When you’re rattled by collateral, do the Fed taper talk; it seems increasingly that Taper talk was forced upon the Fed for market operational reasons rather than anything to do with economic conditions being ripe for a pullback in easing

When you’re rattled by collateral, do the Fed taper talk

Izabella Kaminska

| Jul 19 10:02 | 11 comments | Share

Tim Duy, professor of practice at the department of economics at the University of Oregon, is confusing Brad DeLong, professor of economics at Berkeley, with his observation that the Fed seems to be striving to change the mix but not the level of outright accommodation. This, at least, seems to be the motivation for taper talk. We’re less confused, and quite like what Duy is saying. Note the following (our emphasis):

Bernanke is talking as if the goal is to change the mix of monetary policy but not the level of accommodation, essentially trading some reduced accommodation from ending asset purchases for additional accommodation by extending the forward guidance on interest rates. But why? If the level of accommodation is the same, does the mix matter? That’s an interesting question – does the Fed have research saying the mix matters, and why? I can see two reasons. One is that somehow asset purchases have a more negative distortionary impact. Another is that there exists an internal bias in the FOMC against expanding the balance sheet. Arguably, some elements of both where on display in Bernanke’s testimony today:The second reason for increases in rates is probably the unwinding of leveraged and perhaps excessively risky positions in the market. It’s probably a good thing to have that happen, although the tightening that’s associated with that is unwelcome. But at least the benefit of that is that some concerns about building financial risks are mitigated in that way and probably make some FOMC participants comfortable with this tool going forward.

The point is simple. For some reason, Bernanke and the Fed have opted to rein in asset purchases in favour of pure interest rate steering. In Duy’s opinion there are two possible reasons for this: one is that the Fed is aware of some sort of negative side-effect associated with asset purchases that it wishes to suspend, the other is that the body is getting uncomfortable with ongoing balance sheet expansion.

This is a fair observation.

So let’s consider for a second that the motivation is really the first explanation. If it’s true that the Fed’s asset purchases are creating liquidity problems in the underlying — so much so that short squeezes are impeding daily market operations, causing settlement fails and negative repo rates — this leaves Bernanke in a tricky communication position.

For one, the mechanics of QE are not easy to explain to Congress, or the market — both of whom have become far too accustomed to the notion that QE equals pure money printing.

Second, to say “we have to suspend QE because there aren’t enough assets for us to purchase without us becoming the market” is to admit that the Fed’s most important tool — QE — is now broken, which risks freaking out the market completely.

Even if it’s not, it’s still important for the Fed to maintain the illusion that QE remains a viable option. If the illusion can be maintained, then communication and rate-steering alone may be sufficient to keep the market supported.

If the illusion is shattered, it’s unlikely that inflation expectations will be easy to manage with words alone, opening the door to even more drastic policy shifts such as unsterilised money-printing, expanded asset purchases into Reits and ETFs (a la Japan) or something even more exotic.

So it’s better to pretend that the economy is strong enough to handle a taper, than to admit that the taper is the result of checkmated Fed.

What’s more there’s plenty of market clues to suggest this is really what’s going on.

For example, Ben Bernanke may have publicly denied that the Fed’s purchases were hindering liquidity or causing market dysfunction — but when examined more closely what he told Congress this week was hardly reassuring.

For example in response to a question proposing that the Fed had become the market for mortgage-backed securities, he said (our emphasis):

But our assessment—and, of course, we’re in that market quite a bit, so we have a lot of information about it—our assessment is that that market is still working quite well, and that our purchases are not disrupting the normal price discovery and liquidity functions of that market.

What immediately draws our eye, of course, is the use of the word ‘quite’.

Then there’s the fact that the comments refer only to the MBS market and overlook the Treasury security market completely (which fair enough, he wasn’t asked about).

Bernanke’s reassurances about market liquidity to our eyes conflict with the fact that we know the market experienced enough of dysfunction this year to prompt the Fed to call for a large position report from the market.

We also know that there has been a significant shift in the pattern of Fed purchases since March 2013 — about the time of that large position request.

The Climateer Investing blog points us, for example, to a post by Alhambra Investment Partners which crunches the shift. As they note:

However, if we look at what the Open Market Desk has been doing in its SOMA purchasing (the operational arm of QE), it becomes clear that something has changed since March 2013. QE 4, the UST part of the new balance sheet initiative, as opposed to QE 3 which deals in MBS, isn’t really that old, but this short history of activity in SOMA is quite revealing, in my opinion.


However, a special rate for the 10-year crossing the entire triple issue is particularly noteworthy. That is what we have seen in the months since that first special, going on two consecutive triple issue cycles. For some reason, collateral continues to be short of demand in repo markets and the re-openings have not fully satisfied them.

What the SOMA data above suggests, and highly so, is that the Fed recognizes the role of QE in removing OTR collateral. Why else would they start by purchasing relatively high proportions of OTR’s and then drop to nothing, or nearly nothing, after the repo markets went so special? It seems pretty clear to me that the Fed noticed the repo warnings and acted, thus confirming, operationally, what we have suspected about QE.

Since then, the Fed has remained out of the OTR space almost entirely. But that might not fully help either since there is a growing proportion of OFR in the SOMA portfolio. While the Fed can and does “rent” out SOMA collateral, it adds another layer of cost and complexity to repo markets that for some reason don’t want to follow the “normalcy” script. Therefore, it’s not a perfect solution to the shortage. Bottom line is I believe collateralized lending markets, the marginal source of effective liquidity post-2007, are short of collateral for numerous reasons, leading to all manner of side-effects. I think this data confirms that the Federal Reserve agrees, including the role QE may be playing.

These are important observations. As we now know, if Taper Talk achieved anything it was the liquidation of a large amount of what could have been UST collateral rather than pure sales from Caribbean accounts (proxies for hedge funds). Was that enough to alleviate the market tightness?

Duy himself leaves us with a worthwhile conclusion:

Bottom Line: Trying to reconcile the tapering talk with the data is not easy. I think that’s why many analysts missed the direction the Fed was heading. It was somewhat incomprehensible based on the Fed’s previous guidance. It could be the effort to change the policy mix but not the level of accommodation was Bernanke’s attempt to gain consensus within the FOMC and maintain accomodation, but he may have underestimated the importance of asset purchases in holding rates low.

In short, it seems increasingly that Taper talk was forced upon the Fed for market operational reasons rather than anything to do with economic conditions being ripe for a pullback in easing.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: