Jerome Powell Should 'Get It,' But Maybe I'm Being Obtuse
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A wise man once warned that you never bite the hand which feeds you. That man was Jerome Powell. Seriously. Long before he set foot in the Federal Reserve, thirty years ago the future central banker was an actual banker (as a lawyer, still) who then slid over to the Treasury Department.

By 1991, Powell was the Assistant Secretary of the Treasury for Domestic Finance, a position which meant he was intimately familiar with the government’s perspective on the Treasury debt market. And what an auspicious time to be in that seat.

As I’ve recalled before, the last time a few months ago, the early nineties saw a massive cheating scandal which to this day remains largely unknown. A few might recall something about Warren Buffett (before he was famous famous) rescuing Salomon Brothers from the brink of government execution. Few more would remember old Solly as the BSD (look it up) of eighties legends.

Repo had already come to dominate the monetary system in a way no one had imagined outside those doing the dominating. Time and again officials had glimpsed this transformation (1982’s Drysdale Affair, for example) only to look the other way. Bank reserves, they’d stick with those and when reserves proved utterly worthless (Volcker) as a monetary policy tool focus turned exclusively to interest rates (Greenspan).

Meanwhile, banks around the world had securitized their way to repo. In fact, that was what securitization was all about; carving up formerly illiquid loans to create discrete little chunks whose design was trading.

All a cash lender/collateral taker will ever care about is if there is a dependable, liquid market for the collateral should they be forced to seize and sell. If an issue had regular buyers and sellers, bidders and askers, then repo magic could take place.

Boy did they want the magic, to the point they cheated their asses off. While that might be my characterization, it was also the government’s verdict. Here it is again:

“On January 16, 1992, administrative proceedings were instituted jointly by the SEC, the OCC and the Federal Reserve against 98 registered broker-dealers, registered government securities brokers and/or dealers and banks (the ‘respondents’). In those proceedings, the three agencies found that, in connection with their participation in the primary distributions, each of the respondents made and kept certain records that did not accurately reflect the respondent's customers' orders for the GSEs' securities and/ or offers, purchases or sales by the respondent of the GSEs' securities.”

Jerome Powell’s name doesn’t appear on that report, but he was instrumental both in putting it together and more importantly bringing the Salomon case to its resolution. Later in October 2017, speaking to the Treasury Market Practices Group (TMPG), a gathering of top domestic dealing bankers who advise Treasury about their views of the marketplace, Powell recalled his early nineties experience.

In fact, he told the group that the chapter in Warren Buffett’s biography, The Snowball, which deals with the Solly Affair “still gives me nightmares.” Why?

“As we drew up the [1992] report, we were deeply aware of the importance that Treasury markets held for the American economy…Treasury securities are also an important source of collateral within the financial system.”

Yet, in the very next sentence he couches the idea of collateral in the context of Basel 3 regulations. “This last role has become all the more critical in recent years as regulations have required banks to hold larger amounts of high-quality liquid assets so that they can safely meet their potential liquidity needs.” Huh?

HQLA has nothing to do with repo and derivatives collateral, the kind of secured financing transactions that in the decades since the early nineties have come to dominate even more. Maybe it was a clumsy segue into the topic at hand, otherwise we’re left to wonder if Jerome Powell was being deliberately obtuse.

Or does he really not know how it truly works?

Before scoffing at the latter possibility, remember what Upton Sinclair wrote a long time ago about anyone whose pay is tied to looking at the world in a peculiar, even irrational way.

Obviously, this can’t be the reason I started out here claiming Mr. Powell as the picture of hackneyed wisdom. For that, we have to go when his use was at its perhaps useful zenith. Back in 1991, testifying before the House Committee on Energy and Commerce, Assistant Treasury Secretary Powell told the few assembled legislators:

“Treasury believes that the best way to achieve the goal of minimizing borrowing costs to the U.S. taxpayer is to minimize surprises to the market.”

Give the market what it wants when it wants. What the Treasury market and all its repo-hungry participants want today is Treasury bills. Tens of billions, even hundreds. Wouldn’t hurt to even offer a trillion (the money world seemed to work so much better the last couple times Treasury did).

For the past several years, Treasury has chosen instead to constantly chew on the hand feeding it. The real question is why. Bill prices have been exorbitant, not because the government has priced them unrealistically, rather due to so much market demand they command an instantly enormous secondary market premium.

An example just yesterday, no different from most of this year: the Federal Reserve raised its RRP “floor” to 3.80% yet the 4-week T-bill yield was somewhere in the 3.50% range (depending upon pricing source). As a reminder, there is no reason apart from scarce collateral anyone would prefer to purchase and hold government paper for four weeks returning 30 bps (or more) less than they would receive “lending” the same cash to the Federal Reserve collateralized by USTs every day for the same four weeks.

