Speaker 1: Hello, and welcome to another episode of the Odd Thoughts Podcast.
Speaker 1: I'm Chracy Allowin and I'm Joe. Joe. You know it
Speaker 1: just happened. It's a very very open ended question, so
Speaker 1: I need to tell me what happened. Alright, So let's
Speaker 1: see a couple of weeks ago. It not only was
Speaker 1: the end of the first quarter, uh it was the
Speaker 1: end of March. It was also the end of the
Speaker 1: fiscal year for a lot of big Asia investors, specifically
Speaker 1: Japanese banks. I know that is the highlight of your
Speaker 1: calendar every year. Did you celebrate? I like, do people
Speaker 1: out there do a fiscal New Year's celebration? I mean,
Speaker 1: I know there's a lot of finance out there in
Speaker 1: Hong Kong, and so is that a thing out there
Speaker 1: or is that just it's not the same? Uh I.
Speaker 1: I confess that I didn't notice anyone um celebrating more
Speaker 1: than usual. I did write a high ku on Twitter, though,
Speaker 1: and my high ku, my high ku was about stress
Speaker 1: in the money markets, which is something that occasionally happens
Speaker 1: at quarter ends. That there's been a thing lately and
Speaker 1: people are sort of in the final few days of
Speaker 1: the final week or a couple of weeks of the quarter,
Speaker 1: you start to hear people rumbling about, are we gonna
Speaker 1: see um see stress appearing in various money market and
Speaker 1: fixed income markets, And I feel like I don't have
Speaker 1: my head completely wrapped around why this keeps happening. Ah, well,
Speaker 1: then I know just the person who's going to be
Speaker 1: able to help you with this. But yes, essentially, Uh,
Speaker 1: let's see at right before the year end, right before
Speaker 1: December thirty first last year, we did see a bunch
Speaker 1: of people talking about funding stress in the money market,
Speaker 1: which is just about the biggest money market that you
Speaker 1: can think of. And then just at the end of
Speaker 1: the first quarter we saw that yet again. So something
Speaker 1: is clearly happening in the market. At the same time,
Speaker 1: a big component of the money market, uh, something that
Speaker 1: is often used as collateral for the money market. US
Speaker 1: treasuries are also undergoing massive, massive changes, some of which
Speaker 1: you might have picked up on in the US. Once again,
Speaker 1: I feel like this is an area in which I'm
Speaker 1: extremely weak on, like a lot of the sort of
Speaker 1: the deep plumbing of the financial system I wish I
Speaker 1: knew more about, and I'm I'm optimistic that maybe I'll
Speaker 1: learn more after today's episode, Joe, I know you know this,
Speaker 1: So you know the U. S. Treasury is selling basically
Speaker 1: a record point thank you? Okay, a few Okay. So
Speaker 1: at the same time that the U. S. Treasury is
Speaker 1: selling a lot of debt, we have a bunch of
Speaker 1: changes sort of taking places in the underlying money market,
Speaker 1: and we're going to discuss all of those with someone
Speaker 1: who is really the foremost expert on this topic. So
Speaker 1: I'm very pleased that our guest for this particular episode
Speaker 1: is Reultan Posar. He's a strategist over at Credit Swiss.
Speaker 1: He's also a former US Treasury advisor, So who better
Speaker 1: to talk about the massive changes underway not only in
Speaker 1: money markets but also in the U. S. Treasury market
Speaker 1: result in, it's so good to have you on the show.
Speaker 1: Thank you very much for having me. So I sort
Speaker 1: of alluded to this, uh in the intro, but we're
Speaker 1: going to be talking about money markets and and just
Speaker 1: to back up for Joe's benefit, obviously, can you tell
Speaker 1: us what is your concept of money markets? What are
Speaker 1: we talking about when we say the money market? Thank you.
