial instruments. It ignores all the fraud that went into creating these securities.

        1. Ben Johannson

          The MBS being purchased are government guaranteed, which makes them as safe as a government security. It has the effect of taking away the higher quality assets and leaving behind the junk + reserves paying out a tiny trickle of interest. Meanwhile the Fed gets the higher rate of interest from the government backed securities it acquires and sends it on to the Treasury. So one part of government pays out to another part of government (instead of the private sector) which transfers that to yet another part of government.

          Warren Mosler argues the Fed is actually stepping on the brakes when it thinks it’s hitting the gas.

          1. washunate

            I hear what you’re saying, but this doesn’t answer the point.

            Government guaranteeing these is the subsidy – it artificially elevates the prices of all related assets. When these agency securities were sold, they were sold as explicitly not having taxpayer backing. Private gain and public pain is the antithesis of good governance.

            Furthermore, the only way for the government to back these is for the Fed to buy them! The whole point is that politicians won’t tax the rich. If they would do that, none of the rest of the three card monte would be needed.

      2. nonclassical

        Ben,

        how can those be “profit$” on triple-quadruple valued “toxic assets”-MBS based upon “paper debt”?…aren’t those therefore “paper profit$”, government (at taxpayer expense) guaranteed full paper valued “paper debt”??

          1. nonclassical

            NOPE-here’s a much more complete list of recipients:

            Citigroup: $2.5 trillion ($2,500,000,000,000)
            Morgan Stanley: $2.04 trillion ($2,040,000,000,000)
            Merrill Lynch: $1.949 trillion ($1,949,000,000,000)
            Bank of America: $1.344 trillion ($1,344,000,000,000)
            Barclays PLC (United Kingdom): $868 billion ($868,000,000,000)
            Bear Sterns: $853 billion ($853,000,000,000)
            Goldman Sachs: $814 billion ($814,000,000,000)
            Royal Bank of Scotland (UK): $541 billion ($541,000,000,000)
            JP Morgan Chase: $391 billion ($391,000,000,000)
            Deutsche Bank (Germany): $354 billion ($354,000,000,000)
            UBS (Switzerland): $287 billion ($287,000,000,000)
            Credit Suisse (Switzerland): $262 billion ($262,000,000,000)
            Lehman Brothers: $183 billion ($183,000,000,000)
            Bank of Scotland (United Kingdom): $181 billion ($181,000,000,000)
            BNP Paribas (France): $175 billion ($175,000,000,000)
            and many many more including banks in Belgium..

            http://www.sott.net/article/250592-Audit-of-the-Federal-Reserve-Reveals-16-Trillion-in-Secret-Bailouts

            Audit of the Federal Reserve Reveals $16 Trillion in Secret Bailouts

            “The first ever GAO (Government Accountability Office) audit of the Federal Reserve was carried out in the past few months due to the Ron Paul, Alan Grayson Amendment to the Dodd-Frank bill, which passed last year. Jim DeMint, a Republican Senator, and Bernie Sanders, an independent Senator, led the charge for a Federal Reserve audit in the Senate, but watered down the original language of the house bill(HR1207), so that a complete audit would not be carried out.

            What was revealed in the audit was startling:

            $16,000,000,000,000.00 had been secretly given out to US banks and corporations and foreign banks everywhere from France to Scotland. From the period between December 2007 and June 2010, the Federal Reserve had secretly bailed out many of the world’s banks, corporations, and governments. The Federal Reserve likes to refer to these secret bailouts as an all-inclusive loan program, but virtually none of the money has been returned and it was loaned out at 0% interest. Why the Federal Reserve had never been public about this or even informed the United States Congress about the $16 trillion dollar bailout is obvious – the American public would have been outraged to find out that the Federal Reserve bailed out foreign banks while Americans were struggling to find jobs.

