The horror scenario lurking in the plumbing of finance
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Back when Hollywood was fully functional, horror movies were reliably released around Halloween, or, sometimes, whenever there was a Friday the 13th. This year, though, the horror movie in US Treasuries, the mother of all contemporary markets, is being played over the summer and early autumn.
One of the strings plucked by horror movie makers is the audience’s inability to warn the characters. “Don’t split up to search the ruin in the dark woods!” “Don’t open that door— the guy with the axe is on the other side!”
The equivalent fear hanging over the financial system now is: “Don’t create an artificial shortage of good collateral! No! No!”
Just as the expendable teenagers will always split up and then open the wrong doors, we can count on the US Federal Reserve and Congress to do the stupid thing. In this case, that would be congressional inaction on the artificial debt ceiling limit and the real (as distinct from rhetorical) budget. This nonsense is limiting how many Treasury bills and short-term government securities can be issued.
For its part, the Fed is ensuring that much of the short-term US government paper that might be available is locked up in accounts where it cannot be used to secure the myriad financial transactions that keep the global economy ticking over. Sort of like the idiot teenage horror victim who loses the keys to the escape car.
Most comment on the politics of central banking and the official provision of market liquidity revolve around bank reserves, and whether or not the Fed is buying bonds to “add liquidity” in the form of cash to stimulate economic activity. This tends to pass over the key role of short-term Treasury paper, in particular T-bills, as “good collateral”.
Short-term paper from the highest-rated government issuers, such as the US Treasury or the German government, can be lent and re-lent multiple times after its purchase. This “collateral reuse” is a form of leverage that turns borrowing by trusted governments into liquidity for the world monetary system.
Financial markets have always required collateral for many transactions, especially when buyers and sellers do not completely trust each other. But in the wake of the financial crisis, banking regulation changes known as Basel III and new securities market rules have dramatically increased the demand for government securities to be used as collateral.
As usually with disasters, it started with good intentions. If, say, a “Lehman Brothers” defaults on its obligations, its counterparties can claim title to collateral that will keep them solvent. And, perhaps as an afterthought, the regulator-induced demand for good collateral will make it easier for governments to finance themselves. Then they can send out childcare checks, build highways or send drones on vengeance missions.
Unfortunately, we now have the conflict of two giant and terrifying programmes: “Basel reforms” playing Godzilla, and “Fed asset purchases” taking the place of Rodan, the Flying Monster.
The Basel reforms demand the use of government paper to secure transactions. Fed asset purchases lock that paper up, not only in the form of longer-term balance sheet assets, but also as the asset traded for cash through the now trillion-dollar Reverse Repurchase Programme.
Fed chair Jay Powell finally seemed to acknowledge the problem during his recent testimony before the House Financial Services Committee. Towards the end of his appearance, he muttered like a scientist who realises his experiment has gone very, very wrong, saying: “You could say there is a shortage of safe short assets . . . so yeah, that’s why that’s happening, there’s a shortage of T-bills, not a lot of T-bills . .. ”
So Treasury yields are falling at the same time many measures of inflation are going up. US money market funds can earn 0.05 per cent using the RRP facility, but the securities that are collateral for their deposits cannot be re-lent. It would be better now if the major banks were able to expand their deposit base, buy bills and short-term notes from the Treasury and the Fed, and re-lend those securities for use in the collateral chain. The “Basel” rules must be rethought.
Unless you believe in fairies and cross-party goodwill, there will be no resolution of the debt ceiling and budget legislation before October or November, which means November.
At least until then, the collateral shortage will get steadily worse, which will be a drag on growth. And god help us if there is any global margin call — a demand for leveraged traders to place more collateral with counterparties — before then. The required paper won’t be there.
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