In the months before the debt ceiling was reached and possibly breached in 2011, global markets just could not get enough of Treasury’s bills. Not the ones the Department might use to make payments, of course, rather the debt instruments which rest unchallenged at the apex of the collateral food chain. At times, dealers - who were not investors – were willing to accept zero return therefore paying whatever price necessary to claim these things even as the government refused to get its debt law in order.
Back then, that wasn’t all that much of a liquidity premium to have paid. Rates were already low, the consequence(s) of the Federal Reserve having done such a horrible job in and after the first of these monetary crises. Contrary to popular belief, low rates mean high demand for safety and liquidity which already tells you everything you need to know about actual conditions for safety and liquidity.
In August 2008, for instance, just before Lehman Brothers and AIG would cement each’s place in infamy, the FOMC’s resident troll Bill Dudley was worrying the committee members when notifying them of an upcoming Treasury limit. Not a debt ceiling, rather the Fed was running out of securities.
Before September 2008, authorities had been very careful about the systemic level of bank reserves. Never wanting them to stray at all (you know, money printing), whatever “liquidity” measure officials came up with and market participants accessed the Fed’s Open Market Desk run by Mr. Dudley would immediately “sterilize” any action by selling the requisite number of USTs back to the market.
Having invented several new programs in the wake of Bear Stearns earlier in the year, Dudley and FRBNY staff were concerned there might come a time when the Fed could actually run out of unencumbered instruments to use “soaking” up the excess reserves which might then be printed. At that point, gasp, the systemic level of bank reserves set free to soar.
“MR. DUDLEY. Obviously, further expansion of our TAF or TSLF auctions or single-tranche repo operations would be at our discretion and, thus, does not pose a meaningful problem in terms of reserve management. We wouldn’t expand these programs if we didn’t have the ability to conduct offsetting reserve draining operations. However, what would we do if faced with a huge rise in PCF or PDCF borrowing? An inability to drain the reserves added by such lending would cause the federal funds rate to collapse below the target."
Why anyone at that meeting didn’t leap across the fancy conference table and slap some sense into Bill, it was just such a wasted opportunity.
What I mean is, the effective federal funds rate had indeed moved below – often well below – the Federal Reserve’s target for it. No increase in any bank reserves had ever been required, let alone a major surge in them (which, by the way, would happen a little over a month after this discussion; reserves became abundant but never once changed the fact that effective money was in the opposite shape, thus monetary crisis).
The reason why was obvious enough a few months before when one of the FOMC’s members, FRB Governor Don Kohn, had relayed it to the rest of them in the days leading up to Bear Stearns.
“MR. KOHN. I just got back this afternoon from Basel. I think it is fair to say that Bill’s description of what is going on in U.S. financial markets is going on much more broadly. Liquidity has dried up in London and other European markets in particular, but elsewhere as well. There is really no price discovery. There is aggressive deleveraging and a flight to safety and soundness.”
At the time he spoke, March 10, 2008, the federal funds effective rate was right where it was supposed to be, just a couple bps shy of the 3% target where it would be throughout this stage. The rate for the 4-week T-bill, on the other hand, was a total red flag: it was sitting there yielding all of 1.63%, near 140 bps less than what it “should” have been had the monetary system been functioning.
Those who didn’t know any different would get a glimpse at the dysfunction later that same week when the “shock” of Bear Stearns’ collapse filtered out into the public.
Even if we accept Dudley’s August 2008 premise about the fed funds rate relationship with reserves (which you shouldn’t), how, then, to explain T-bills?
Bear itself provides more of the answer given its mode of failure. Not credit losses nor OTTI write-downs, triparty repo custodian JP Morgan demanded a claim on collateral Bear just didn’t have nor could find any way to access. This demand was not unique to just this one investment bank, either, its failure a single symptom of a much wider monetary disease.
The same demands had been made all over the world, the eurodollar’s world, at the same time. Mortgage bonds which had been accepted as collateral on terms often at par with UST’s, even T-bills, those were being revalued if not rejected herding a massive and massively complicated global monetary system into a narrower and narrower section of collateral markets.
Bidding for T-bills understandably became fierce.