            To place $16 trillion into perspective, remember that GDP of the United States is only $14.12 trillion. The entire national debt of the United States government spanning its 200+ year history is “only” $14.5 trillion. The budget that is being debated so heavily in Congress and the Senate is “only” $3.5 trillion. Take all of the outrage and debate over the $1.5 trillion deficit into consideration, and swallow this Red pill: There was no debate about whether $16,000,000,000,000 would be given to failing banks and failing corporations around the world.

            In late 2008, the TARP Bailout bill was passed and loans of $800 billion were given to failing banks and companies. That was a blatant lie considering the fact that Goldman Sachs alone received 814 billion dollars. As is turns out, the Federal Reserve donated $2.5 trillion to Citigroup, while Morgan Stanley received $2.04 trillion. The Royal Bank of Scotland and Deutsche Bank, a German bank, split about a trillion and numerous other banks received hefty chunks of the $16 trillion.
            “This is a clear case of socialism for the rich and rugged, you’re-on-your-own individualism for everyone else.”- Bernie Sanders (I-VT)
            When you have conservative Republican stalwarts like Jim DeMint(R-SC) and Ron Paul(R-TX) as well as self identified Democratic socialists like Bernie Sanders all fighting against the Federal Reserve, you know that it is no longer an issue of Right versus Left. When you have every single member of the Republican Party in Congress and progressive Congressmen like Dennis Kucinich sponsoring a bill to audit the Federal Reserve, you realize that the Federal Reserve is an entity onto itself, which has no oversight and no accountability.

            Americans should be swelled with anger and outrage at the abysmal state of affairs when an unelected group of bankers can create money out of thin air and give it out to megabanks and supercorporations like Halloween candy. If the Federal Reserve and the bankers who control it believe that they can continue to devalue the savings of Americans and continue to destroy the US economy, they will have to face the realization that their trillion dollar printing presses will eventually plunder the world economy.”

          2. Ben Johannson

            nonclassical,

            Those monies were loaned under differing programs and facilities. I’m only discussing QE3 here.

      3. washunate

        I’m not familiar with the mechanics and thus am perfectly open to technical explanations that are counterintuitive, but I don’t understand that comment at a conceptual level.

        1. For the Fed actions that buy treasury securities, if the Fed didn’t buy them, then that would end the subsidies to the banks (and defense, healthcare, telco, agribusiness, prisons…). USFG has to expend new dollars, because raising existing dollars to pay for corporate welfare would require taxing the very people on the receiving end of the transfer payments, defeating the whole charade.

        2. For the Fed actions that buy other financial assets (MBS, etc.), the whole point is to pay above market prices. That itself is the subsidy, the externalization of specific fraud onto the general populace so that no one act must face scrutiny or accountability. The very absence of market clearing prices (and proper cost allocation from other government spending) is what allows this to appear, over short periods of time, as if it is profitable rather than a bailout.

        3. For the Fed actions that are longer term, indefinite commitments (guarantees, backstops, implict support, etc.), the costs wouldn’t show up in present accounting, because the government uses a cash based, not accrual based, framework. The very concept of profit doesn’t make any sense, because the revenue and expense categories are not calculated the way that a GAAP public company financial statement would be calculated.

        Just to give a simple example, if you give me $10 and I promise to mow your lawn tomorrow, in cash based accounting, I book a profit (revenue minus expenses) of $10 today. It’s only tomorrow that I have to worry about mowing your lawn.

        It’s precisely when something goes wrong – the cost of renting the lawn mower skyrockets – that I default on my obligation to mow your lawn, give you back the $10 (but not the interest I earned overnight of course), and say good luck. And then lambast you for how wasteful you are with money when it costs you $15 to get your lawn mowed properly.

        1. Ben Johannson

          I believe the confusion rests on the sort of money with which the Fed “buys” those financial assets.

          There are effectively three types of money in the American economy: monies created by banks, monies created by government spending, and monies used for bank liquidity management.

          The third sort are called bank reserves. They are used solely for the purposes of buying government securities, obtaining cash for things like ATMs and clearing of payments between banks (a form of double-entry book-keeping).

