Posts Tagged ‘budget deficit’
BNP Warns On Japanese Repression: Echoes Of The 1940s Fed
Friday, 24 May 2013 11:12
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In the 1940s, the Fed adopted pegging operations to protect the financial system against rising interest rates and to ensure the smooth financing of the war effort. In effect, the Fed became part of the Treasury’s debt management team; as the budget deficit hit 25% of GDP in WW2, it capped 1Y notes at 87.5bps and 30Y bonds at 2.5%. From the massive bond holdings of its domestic banks to its exploding public debt, Japan today faces a situation very similar to the US in the 1940s. (Read more…) With the market becoming dysfunctional as the BoJ’s massive buying operations drain the pool of available bonds, the BoJ’s overriding presence in the market each day has increasingly made the JGB market seem like a government-made market.

But a much bigger problem is Japan’s exploding public debt. With the debt already the largest of the developed nations, it could snowball out of control if an upturn in interest rates causes interest payments to escalate. So, even if 2% inflation is achieved, the BoJ’s zero-rate policy and massive JGB purchases will have to continue until the debt is made more manageable.

When the long-term rate climbs above 2%, the BoJ will probably adopt outright measures to underpin JGB prices to prevent turmoil in the financial system and a fiscal crisis – and just as Kyle Bass noted yesterday, they are going to need a bigger boat as direct financial repression in Japan is unavoidable.

Via BNP,

With the market becoming dysfunctional as the BoJ’s massive buying operations drain the pool of available bonds, the BoJ’s overriding presence in the market each day has increasingly made the JGB market seem like a government-made market. Those well versed in history may recall that the Fed’s policies in the 1940s to stabilise prices and yields on US government securities – the so-called pegging operations – also resulted in a government-made market. The Fed at the time was deeply entangled in the government’s debt management, so, despite the upturn in inflation, it had to keep long-term rates very low and continue to buy massive amounts of government securities as part of financial repression.

 

The Fed started down the road towards pegging operations when it intervened in the bond market in the spring of 1935 to prevent rising interest rates from degrading the capital of US banks (more than 50% of assets had to be “safe” government securities) and thereby destabilising the financial system. With the start of WWII, the Fed’s government bond buying morphed into outright support of bond prices (pegging operations), as the shift to a wartime footing necessitated low-cost financing of the war effort. Even when inflation picked up, the policies supporting government bond prices were not allowed to end, causing the Fed to come into repeated conflict with the Treasury Department over policy independence.

 

 

Ultimately, the Fed’s bond price-supporting policies enabled banks to reduce their long-term bond holdings substantially, reducing the impact of rising interest rates on the financial system. And after roughly 10 years, the Fed was finally freed from the constraints of this support programme because (a) banks came to favour ending the programme, as they were now in a position to enjoy the merits of widening margins of a steepening yield curve, (b) the US economy and fiscal conditions returned to normal, as public debt was significantly reduced thanks to improved tax receipts from the expanding economy and the “inflation tax” and (c) subsiding concerns about higher interest rates threatening the financial system and state finances allowed inflation to be perceived as the main problem for the economy and society. While the pegging operations may have been inevitable owing to special factors like WWII, the result was the sacrifice of price stability and the destabilisation of the US economy.

 

 

Japan’s situation today, from the massive bond holdings of its domestic financial institutions to its exploding public debt, has many similarities to the US of the 1940s. Of course, BoJ Governor Haruhiko Kuroda is adamant that the BoJ’s quantitative and qualitative monetary easing is meant only to defeat deflation and should not be construed as bankrolling the government’s spending. At this juncture, there is no clear line separating JGB buying to fight deflation from JGB buying to underpin debt management. But we think that once 2% inflation is attained and the BoJ finds itself prevented from seeking a way out, it will be clear that the BoJ has, indeed, embarked on monetisation.

 

The BoJ will first be confronted with concerns about financial system stability. If we assume that the equilibrium real interest rate is 1%, the realisation of 2% inflation will necessitate raising the long-term rate above 3%. But a long-term rate of just 3% could put financial institutions for small businesses, with their huge JGB holdings, at increased risk of insolvency, something that could induce turmoil in the financial system. At 4%, even regional banks could be in trouble. So, even after 2% inflation is achieved, concerns about damage to the financial system could force the BoJ to maintain its zero-rate policy and massive JGB buying.

 

In the US in the 1940s, with the Fed’s aggressive purchases, financial institutions greatly reduced the durations of their bond portfolios and were more resilient to rising interest rates.