It is this huge demand which has finally brought official notice. The minutes of the Treasury Borrowing Advisory Committee (TBAC), another one of these Wall Street/government corroborations, from November 1 reveal specific and serious talk of a Treasury buyback program, coming on the heels of Secretary Janet Yellen making similar comments in the middle of last month (though more speculation from the marketplace isn’t expecting much, and even if it does eventually take shape is thought to be a long way off).

The premise of the buyback program is to “improve liquidity”, an overused euphemism for all the real problems no one wants to state forthrightly. Everyone talks about a breakdown in the Treasury market, implied problems in liquidity, yet hardly anyone addresses the real issue; why there is so much demand for certain segments of the Treasury market increasingly at the expense of others.

Truth is there are dependably liquid USTs and other securities which are…not. Of those which are, the very instruments Salomon Brothers and its ninety-seven fellow felons, so to speak, were cheating for, those are whatever have just been auctioned most recently. These securities are called on-the-run (OTR), the ideal instrument because it most closely matches the current fundamental factors of maturity length and market condition.

A ten-year Treasury note, for example, one that was auctioned off five years ago is today considered part of the five-year UST bucket. But while it has a maturity of five years, it has five-year-old characteristics in its coupon. And the price has moved around over that half decade to reflect the changing market demands for yield.

All that makes it less than ideal for trading and, yes, collateral purposes. You can use this off-the-run (OFR) note for repo or as collateral in, say, a currency swap, but when times get rough and the dealers on the other side grow cautious, again, those dealers only care about the liquidity characteristics of the collateral you are offering.

A brand spanking new five-year note, on the other hand, there’s going to be a thoroughly dependable market for it. Even though both the OTR and OFR are absolutely free from credit risk, they could be treated very differently in a collateralized financing transaction.

This is no theoretical case; it has happened on more than one occasion, the last in, of course, March 2020. A case that, to this day, everyone still gets very wrong.

The mainstream, Fed/Treasury narrative is that Fed buying of USTs was necessitated by a “breakdown” in the Treasury market. Ha! In fact, the Fed said so in its prepared minutes from the chaotic, crisis-filled March 2020 FOMC meeting:

“In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.”

Everything since has made it seem as if the Treasury market was broken and the Fed fixed it when buying under its massive QE. No one ever stops to consider let alone ask why so many OFR USTs were being sold in the first place!

The problem wasn’t dealers or even OFR, it was a massive, widespread dollar shortage which caused mainly but not exclusively foreign reserve managers to liquidate any USTs they had – which were largely OFR – in a losing attempt to stay on top of local dollar illiquidity (which is allegedly what the Fed does with its central bank liquidity swaps, but we all know it doesn’t; just no one says it out loud).

By mobilizing their reserves of OFR issues, inelasticity was simply moved and transmitted into domestic repo. Contagion, folks! Overseas reserve managers who have to sell their OFR USTs contact their dealers (domestic or not) who contract to buy them (can’t say no to some of their biggest customers) even if they’d rather not.

Normally, dealers fund this involuntary OFR UST purchase in repo, offering the UST as collateral. But with repo markets disrupted (the other part no one ever talks about), dealers on the other side weren’t willing to take OFR UST collateral because everyone “found it especially difficult to make markets in off-the-run Treasury securities.” There was too much price uncertainty.

You cannot expect market-makers to make markets in securities where no market for them exists, especially under strain when the volume of sell orders suddenly skyrockets. That’s not broken liquidity, it is purposefully mischaracterizing the problem which is the selling not the lack of buying.

As a direct consequence when this happens, demand for OTR collateral surges.

Having been through especially 2020’s experience, are we really supposed to be surprised there’s so much sustained demand after it for mostly OTR collateral? Again, this isn’t a broken Treasury market, it is damning commentary on the Fed’s claim of elasticity via QE (which is its own disaster when it comes to collateral).

Having touched the red-hot stove of global dollar illiquidity, rational humans greatly desire not to get burned again. And when they can see the modest amber glow and feel the heat rising all over, as in so much of 2022, all the more reason to cast a wary eye on OFR while paying near any price for OTR.

Thus, the purpose of Treasury’s buyback program – if or when one ever happens – would be for the government to buy back older, illiquid OFR securities in favor of issuing more OTR especially bills. Sell more bills than otherwise needed to fund those purchases of collateral the marketplace has more systematically segregated.

The what here is just that easy, but when it comes to why there is obfuscation and blame-shifting. Everyone just repeats what they heard someone else say about liquidity in the Treasury market being broken (some predictably try to tie this back to not enough bank reserves, because when all you have is hammer…)

Repeated global dollar shortages regardless of the systemic level of bank reserves in the context of repo collateral liquidity is actually pretty easy to understand. The very fact Treasury has (re)introduced the buyback concept shows both how bad it has become and how far away from fixing it we are. Though a wise guy like Jerome Powell seems like he should “get it” and pass along what he learned, maybe I’m the one who’s being obtuse. 

Jeff Snider is Chief Strategist for Atlas Financial and co-host of the popular Eurodollar University podcast. 

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