          When the Fed wishes to increase the level of reserves in the banking system it must swap them for another sort of financial asset (like Treasurys, corporate bonds, etc). So the Fed acquires those assets on its balance sheet and the banks receive a credit to their reserve accounts. In the current environment banks have $1.5 trillion in excess reserves, money they have no use for (contrary to what many believe reserves are not used for making loans). Banks with these excess reserves must simply let them remain in their reserve accounts on which the Fed pays them a whopping 0.25% interest rate.

          Meanwhile the Fed now holds bonds paying 0.6-2.2% interest and MBS paying out 1-3%. The central bank is swapping its extremely low interest reserves for assets with a greater return and thereby running a profit which it is required to deposit in the Treasury Department’s account.

          1. washunate

            Ah yes, thanks for continuing the discussion. This is definitely where we disagree:

            “There are effectively three types of money in the American economy”

            I would counter that money is a concept, an idea, a mental framework for relating the labor values of otherwise unrelated things and transporting this value across time and space. Money is debt, an IOU, a promise, a claim on this labor. Its implementation in our system of political economy, the dollar, does not have three types. It doesn’t matter whether the dollars are created as coins or pieces of paper or bank reserves or whatever. They are all dollar claims on the productive output of our system.

  8. TomDor

    Bottom Line (well at least to my odd thinking) is: The only time housing is economically wealth creating in the real economy is, when a house is built or is being upgraded in some way — IE: labor is being hired using capital investment.
    If in-place housing is rising in cost, it just does not create wealth — it just means housing is more expensive.
    If mortgages (don’t know what percentage) interest rates are indexed off a 10-year treasury and that rate rises – well, you will have more people paying more money to service this debt – It will leave less money for people to spend into the real economy and demand for other produced items will fall.

    Of course lumber prices are down because, new housing is down – ie: demand for lumber is down. If existing housing stock is rising in cost and real wages are frozen or falling – it just will not work out.

  9. flow5

    Nothing’s changed for 100 years. Bonds fell because the rate-of-change in MVt rose. They will rise after June. They bottom in Oct:

    This is how I forecast AAA corporates in 81 (only using bank debits):

    2013-01 ,,,,,,, 0.025
    2013-02 ,,,,,,, 0.025
    2013-03 ,,,,,,, 0.021
    2013-04 ,,,,,,, 0.021
    2013-05 ,,,,,,, 0.023
    2013-06 ,,,,,,, 0.022
    2013-07 ,,,,,,, 0.018
    2013-08 ,,,,,,, 0.012
    2013-09 ,,,,,,, 0.012
    2013-10 ,,,,,,, 0.011

    It’s a 24 month moving average of the 24 month rate-of-change in required reserves. The caveat is that you average the figures for the same length of time as rates move in one direction & then the other.

  10. Brick

    There is a risk that repo rates will overshoot the interest on excess reserves rate forcing depository institutions from switching liquidity from the Fed to repo markets. This leads to a risk that depository institutions which have been making a nice little earner by buying Fed funds from participants that are not eligable for IOER (GSEs) and parking them at the Fed to earn IOER (This was somewhat curtailed by the FDIC implementation of an expanded assessment base). This would suggest to me that convexity hedging in the mortgage market at QE Exit would not be that much of an issue.
    However I could see the pick up in the repo market affecting the ability (help) for Dealers to sell short on the run treasuries in order to hedge interest rate risk. I conclude in my opinion that you will not get a bond meltdown, but you should expect different maturities along the treasuries curve to respond at different speeds. The long end of the curve goes up first (reducing mortgage rates was after all a key target of QE), hitting the household mortgage market, even if the housing market as a whole is not affected (eventually house price rises of 10% per year without wage increases to match will run out of steam).

  11. Generalfeldmarschall Von Hindenburg

    Regarding housing, I can attest there is a huge glut of McMansions and exurban development that’s deliberately being kept off market to maintain prices. In my market in Oregon anyway. I imagine this phenomenon is common throughout the US

    1. Bruce Krasting

      When did I say anything about a bond market meltdown?