 

 

The actions by the BoJ may work the same magic here. According to our estimates, if the BoJ continues to buy long-term JGBs at the current pace, at the end of 2014, it will hold roughly 40% of the entire 2- to 10-year market – the core assets of regional banks – compared with just 10% at the end of March 2013. Banks’ portfolio durations will be significantly reduced, making them more resilient to rising interest rates. This should alleviate fears of a financial crisis somewhat.

 

 

But a much bigger problem is Japan’s exploding public debt. With the debt already the largest of the developed nations, it could snowball out of control if an upturn in interest rates causes interest payments to escalate. So, even if 2% inflation is achieved, the BoJ’s zero-rate policy and massive JGB purchases will have to continue until the debt is made more manageable. This means that the BoJ’s balance sheet won’t be determined by price stability. As Thomas Sargent and Neil Wallace noted in Some Unpleasant Monetarist Arithmetic (Federal Reserve Bank of Minneapolis, Quarterly Review, autumn 1981), the BoJ will face being fiscally dominant.

 

Currently, with volatility continuing in the JGB market, if the upturn in the long-term rate persists, the BoJ will probably have to enlarge the scale of its annual purchases at a later stage. Then, when the long-term rate climbs above 2%, the BoJ is likely to adopt outright measures to underpin JGB prices so as to stave off turmoil in the financial system and a fiscal crisis. For example, like the Fed in the 1940s, the BoJ may fix the 3m and 1y rates, thereby effectively setting ceilings on the 5y and 10y rates. While this could ensure financial institutions earn carry, this would be nothing other than the start of financial repression.

 

The US was able to liquidate the massive debts built up from the Great Depression and wars thanks to robust post-war growth, coupled with the negative real interest rate engendered by financial repression. Today, however, as we cannot expect economic growth to be as robust as it was then, we may have no choice but to adopt financial repression, so that our public debts can be liquidated via an inflation tax on depositors. Considering Japan’s huge public debt, it seems inevitable that even after the inflation target is achieved, the zero-rate policy and massive JGB purchases will have to continue for a long time as part of financial repression.

    



 
As Of This Moment Ben Bernanke Own 30.5% Of The US Treasury Market… And Will Own All By 2018
Thursday, 23 May 2013 20:37
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As is well-known by everyone, the Fed monetizes the US deficit on a daily basis, thanks to the 45 minutes of POMO love each day when it buys Treasuries from Dealers. Of course, the Fed monetizes bonds from across the entire curve (mostly the longer end), which is why it is somewhat complicated to express the amount of risk transfer the Fed takes on every time the S&P posts an uptick as a result of yet another bond purchase by the hedge fund with the largest fixed income portfolio in the history of the world. However, one simple way of expressing just this risk is through the use of ten year equivalents: Ten-year equivalents are the amount of 10-year notes that must be held by the Fed in order to remove the same amount of interest rate risk (Read more…) the market as its current holdings. What this methodology allows is to represent the Fed’s holdings of all marketable securities on a linear continuum, and represent the remainder, or those bonds held by the private sector, on the side.

So what may come as a surprise to most, is that as of this week’s H.4.1 update, the amount of ten-year equivalents held by the Fed increased to $1.583 trillion from $1.576 trillion in the prior week, which reduces the amount available to the private sector to $3.637 trillion from $3.668 trillion in the prior week. And also, thanks to maturities, and purchase by the Fed from the secondary market, there were $5.219 trillion ten-year equivalents outstanding, down from $5.244 trillion in the prior week.

What this means simply is that as of this moment, the Fed has, in its possession, a record 30.32% of all outstanding ten year equivalents, or said in plain English: duration-adjusted government bonds. It also means that the amount of bonds left in the hands of the private sector has dropped to a record low 69.68% from 69.95% in the prior week.

America may or may not be becoming increasingly socialist and/or nationalized, but there is no doubt about it: its bond market most certainly is.

Chart of total ten year equivalents, broken down by Private sector and the Fed (courtesy of StoneMcCarthy):

The percentage of the entire US bond market currently owned by the Fed (courtesy of StoneMcCarthy):

 

Finally, the above means that with every passing week, the Fed’s creeping takeover of the US bond market absorbs just under 0.3% of all TSY bonds outstanding: a pace which means the Fed will own 45% of all in 2014, 60% in 2015, 75% in 2016 and 90% or so by the end of 2017 (and ifthe US budget deficit is indeed contracting, these targets will be hit far sooner).

By the end of 2018 there would be no privately held US treasury paper.

Still think QE can go on for ever?

Actually, nevermind.  

P.S. as a bonus, here is a breakdown of the Fed’s SOMA holdings by CUSIP


    



 
Two Issues for the Fed: When and How
Tuesday, 21 May 2013 09:27
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Federal Reserve Chairman Bernanke testifies before the Joint Economic Committee of Congress tomorrow. The market is anxious for the Chairman to weigh in on the recent comments suggesting that even some like-minded regional presidents like Chicago’s Evans seems to be warming to the idea of tapering off purchases.

