Real rates as tools of repression

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Good morning. Lots of comments from readers on Wednesday’s real yields piece, some of which I cite below. Also, some ideas for fixing the Treasuries market and a word on the Fed. 

Today is my 50th birthday. I’m celebrating by taking two weeks off to recharge my middle-aged batteries. The next newsletter will appear, ominously, on Friday the 13th. While I’m away, may I suggest two other excellent FT newsletters? Swamp Notes on US politics and City Bulletin on UK finance. Good stuff from my smartest colleagues. 

What is the right analogy for what the Fed is doing?

The Federal Reserve, it seems, wanted to use its meeting on Wednesday to do almost nothing. It appears to have succeeded. In the written statement, the phrase “the economy has made progress toward these goals” was just about the only novelty. This tiny droplet of hawkishness sent a most delicate ripple through markets, in the form of a slight flattening of the yield curve and a little fall in Tips yields. We are in a holding pattern until Jackson Hole.

James McCann, deputy chief economist at Aberdeen Standard Investments, described the delicacy of the Fed’s movements like this: “[Jay] Powell’s job at the moment is like trying to turn a cruise ship in a bath tub.” Meaning he has limited choices and that a small wrong move could create big waves.

I think the analogy is not extreme enough. I think of the Fed as the family in the film A Quiet Place, who are stalked by vicious monsters that are incredibly sensitive to sound. So far, the Fed has managed to do its job while tiptoeing in stocking feet and communicating with hand gestures. But the audience knows that eventually someone is going to knock over some crockery.

Real rates redux

Reader mail on real rates had two common themes. One was that I was naive. Of course QE is distorting real rates, several readers said; that’s the whole point. In an era of fiscal profligacy, suppressing the real rate of interest is the only way to make national debt burdens bearable. This view is not confined to muttering conspiracy theorists. One reader pointed out this comment form Deutsche Bank’s Jim Reid: 

With debt so high real yields are likely to stay negative for the rest of my career as the authorities have to control funding [of] this rising leverage. I’m even more convinced of this post-pandemic . . . positive US real yields for any length of time would likely set off debt crises around the world so we are probably stuck with the regime. However you can still have negative real yields and higher nominal yields. Most of the big debt reductions seen through history have seen such a wide gap via higher inflation. In some ways we are seeing that now.

Thomas Mayer of the Flossbach von Storch Research Institute expressed a similar statement via email:

I suggest that we go back to the financial repression of the pre-1980s. Reinhart and Sbrancia [in The Liquidation of Government Debt] produced excellent research on this. They explain: “One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things equal, reduces the governments’ interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression combined with inflation produces negative real interest rates, this also reduces or liquidates existing debts. It is a transfer from creditors to borrowers.” In a free market, no sensible creditor would volunteer for such a transfer. Hence, if we observe it, the market must be manipulated by a very big borrower who has the power to do this.

The second group of correspondents argued that real yields are not so much a gauge of growth as of risk, whether of inflation or financial stress. Here is Jack Edmondson of OU Endowment Management:

Sometimes it’s useful to see the depth of negative real yield as the price some market participants are willing to pay to hedge against inflation outcomes, not just to reflect the central expectation of inflation . . . For example, it’s rational to pay a significant negative real yield to own an inflation-linked bond if you think inflation could run very high, or, in fact, even if you thought there was even a small chance of very high inflation.

Explained another way, the real yield can be seen as an insurance premium for a distribution of outcomes over and above the implied break-even rate.

My colleague Martin Sandbu (whose economics newsletter, Free Lunch, you should subscribe to) made a related point:

We should think about whether changes in risk attitudes are a good explanation of Tips price behaviour. Here’s how I think about it: investors/“markets” have some view of the overall (real) growth prospects of the economy and hence the real returns they can hope to achieve in various investments. They also have some sense of the uncertainty of those prospects. The more uncertain, the more of a (real) risk premium they will demand between safe and risky assets, even given completely constant inflation expectations. 

How would you test this? By looking at some measure of the risky real rate of return and then comparing it with Tips yields for a measure of the (real) risk premium. If my hunch makes sense, we should have seen this rise.

And, voila, here is a chart of just this from a few days ago, showing the spread between equity earnings yields (risky expected returns) and (risk free) real yields widening in recent months (see the little red arrow):

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Fixing the Treasuries market

The Group of 30 is a group of very serious finance people — from Timothy Geithner to Mervyn King — with a very pretentious name. On Wednesday they came out with a set of recommendations for making the US Treasury market work better. 

That reform is necessary, the group says, was demonstrated by the events of March 2020, when everyone at once wanted to sell their Treasuries for cash, liquidity disappeared, bid-ask spreads blew out, the moon turned blood red, and so on. The group’s primary recommendation is that the Fed stand ready at all times to swap Treasuries for cash with a wide range of market participants, not just banks and broker-dealers. Centralised clearing would be a good idea, too. 

This all makes sense to me, but two things in the report struck me as funny. The group says that having a standing repo facility is preferable to having the Fed simply come in and buy tons of Treasuries whenever there is trouble, because

if market functioning can be sustained only by frequent, large-scale purchases of Treasuries by the Federal Reserve, market participants could come to believe that fiscal concerns rather than macroeconomic objectives are motivating the purchases.

Ahh, guys? There’s a lot of smart people who think that already (see the discussion of real yields, above).

Second funny thing. The authors write that,

the root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding, in part because leverage requirements that were introduced as part of the post-global financial crisis bank regulatory regime. 

I’ve never really bought this line of thinking, maybe because I’ve heard so many bankers bang on about it over the years, but also because market maker liquidity has historically been the umbrella that you only use when it isn’t raining. That’s just me though. What is funny is that the group turns out not to agree with it, either, at least not in the cases that really matter: 

Even if far more capital had been allocated to market-making, the Treasury market could not have functioned effectively in March 2020 . . . The underlying economic uncertainty created by the pandemic and the associated massive and widespread “dash for cash” by holders of Treasury securities was so extreme that no market structure could have provided the capacity to absorb the widespread selling pressures.

I don’t care about little liquidity crises. They work themselves out, and probably are a good reminder for everyone to be prudent. I care about big ones, and in the big ones, market-maker capital is not much help.

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Reading the report also made me wonder about a larger issue. Several biggish market players have said to me in recent weeks that they are not worried that Fed tapering and tightening will lead to a market “accident”, for the simple reason that there is masses of liquidity around now, and as long as cash is abundant, you can’t have big chain-reaction market crack-ups. That is, in a way, the animating notion of the Group of 30 report (though they are careful to point out that there are sorts of crisis that even a broad Fed repo facility can’t prevent). Is this right? We may find out in the coming months. 

One good read

Somebody call a mechanic. The Fed is having transmission problems. 

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