And it would remain fierce for weeks to come. As late as April 28, the 4-week yield was still less than 1% even though the Fed’s target for fed funds was by then 2.25%. To be clear, the Fed did not target bill rates, of course, but all else equal those should trade closely to fed funds and other money rates as one close money substitute.
But all else was not equal, and that they didn’t really should’ve heightened awareness about the gravity of the developing situation.
On a like-to-like basis, there is otherwise no reason why anyone would rationally choose to pay such a huge premium for a 4-week Treasury bill (or other maturities), yielding so much less of a return, when there are so many other close enough substitutes paying so much better. Instead, there must be something uniquely valuable about bills as instruments well over and above whatever they might be worth as an investment.
The world would regrettably have the chance to revisit this deficiency (in money and official worldview) again later that year in September 2008 before again in the Spring of 2011.
Bill rates, as I began here, had already tumbled throughout that March and into April. Early May 2011, we started to see more regularly zero rates, though Treasury pricing more often put them at a single basis point rather than at nothing (though zeroes would show up in their numbers, too, around mid-August).
Within this crisis period, the US Congress and Obama administration were fighting, as they typically do, over the debt ceiling. For the most part, it was completely ignored in favor of these same collateral concerns (though unrelated to mortgage collateral, this time more so European banks transforming and exposed to European sovereigns issued by Portugal, Ireland, Italy, Greece, Spain, etc.)
When in doubt about the politics, some money market funds will, out of an overabundance of caution, sell any T-bills they own and hold which might come due when the government’s debt limit could be breached. The possibility of a small-scale default at that point is exceptionally low but still not zero.
Fiduciary duty demands fund managers refuse even the chance.
If any were doing so in that collateral maelstrom of 2011, they only found an unending welcome of buyers. The only exception was over the week leading up to the resolution which authorities reached on July 29; the 4-week rate would hit 10 bps on the 28th, then 16 bps the 29th, then right back to 1 bps by August 3 as the global crisis would continue to rage all the way into the following year (with immense economic damage, of course, for everyone’s trouble).
The debt ceiling is once more back on the table, and like 2011’s fiasco, Republicans in Congress are, so far, taking a hardline against the Biden Administration.
At the same time, oh boy, the bill market has again gone absolutely wild. Yesterday, exactly one month after Credit Suisse, the 4-week bill yield plummeted once more – it keeps happening. At one point, the rate sank under 3.15%, down almost 60 bps and reaching a staggering 165 bps less than the Fed’s current money alternative mechanism, the ill-fated RRP.
The downward force of collateral gravity on yields was exerted by extreme premiums collateral-seekers were paying at Treasury’s regular Thursday auction: the median yield there was just 3.00%; the low, yes, zero.
For the fourth time over the last six weekly bill sales, the low yield was nothing, meaning there were substantial chunks (at least 5%) of buyers who basically told the government they would pay the highest possible price to ensure they got their allotment of 4-week bills. Do they sound worried about Congress and Biden’s abilities to get along?
Back a dozen years ago, that premium was so much less, rates already close to zero, and yet conditions became seriously dire anyway. Instead, the behavior in these markets today is only too similar to what it had been fifteen years ago.
It’s not as visibly awful today as it was then, but do reread Don Kohn’s summation for the general gist. The primary fault is not mortgage or PIIGS bonds this time upsetting the collateral streams, maybe CLOs particularly those issued on commercial real estate projects once financed by the high-flying US regional banks.
Outside America, there are any number of potential suspects in a system which has been so hugely distorted the past few years.
The debt ceiling has nothing to do with it, either. Like 2011, if it does come into play what that would mean is money market funds selling whichever instrument might come due around the estimated time the government runs out of borrowing capacity. Yields would pop up a little (like they also did in October 2013, and very briefly in September 2017), not go way down.
Going way down as they have consistently from the middle of last month is, not hyperbole, more 2008 than even 2011.
No one wants to admit this is even possible. After all, the Fed has pledged more tools, more effort, has already patted itself on the back for deftly handling last month’s crisis (already past tense, the way officials today tell it) and nowadays having gone almost all the way back to worrying exclusively about an inflation problem that doesn’t exist (conveniently another 2008 parallel!)
If only someone had slapped Bill Dudley to his senses, then maybe it would have stuck around in the official lore for at least those reasons and instead of wasting effort obsessing over the debt ceiling we might be working out something useful. As it is, get ready.