It is one thing for the more hawkish members, several of whom have never felt comfortable with the latest iteration of quantitative easing, to talk of slowing purchases, but it is another thing for some of the more dovish members to talk in this vein. Yet we suspect there is less than meets the eye. (Read more…) With the stock market extending its advancing streak to near 200 days without a 5% pullback and what Bernanke has called “the reach for yield” has driven the industry index of below investment grade yields below 5% for the first time; it is incumbent on Fed officials to demonstrate their vigilance.

To this end, the leadership needs discuss the conditions that would allow it to taper off its purchases. The Fed has been reluctant to provide much guidance in this regard, unlike the inflation and unemployment thresholds cited for interest rates. How the Fed exits from QE3+ is generally understood to be a slowing of purchases, probably of the mortgage-backed securities first. In a recent much-vaunted Wall Street Journal article, how the Fed exists QE3 was said to be “careful” with “potentially halting steps”.

Arguably the more important issue is when and here the Wall Street Journal article was even less revealing, noting that it is still being debated. Although one non-voting Fed president talked about tapering off purchases as early as next month’s meeting, this does not appear to be consensus. Instead, there is a consensus to wait for more economic data. More data seems to mean another quarter or so.

Some officials, including Chicago Fed’s Evans, who was among the most dovish members, noted that the economy is “improving quite a lot”, but wants to see if the economy sustains its momentum after having experienced other episodes of growth that proved temporary. Employment growth is understood to be among the most important real economy measures.

It is true that the 3-month and 6-month average non-farm payroll growth is just about the 200k threshold that Evans, among others, has cited.  However, this overstates the strength of jobs growth.  Consider that we have four months of data for this year.  In three of the months, non-farm payrolls were 165k or lower.  In one month, February, there was an outsized jump of 332k jobs, which skews the averages.  However, with the May report on June 7, the February figures drop out of the 3-month moving average calculation.

Fed officials, and especially Bernanke who as a student of the Great Depression, is particularly sensitive to deflation risks, a few more months of data on inflation measures may also be helpful.  The Fed’s preferred inflation measure, the core PCE deflator stood at 1.1% in March.  Only in two of the past nine months, has the deflator risen by more than 0.1%. 

Some officials, like Evans, suggest that the decline in inflation may be transitory.   Looking at the base effect for the year-over year measure, in Q2 last year, the monthly increase averaged 0.13%.   As these drop out, the core PCE deflator will likely fall below 1%.  Such a low inflation reading would risk deflation and would seem to argue for continued easing of monetary policy.

In addition to employment and prices, there is a third consideration: fiscal policy.  Bernanke has commented previously on the fiscal drag.  However, the US budget position is improving considerably faster than expected.  Last week, the Congressional Budget Office updated its budget outlook. 

Assuming no changes in the current laws and plans regarding taxes and spending, the FY13 budget deficit is expected to now shrink to about $642 bln, the smallest since 2008 around 4% of GDP.   This is less than half the 2009 shortfall (~10.1%) and an impressive decline from the 7% shortfall in FY2012.   To appreciate this consider that the UK government which has been committed to austerity since getting elected in 2010 has seen no change in public borrowing as a percentage of GDP (~7.5%).

The US public debt/GDP ratio is projected to begin falling next year.  The CBO estimates that the FY2015 deficit will fall to almost 2% of GDP.    The less accommodative fiscal stance may also encourage the Fed’s leadership to take their time.  The US economy remains fragile and reducing both monetary and fiscal accommodation at the same time may not be desired.  

Bernanke’s testimony tomorrow takes place before the FOMC minutes are released.  Bernanke’s comments are more important of the two events.  However, recall that the FOMC statement released on May 1 contained one notable tweak and that is that “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”  This symmetry contrasts with previous talk that focused on tapering off the purchases.  In turn, this suggests some doves pushed back. 

Data released since the meeting has generally been soft and/or disappointing.  This includes non-farm payroll report, which included a decline in aggregate hours, surveys for May, softer auto sales, industrial production and manufacturing and housing starts.  The resilience of consumer confidence and retail sales were the exception.

On balance then, we suspect Bernanke will recognize, as the FOMC statement did, that the economy is growing at a moderate pace and that decisions on the pace of asset purchases is a function of changes in employment and inflation.  It serves his interest to indicate it is data determined and that more data is needed.  If this does in fact materialize, we suspect it would be supportive for US Treasuries while weighing on the dollar.  To the extent that the FOMC minutes show that there are some at the Fed who think it should be doing more, it may also push the markets in the same direction.