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Real rates as tools of repression

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Good morning. There are a lot of comments from readers about the actual yield on Wednesday. Some of them are quoted below. Also, some ideas for modifying the government bond market and a few words about the Fed.

Today is my 50th birthday. I’m celebrating with a two-week break to charge my middle-aged battery. The next newsletter, ominously, will appear on Friday the 13th. Can I suggest two other great FT newsletters while I’m away? Swamp memo With US politics City bulletin About UK finance. Good stuff from my smartest colleague.

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

The Federal Reserve Board uses Wednesday’s meeting largely none. It seems to have succeeded. According to the document, the phrase “the economy has progressed towards these goals” was almost the only novelty. These hawkish tiny droplets sent the most delicate ripples throughout the market in the form of a slight flattening of the yield curve and a slight drop in the yield of the tip. I’m waiting for Jackson Hole.

James McCann, Deputy Chief Economist at Aberdeen Standard Investments, explains the delicacy of the Fed’s movements:[Jay] Powell’s job today is like trying to spin a cruise ship in the tub. That means he has limited choices and small mistakes can create big waves.

I don’t think the analogy is extreme enough.I think the Fed is a family of movies Quiet place, Stalked by a vicious monster that is very sensitive to sound. So far, the Fed has managed to get the job done, wearing socks and communicating with hand gestures. But the audience knows that in the end someone is trying to knock down the dishes.

Reduction of real interest rate

Readers’ emails about real interest rates had two common themes. One is that I was naive. Of course, quantitative easing is distorting real interest rates, some readers said. That is the point. In an era of fiscal prosperity, curbing real interest rates is the only way to make a country bear the debt burden. This view is not limited to conspiracy theorists’ tweets. One reader pointed out this comment from Deutsche Bank’s Jim Reed.

Real yields can remain negative for the rest of my career as the debt is so high that the authorities have to control the financing. [of] This rising leverage. I’m even more confident after this pandemic. .. .. Probably sticking to the administration, as long-term positive real yields in the United States are likely to cause debt crises around the world. However, the actual yield can be negative and the nominal yield can be high. Most of the big debt cuts seen throughout history have seen such big gaps due to higher inflation. In some respects, we are looking at it now.

Thomas Mayer of the Flossbach von Storch Research Institute issued a similar statement by email.

We propose to return to the pre-1980s fiscal repression.Reinhardt and Subrancia [in The Liquidation of Government Debt] It has produced excellent research on this. They explain: “One of the main goals of monetary restraint is to keep the nominal interest rate lower than other methods. This effect reduces government interest expense on certain debt stocks, all other things being equal. However, if monetary restraint combined with inflation creates negative real interest rates, it also reduces or clears existing debt. It is a transfer from creditors to borrowers. ” In the free market, wise creditors do not volunteer for such transfers. Therefore, if we observe it, the market must be manipulated by a very large borrower who has the power to do this.

A second group of correspondents argued that real yields, whether inflation or financial stress, are not as an indicator of growth as risk. Jack Edmondson of OU Endowment Management is:

It may be helpful to see the depth of the negative real yield as the price that some market participants are willing to pay to hedge the outcome of inflation, as well as to reflect the central expectations of inflation. .. .. .. For example, if you think inflation can be very high, or in fact, even if you think there is even a small chance of very high inflation, there is a big negative to own inflation-indexed bonds. It is reasonable to pay the real yield of.

In other words, the actual yield can be thought of as a premium for the distribution of results beyond the implicit break-even point.

My colleague Martin Sambu (its economic newsletter, free lunch, you should apply) Created related points:

You need to consider whether the change in risk attitude is a good explanation for the price behavior of the hint. My idea is as follows. The investor / “market” has some view of the overall (actual) growth outlook of the economy, and thus the actual profits that can be expected to be achieved with various investments. They also have some sense of uncertainty about their outlook. The higher the uncertainty, the greater the (actual) risk premium required between safe and risky assets, even given a completely constant inflation expectation.

How would you like to test this? Find a measure of the actual rate of return at risk and compare it to the yield of the hint to get a measure of the (actual) risk premium. If my premonition made sense, we should have seen this rise.

And when it’s done, this is just a chart a few days ago, showing the spread between equity return yields (risk-free expected returns) and real yields (risk-free) that have been expanding in recent months ( See small red arrow):

Treasury market revision

The Group of 30 is a group of very serious financial professionals with very exaggerated names, from Timothy Geithner to Mervyn King.On wednesday they Set of recommendations To make the US Treasury market work better.

The need for that reform was demonstrated by the events in March 2020, the group says. The Group’s main recommendation is that the Fed is ready to exchange government bonds for cash with a wide range of market participants, not just banks and broker-dealers. Centralized clearing is also a good idea.

All this makes sense to me, but two things in the report found me interesting. The group says it’s better to set up a repo trading facility than to just come in and buy a bunch of Treasury when the Fed encounters a problem.

Market participants believe that financial concerns, not macroeconomic objectives, are the motivation for purchases if the market can only be maintained by frequent and large Treasury purchases by the Federal Reserve. It may become.

Oh everyone? Many wise people are already thinking about it (see the actual yield discussion above).

The second most interesting thing. The author is writing it,

The root cause of the increased frequency of episodes of Treasury market dysfunction under stress is the total amount of capital allocated to market making by banking dealers, but in part, the marketable Treasury. It is not keeping up with the very rapid growth of bond balances. Leverage requirements introduced as part of the banking regulatory system after the global financial crisis.

You may have heard many bankers bang about it over the years, because market maker liquidity has historically been an umbrella used only when it’s not raining. .. It’s just me. What’s interesting is that the group turned out to disagree, at least when it really matters.

Even if much more capital was allocated to market making, the Treasury market would not have been able to function effectively in March 2020. .. .. The underlying economic uncertainty caused by the pandemic and the associated large-scale, widespread “dash for cash” by government bond holders was so extreme that it provided the ability to absorb widespread sales pressure. There was no market structure to do.

I don’t mind a little liquidity crisis. They work well on their own and are probably good for reminding everyone to be cautious. I care about the big ones, and with the big ones, the market maker’s capital doesn’t help much.

After reading the report, I also wondered about bigger issues. Several major market players say they haven’t been worried about the Fed’s tapering and tightening leading to a market “accident” in recent weeks. This is for the simple reason that we currently have a lot of liquidity and a lot of cash. , You can’t have a big chain reaction market crackdown. In a sense, it’s a concept of animation in the Group of Sir Report (although it carefully points out that there are some types of crises that even the Fed’s extensive repo trading facility cannot prevent). Is this correct? It may be revealed within the next few months.

One good reading

Someone calls a mechanic.I have the Federal Reserve transmission problem.

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