Ever since March 2020, GFC2, Federal Reserve officials from Jay Powell on down have been busy patting themselves on the back for their splendid performance during last year’s big event. Again, market-of-last-resort. It would’ve been much worse, they claim, particularly given what happened in the Treasury market itself which we are supposed to believe QE bailed out just in the nick of time.
But when you review what actually happened, what you find is instead, as GFC1, the janitor who celebrates skillful broom-work amidst widespread flaming debris rather than successfully having thwarted even limited damage as any effective central bank might.
Though officials repeatedly refer to this Treasury market “breakdown” not once have I witnessed a thorough explanation for what they believe this was. Instead, they quite purposefully begin in the middle with foreigners selling mostly off-the-run UST notes and bonds to US-based dealers. These are facts, just not arranged in the right order (see: below).
Dealers were “forced”, in a way, to accept these sales because they were foisted upon them largely by large foreign customers, including those from overseas reserve managers at the direction of local big wigs.
Since typically dealers fund their purchases in repo, pledging the assets as repo collateral, the flood of foreign UST sales purportedly “clogged” the repo market. This story leaves out many crucial details about what truly happens in these situations, including, importantly, the distinction between off-the-run (OFR) UST collateral and on-the-run (OTR).
I wrote last Friday in detail about them here. It’s not absolutely essential that you read my (lengthy) description first, but it would help you understand what’s coming next (and then much of what follows from it) and what it all really means. For now, the short version:
Unwilling, likely unable, to upset a custodial relationship of such substantial potential revenue, the dealer dutifully obeys and takes the illiquid OFR asset off the Reserve Manager’s hands and crediting its account with some form of “cash”; which does deserve the quotation marks.
Where does our harried primary dealer get such “cash” in order to purchase this foreign-reserve OFR UST? It could, in theory, adopt several postures but for now we’ll assume it would stick to what is very common practice: repos, reverse repos, likely some securities lending/swaps/transformations and a literally insane use of badly outdated accounting provisions.
But to our system janitors, all they know is the repo market is “clogged” and it has led to a flood of distressed sales in an increasingly illiquid part of the already less-liquid OFR Treasury market.
From this view, the job of any monetary custodian is quite simple: market-of-last-resort, just start buying up a bunch of these illiquid Treasuries. Thus, QE6 and its enormous proportions given that function in the OFR Treasury market had become just so badly impaired.
Following this new monetary doctrine, Powell’s Fed absorbs much (or all?) of the distressed selling from the private marketplace, which then, according to this new conventional viewpoint, restored market function therefore limiting economic damage (tons of jobs saved).
Having established what seems to be an easy and straightforward even linear chain of cause and effect, the Federal Reserve’s actions stood seemingly as a solid firewall against any worse conflagration spreading much further. Ever since, it has been using this view to fortify the new dogma by courting public opinion purposefully focused on only the last parts in its carefully cultivated chain.
All hail the janitor!
This market-of-last-resort diction, however, curiously leaves unanswered more than a few self-evidently key questions.
One of those, which probably immediately sprung to your mind, was this otherwise decently annoying query looking back toward the unpictured beginning rather than much at all about what happened toward the end of the process.
Why the hell was there so much foreign UST selling – all at once, no less – in the first place? Seems like a vitally important detail to just leave out of this, hoping everyone just shrugs and says, well, COVID.
Already thinking this way, it’s unnerving how there is even now no answer from the official standpoint. If you’ve read my last Friday’s column, I’ve already spelled it out as well as having written about it repeatedly (including here in GFC2’s immediate aftermath, as well as here during the event itself).
Back to last week’s chronicle:
On net: the Treasury market appears to break down when in fact it isn’t the Treasury market what’s failing at all. Because of these repo complications, as well as others not discussed here, massive OFR dysfunction simply herds more and more participants toward the only parts of “the” market still available: OTR. Bills, mostly. Remember what bill yields were doing last March.
So, let’s go back and start from the beginning employing a realistic review of what happened, one actually backed up by evidence in markets and data, as well as, embarrassingly, the FOMC’s own publicly stated words.
There was no separation foreign selling from repo “clogging”; in other words, the repo problems didn’t develop as a consequence of the overseas selling. On the contrary, those two things happened simultaneously, at the least, with a great deal of evidence the repo problems actually predated the overseas OFR deluge, meaning dealers were already managing repo difficulties as that UST selling complicated them so much more. This matters a great deal.
Either way, these were concurrent manifestations or reactions to the same preceding factor/reason (which I’ll get to in a moment).
Because of the repo market impairment, this led to distressed sales in OFR UST’s at the same time dealers unwilling (or unable) to take losses on customer books sought out each and every possible way of avoiding that situation. This meant, in addition to selling OFR’s, a stampede toward collateral that was still negotiable and usable: OTR Treasuries, especially bills (again, remember what bill yields were doing during this “Treasury market” breakdown).
Therefore, when the Fed came in with first “repo operations” before finally QE6, these were unhelpful to the point of distraction. Neither did a thing about the developing bottleneck more destructively limiting the availability of usable collateral. Instead, the Fed focused almost exclusively upon the one problem in OFR Treasury because that’s the only place market-of-last-resort could have been applied.
And it was with exclusively bank reserves initially; even QE6 didn’t show up until late on Sunday March 15! See what I mean about the janitor who comes in only at the end and tries to pass off a partial job as some full one?
This is why the entire global financial space was rocked continuously by a global bout of serious inelasticity – in US$’s, nonetheless. The result hadn’t been a successful interruption or even a fruitful deployment of market-of-last-resort policies.
The dollar surge/shortage had already become self-reinforcing such that no matter what of the mess the janitor attempted to sweep up all these breakdowns of elasticity contributed back to more of the same. Rinse. Repeat. All throughout the first twenty-some days of March (as well as late February) no matter what “repo operations” or initial QE6 purchases.
And, of course, this would bring the public’s attention rather than focused like a laser on the ends of the process back to where it truly belonged the entire time: in realizing that our central bank is not a central bank, and this janitor stuff, or market-of-last-resort, truly amounts to a stunning admission of dereliction given the underlying facts of this money-less monetary policy.
The Treasury market didn’t just out-of-the-blue break down because overseas accounts suddenly, for COVID pandemic reasons, began selling illiquid Treasuries in a tidal wave; on the contrary, the growing inelasticity in the true global monetary system (eurodollar) had first caused all those things. It’s always the first domino (balance sheet capacity).
Global dollar shortage.
Likewise, the accidental delivery of collateral elasticity in the form of T-bill supply issuance (among other things) had broken the cycle of financial violence but not before a tremendous and as-yet uncounted amount of permanent economic damage had been committed globally (long run demand destruction that is more visible and apparent outside the US than immediately inside).
The central bank model envisioned in Bernanke’s long ago promise to Milton Friedman had already been erased, and because it had, that plus the pre-2008 arrogance has pushed the post-crisis version of the central bank to essentially admit in practice it isn’t actually a central bank.
The Fed’s your financial janitor; and not an especially good one, either. Elasticity, especially in collateral, remains a full problem and that, dear friends, explains much about how the world since August 2007 had gotten this way as well as even inflation/deflation today.
While the public may not have noticed or accounted for any of these things, you better believe participants within the system itself have and continue to do so – at our expense.