Speaker 1: I'm glad you asked this and didn't skip over this
Speaker 1: question because I would have. Yes, money markets, I think
Speaker 1: in my inserprevision, I think anything from overnight and introduced
Speaker 1: stuff out to I would say three months. And so
Speaker 1: that's the core of it. And you know money markets
Speaker 1: are hierarchical, and that that shows up in you know,
Speaker 1: the term aspect of it, the institutional aspect of it,
Speaker 1: the instrumental aspect of it. But I think the core
Speaker 1: of it is definitely all the flows that happened in
Speaker 1: the financial system three months and in so very short
Speaker 1: term funding. And the people who are buying and selling
Speaker 1: this short term funding, they're basically rolling over it constantly
Speaker 1: right in in the overnight market usually or through the
Speaker 1: repo market where they sort of use the underlying securities
Speaker 1: as collateral to secure extra financing. Yes, so so there
Speaker 1: is there is various types of players. Um, maybe we
Speaker 1: can start from outside in so you have you know,
Speaker 1: I guess the the every time you think about a
Speaker 1: carry trader, whoever is buying a bond and financing it
Speaker 1: short in the short term money markets. You know, Perry
Speaker 1: Merlin would say that they do money market funding of
Speaker 1: capital market landing another way of saying, shadow banking, carry trading,
Speaker 1: all that stuff. Uh, that typically gets funded at the
Speaker 1: three month point, simply because most bonds paid coupons every
Speaker 1: quarter and so it's convenient. I guess it's just an
Speaker 1: industry convention. So if you are someone who is not
Speaker 1: a dealer and who's not a bank, you will tend
Speaker 1: to fund the three month points. And there are obviously
Speaker 1: any other end of the spectrum. You have players that
Speaker 1: fund overnight. Those would be banks and dealers that have
Speaker 1: a deeper ability to roll this financing every day. And
Speaker 1: then the arbit treasures, I would say in the money
Speaker 1: market live between the overnight point and a three month point,
Speaker 1: because some of these arbitrast trades are about, you know,
Speaker 1: borrowing money for one months and lending it at the
Speaker 1: three month point and rolling it every three months I'm sorry,
Speaker 1: every month, or if you want to do shorter arm
Speaker 1: you can do one week to one month and one
Speaker 1: day to one week. And so you know, the three
Speaker 1: months and the overnight points are the extremes and and
Speaker 1: the large gesips or whatever you want to call them
Speaker 1: these days, they are the ones that move the money
Speaker 1: between the overnight point and the three month point. But
Speaker 1: all these ending that end users of funding tend to
Speaker 1: live at the three month points. So all these different
Speaker 1: players are engaged in different transactions, but essentially if they're
Speaker 1: borrowing at very short term rate for some sort of
Speaker 1: further trade, whether it's a lending or buying some bond
Speaker 1: out there that has a higher yield, how big and
Speaker 1: hoping the profit from the spread? How big is the
Speaker 1: money market? I mean, it's huge. It's uh, I never
Speaker 1: counted it. It's probably north of five trillion dollars. And
Speaker 1: then if you just look at the the large groups
Speaker 1: of investors that borrow in it, I mean the most
Speaker 1: obvious investor example is governments. The U S. Treasury they
Speaker 1: have um, you know, trillions of bills outstanding. You have
Speaker 1: the large banks, all of which now have to fund
Speaker 1: their so called h qul A portfolios around the three
Speaker 1: month points, so that's that's another trillion. You have the
Speaker 1: federal homeland banks in the US, which issue easily a
Speaker 1: trillion dollars um. The report market, we have daily statistics
Speaker 1: on it. It's at least a trillion dollars only at
Speaker 1: the overnight point, and the most of the report market
Speaker 1: is overnight anyway, So I think that's that's already around
Speaker 1: five trillion. And then The thing that's unmeasured, but it's
Speaker 1: very important and very huge is the f FX swap market,
Speaker 1: which is, you know, people think of it as a
Speaker 1: derivative and whatnot, but I mean, at the core of it,
Speaker 1: it's it's really a funding market. One thing we know
Speaker 1: is that in Tokyo alone, the dollar yen f swap
Speaker 1: market UM is roughly one and a half trillion dollars
Speaker 1: in size, or that's what it used to be at
Speaker 1: least UM through the end of twenty eighteen. The Bank
Speaker 1: of Japan they have a wonderful Financial Stability Report UM,
Speaker 1: and there's a chart they used to publish there where
Speaker 1: they broke down UH life insurers UM and large megabanks
Speaker 1: demand for dollars in the f S pop market UH
Speaker 1: and recently they stopped publishing it, but up to the
Speaker 1: point where they published that those numbers were north of
Speaker 1: a trillion dollars. And you know, the f FX spop
Speaker 1: market is big, not only in Tokyo, but also in
Speaker 1: Europe and in uh in you know Satellite Europe as
Speaker 1: I call it, you know, Switzerland, Scandinavia, all these other places.