      What I said was that I anticipated a 20bp move in the ten year (from 2-2.2%). We got that on Tuesday.

      A move in the T-bond from 2 to 2.5% is not a meltdown. The meltdwon would happen if the bond moved from 2.5% to 3.5%.

      And just what political bias do I have again?

  12. Malmo

    No way will stocks flourish under a protracted surge in rates. Once stocks begin falling off a cliff in response to rising rates bonds will be bought hand over fist and thus appreciate in price once again. Rinse and repeat. Bernanke is trapped, period.

    1. curlydan

      Agree. The only way I see us leaving ZIRP and permanent QE is a loss in confidence in USTs that not even promises and enticements of QE can cure. Any hints of losses or consternation will be met with the soothing voices from Bernanke or Dudley saying, “hey, ho, wait a minute…we’re not done with QE just yet”

  13. Jackrabbit

    Shouldn’t we be talking about:

    Did the Fed succeed in their great experiment?

    What was the cost (including costs to be borne in the future) of said experiment?

    Did the Fed misled us? (flow NOT stock?; unemployment was going to fall anyway as people fall off the rolls)

    What does the Fed’s failure/success mean for economics? for political economy?

  14. Hugh

    Under our current regime, if the financial economy implodes, it will take out the real economy, but I don’t know that the real economy has all that much effect on the financial economy, except to fournish random excuses for various financial moves.

    QE and ZIRP, for example, have sent the stock market to record levels, but the real economy where most of us live is still in recession. Remember virtually all the gains of the so-called recovery have gone to the 1%, that is the financial side.

    I disagree with most of Auerback’s comment. The Fed is buying securities at a rate of $85 billion a month (or about a trillion a year) with money it is creating out of thin air. And while bank reserves at the Fed have risen sharply since 2009, they have only gone up $800 to $900 billion. So I don’t think it is true that $85 billion just ends up as reserves.

    As for the securities, the Fed is holding, many overpriced as they are, is there any reason the Fed can’t hold them to maturity? In regard to Treasuries, wouldn’t this be a particularly good deal for the government since any money it remitted to the Fed would be surrendered by the Fed as profit to the Treasury?

    As for the reductions in the deficit, this does not drain money from the economy, as long as there is a deficit. Rather it is reducing the amount of money the government is injecting into the economy.

    1. nonclassical

      many, many interesting responses for we naiveté’s, attempting to come up to economicspeed…THANKS

    2. charles sereno

      Hugh, I’d like your opinion on this question that many readers are confused about. We’ve often heard about the Fed sequestering “toxic” assets from Banks. Our imaginations run wild. Is there a secret vault somewhere? How is everything detoxified? I hope you say more than — “I’ve already explained it.”

      1. Hugh

        Yves knows a lot about the Maiden Lanes which were one approach. The QE buys of MBS don’t detoxify anything. They were a way of removing risk from the banks, via the GSEs (Fannie and Freddy), and ultimately sticking any losses with the Fed and/or the Treasury (Geithner’s removing loss limits on the GSEs).

    3. Chauncey Gardiner

      Hugh,
      Per the Fed’s own reports ( H.3 and H.4.1), Reserves have risen to $1.975 trillion at 5/22/13 from ~$44 billion on Aug 27, 2008 (two weeks before Lehman collapsed):
      http://www.federalreserve.gov/releases/h3/default.htm
      http://www.federalreserve.gov/releases/h3/current/
      http://www.federalreserve.gov/releases/h41/current/h41.htm

      I believe there are multiple reasons why QE policy has been implemented, in addition to the issue you have raised many times. With respect to the wealth concentration issue, Jesse had an interesting article earlier this week in which he considered how one might quantify the broad economic losses that have been incurred:

      http://jessescrossroadscafe.blogspot.com/2013/05/dollar-of-gdp-added-for-each-dollar-of.html

      As far as the question Yves posted in her headline is concerned, I think QE will be tapered off over a prolonged time frame and that different financial asset categories will respond with different price elasticity as the program is gradually phased out.