Speaker 1: So I think the money market is easily north of
Speaker 1: five chillion probably even seven trillion dollars, all right, So
Speaker 1: it's it's a big market to say the least. There
Speaker 1: are going to be a lot of super relatives used
Speaker 1: in this particular chat. But Salton, I'm glad you mentioned
Speaker 1: the f X swap market. So this is basically the
Speaker 1: place where big investors hedge or convert their currencies. So
Speaker 1: you know, if you're buying US dollar debt and you're
Speaker 1: a Japanese investor, you probably don't want to be exposed
Speaker 1: to that currency risk, so you might do a swap
Speaker 1: um in the market to sort of offset that cost. Now,
Speaker 1: you argue that a lot of the flows that we've
Speaker 1: seen in money markets recently have been changing partly because
Speaker 1: of what's going on in the f X swap market.
Speaker 1: Can you explain that there's obviously always two sides of
Speaker 1: the same coin, right, So on the one hand, if
Speaker 1: you are a foreign investor, like a Japanese investor who
Speaker 1: buys dallar assets, it's not only that you don't want
Speaker 1: to have that dollar f X exposure, it's not in
Speaker 1: your mandate to run with that risk, right, So by
Speaker 1: mandate you basically have to manage the FX risk of
Speaker 1: that position. And eliminate it. And that's what you use
Speaker 1: the swap market for. And it's been, uh, it's been
Speaker 1: the case that for many years the primary destination for
Speaker 1: all these and again let's just you know, broaden this out,
Speaker 1: so this is not just about the Japanese life insurers.
Speaker 1: This is about Swiss life insurers, Swedish life insurers, Northern
Speaker 1: European UH long only pension funds and and and insurers.
Speaker 1: Whoever is basically trying to escape a negative rate jurisdiction
Speaker 1: at home has been playing a game where they have
Speaker 1: been looking for UH decently yielding assets, primarily in the
Speaker 1: US UH and then buying those assets and hedging it
Speaker 1: back to the local currency. And for as long as
Speaker 1: the curve treasury curve was steep in the US, that
Speaker 1: was an easy trade, right because if you could buy
Speaker 1: the tenure treasury at two and a half percent and
Speaker 1: pay UM one percent to hedge, the f X component
Speaker 1: of that of that bondy would still end up with
Speaker 1: one and a half percent, which compared to negative rates
Speaker 1: in the in the home country are great. UM. And
Speaker 1: you know, if you go back to twenty fifteen, that's
Speaker 1: been that's been the case. There were a couple of
Speaker 1: structural things that happened. I mean, number one, basiltry was
Speaker 1: obviously introduced, and that raised balance sheet costs for all
Speaker 1: the intermediaries that we're providing these effects edges to to
Speaker 1: the life insurance the world over. And then we had
Speaker 1: a couple of episodes of financial reform, like money fund reform,
Speaker 1: like tax reform, which messed around with the spread that uh,
Speaker 1: these foreign investors had to pay over O I s,
Speaker 1: which is basically the feds preferred path for short term
Speaker 1: rates UM. And and you know, sometimes these spreads periodically
Speaker 1: flared up and they raised hedging costs, but then hedging
Speaker 1: costs came back down after um. You know, these episodic
Speaker 1: storms have subsided. But the very important thing that has
Speaker 1: happened from twenty seventeen onwards is that the FED really
Speaker 1: started to hike interest rates. And as the FED started
Speaker 1: to hike interest rates, they flattened the curve completely. So basically,
Speaker 1: relative to three month bills, the tenure treasury barely yielded
Speaker 1: a lot more. And then when you add up these
Speaker 1: post basal three spreads on top of very elevated front
Speaker 1: and rates, you basically ended up in a situation that
Speaker 1: where if you're a foreign investor, you just cannot buy
Speaker 1: treasuries on a hedged basis and make a positive spread. Okay,
Speaker 1: And you know, this has also been a theme that's
Speaker 1: been going on for a while. And because treasuries were
Speaker 1: no longer attractive given hedging costs, another important theme in
Speaker 1: the US has been that all of the foreign flow
Speaker 1: has been going into the credit markets, anything from I
Speaker 1: G to high yield to c l os. So obviously
Speaker 1: that that helped, UH strong conditions in those markets, and
Speaker 1: you know, those assets trade at a reasonably you know,
Speaker 1: widespread the treasuries, and those widespreads were basically what offset
Speaker 1: the rising hedging costs. Do these uh foreign institutional investors
Speaker 1: um And you mentioned earlier that currency risk was not
Speaker 1: part of their mandate, How does the credit risk of
Speaker 1: buying corporates fit into their mandate? Credit risk is fine,
Speaker 1: that's no problem for them, right because you know, the
Speaker 1: thing about FX pop market, the FX markets is that
Speaker 1: you know, currency is gonna can go up and down,
Speaker 1: you know, five fairly easily. I think in the credit world,
Speaker 1: if you don't have anything systemic or anything sector specific,
Speaker 1: and for as long as you're diversified, and I mean
Speaker 1: it's very hard to get mark down. Is that big?
Speaker 1: So we've we Tracy started this or in the intro
Speaker 1: we talked about all of this, the weird stuff we
Speaker 1: keep seeing at the end of each quarter in these markets.
Speaker 1: And I'm what is that all about? So what what's
Speaker 1: changed such that the final several days of each quarter
Speaker 1: become this period where suddenly stressed starts to emerge. I
Speaker 1: think in simple terms, UM, we now have a regulatory
Speaker 1: regime which banks are following chapter and verse. And this
Speaker 1: regulatory regime has changed the economics of a bank's balance sheet.
Speaker 1: And there is certain days when you have to report uh,
Speaker 1: your leverage ratio. It used to be, you know, the
Speaker 1: focus used to be UNRISC created assets. Now this is
Speaker 1: just a simple leverage ratio where demotional size of your
Speaker 1: balance sheet cannot be bigger than x. You have liquidity ratios,
Speaker 1: term funding ratios, you have interday equidity requirements UM so
Speaker 1: called g CP scores, which means, you know, the bigger
Speaker 1: and the more complex you are, the more search arts
Speaker 1: you have to carry as capital in future periods. And
Speaker 1: you know, the the system takes these reporting dates extremely seriously. UM,
Speaker 1: and every time these deporting rates come come by, you know,
Speaker 1: quarter ends, year ends, year in particular, UM, banks just
Speaker 1: shrink their balance sheets because they have to meet certain targets.
Speaker 1: And when these balance sheets shrink, the market disappears, right
Speaker 1: because a lot of these markets that we're talking about,
Speaker 1: RIPO and f X pops are basically intermediated through banks
Speaker 1: balance sheets. UM. I think academics have this tendency to
Speaker 1: think about markets as some you know, magical cloud on
Speaker 1: a chart that always clears. I mean, there's nothing magical
Speaker 1: about them. It's basically people putting balance sheet on the line,
Speaker 1: and if they take that balance sheet away, you have
Speaker 1: a vacuum. And when you have a vacuum, great spot.
Speaker 1: So UM, I want to go back for a second
Speaker 1: to what we're discussing about how it's becoming more difficult
Speaker 1: for foreign investors to buy US treasuries. Uh this basic
Speaker 1: idea that you know, they used to be able to
Speaker 1: buy them and then hedge them and still make one
Speaker 1: and a half percent on something like the tenure, and
Speaker 1: now that's not possible, partly because the FED has raised rates,
Speaker 1: but also partly because of what's been going on in
Speaker 1: the FX swap market. How has that changed the body
Speaker 1: of buyers for US treasuries, How has that been different
Speaker 1: in recent months or years? And also why should we
Speaker 1: care about a different group buying up US treasuries as
Speaker 1: opposed to an old group like Japan these banks. So
Speaker 1: I'll tell you the punchline first. You should care about
Speaker 1: this because I think all of these impacts the FEDS
Speaker 1: ability to taper entering the balance sheet tremendously. And I
Speaker 1: think that that concept is is he'll understood. So let's
Speaker 1: let's start with the past and they will come to
Speaker 1: the present. So it's been the case that foreign investors
Speaker 1: used to be very you know, avid buyers of treasuries
Speaker 1: at auction and again for as long as the economics
Speaker 1: of it were there, you know, could buy treasuries and
Speaker 1: hedge it back for a positive carry. You did it. Um.