      Thank you, Hugh, I always appreciate your insightful observations.

      1. Hugh

        This is complicated. So forgive me for taking so long to answer. You make good points. It depends on the start times. I will use weekly averages (for this part) which are slightly different from your numbers for bank reserves held at the Fed (and I will round):

        On September 10, 2008: $9 billion
        (pre-Lehman)
        On September 17, 2008: $47 billion
        (post Lehman)
        On January 1, 2009: $847 billion

        QE1 lasted from December 2008 (actually January 2009) to June 2010. QE1 was supposed to be a buy of $600 billion of MBS but it also involved Treasuries. I start the clock in January 2009 because this is when the MBS buys begin showing up on the Fed balance sheet. However, by this time, the bank balances at the Fed have already jumped from almost nothing to $800 billion+. As I was focusing on the QEs, this is why I started where I did. The buys of MBS and Treasuries topped out at around $1.4 trillion during this period.

        QE2: November 2010 through June 2011, $600 billion of Treasuries buys.

        QE3: September 2012-December 2012, $40 billion in MBS/month
        December 2012- , $85 billion/month in MBS.

        As of May 22, 2013, the Fed held $1.877 trillion in Treasuries and $1.179 trillion in MBS.

        Bank reserves at the Fed were $1.975 trillion.

        If we subtract out $800 billion from the Fed and Treasury’s pre-QE aid, this leaves around $1.1 trillion of bank reserves stemming from the various rounds of QE.

        However, as of December 31, 2008, the Fed had $475 billion in Treasuries and no MBS (The MBS buys started showing up on January 14th). But as we saw above, the current sum of Treasuries and MBS at the Fed is $3 trillion. Subtract out the $475 billion, and we are left with about $2.5 trillion of QE.

        What this means is that the aid through the QEs exceeds increases in bank reserves at the Fed by $1.4 trillion. This is probably not the whole story but I hope this helps.

        1. financial matters

          I wonder how much of this MBS purchase is slipping out into bank subsidiaries/off shore accounts. I guess the Fed is only buying MBS which the banks got stuck holding. If the Fed is buying MBS that is actually held by other parties then it seems that the money would flow out of reserves to these others. If it is actually held by the banks then it seems possible that some is leaking into off balance accounts and being used for various carry trades etc.

  15. charles sereno

    Investor pundits in a heated environment are beginning to sound like courtiers in the reign of Louis XVI. Don’t misunderstand me. I don’t think the French Revolution was inevitable. Certainly not as quickly as it came. The same goes for ours.

  16. The Rage

    Man are people dumb. There is so much demand for “Treasuries”, the FED doesn’t own anymore securities than in the past. They own alot more MBS than in the past, but that is another point all together.

    When are people going to get it, when the FED ‘buys’ securities, it itself is trying to drop bond prices and reverse the flight to saftey that has oversaturated markets since 2001 as real US growth peaked and began a long decade + decline. So “rates” move to 4.00-6.00% range nominally across the yield curve…….that is probably a good thing from a mainstream view.

    If the flight to saftey is over and yields are going to rise, that means the bubble has been reinflated. Then controlling leverage is the next challenge minus Glass Steagall.

    Heck the whole “RE” “bubble” was only because of Glass Steagall’s repealment in the first place. That surged leverage in the 99-01 period(also during tight monetary policy) and laid the foundation for the “bubble” which also explained the suprisingly mild recession.

    Interest rates are overrated and overblown. Get over it and look to other areas for “truth”. About time people smack into this, it is leverage stupid. When you are seeing leverage rise and in a non-GS world, it will happen again, you better knock it down

    1. The Rage

      and oh, yes, when monetary policy goes tighter, leverage has a tendancy to rise ala Mr. Volcker found out in the 80′s.

      Right now, we have a complete misunderstanding of how monetary policy and its real impacts, really work. I feel like that guy in Moneyball telling Bill Beane about these “misconceptions”.

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