Speaker 1: What changed over the course of last year, and particularly
Speaker 1: during the fourth quarter of last year, the foreign buyers
Speaker 1: for all intents and purposes, you know, the bread and
Speaker 1: butter hedged buyers, they disappeared. Because what happened in the
Speaker 1: fourth quarter of last year, actually coming into the fourth quarter,
Speaker 1: is that the yield curve um outright inverted relative to
Speaker 1: foreign investors hedging costs. Okay, so I guess one important
Speaker 1: observation is that people tend to obsess over the inversion um.
Speaker 1: Then they tend to obsess about it in a way
Speaker 1: where they measure it using three stands, and actually, like
Speaker 1: looking at the curve shape using the three month bill
Speaker 1: yield versus the ten year yield actually is not very
Speaker 1: meaningful these days, because the reason why we did that
Speaker 1: metric ten years ago, when by uh that metric had
Speaker 1: meaning to it, was because everybody used to fund around
Speaker 1: the three month bill yield, and everybody used to fund
Speaker 1: around the three month bill yield because we didn't have
Speaker 1: Basil three. Bank balance sheets were an unlimited supply, so
Speaker 1: basically banks were arbitraging funding spreads all the way until
Speaker 1: they roughly equaled three month billiards. And that's obviously not
Speaker 1: the case anymore. So looking at curve slopes using three
Speaker 1: stands makes no sense. Under Basil three, what you need
Speaker 1: to do is actually you need to look at actual
Speaker 1: funding costs relative to the ten year point, and that
Speaker 1: those relative funding costs are term repo, three month lib
Speaker 1: or three month hedging costs, and all of these rates
Speaker 1: are going to be you can translate, as you know,
Speaker 1: three month bills plus twenty three month bills plus forty
Speaker 1: three month bills plus okay, and so those are your
Speaker 1: actual funding costom when you look at UM the level
Speaker 1: of these actual funding rates relative to the tenure, relative
Speaker 1: to all of them. The curve has inverted last October,
Speaker 1: the first week of October UM. And the reason for
Speaker 1: that was obviously you had the year and turn was
Speaker 1: getting priced into the FX pop markets UM, so you
Speaker 1: had a big pop in hedging costs. Library was going
Speaker 1: through its typical year and UH widening, which has been
Speaker 1: a mainstay of of of the post Bassal three regime.
Speaker 1: And you know, collateral supply and treasury issuance was heavy
Speaker 1: and that was pressuring GC rates. And so you know, interestingly,
Speaker 1: you know, even though the outright inversion only happened one
Speaker 1: or two weeks ago, relative to the rates that matter,
Speaker 1: we've been living in an inverted curve environment since last October,
Speaker 1: which I cannot find it important to highlight because sometimes
Speaker 1: you can still read fat speeches that say, while I'm
Speaker 1: not worried about the inversion just yet, because it only
Speaker 1: lasted two weeks, and I want to see deeper than
Speaker 1: what we can actually see in three stands. Well, actually
Speaker 1: it didn't happen only two weeks ago, but since last October,
Speaker 1: and depending on what funding rids you look at, it's
Speaker 1: been as deep as thirty or forty basis points. So
Speaker 1: so these things, these things are changing as we speak.
Speaker 1: So we are living through this inversion. And importantly, you know,
Speaker 1: to get back to your question, Tracy, when this inversion happens,
Speaker 1: you basically knock away a few by buyers potential buyers
Speaker 1: of treasuries. So if the foreign hatched buyer cannot buy
Speaker 1: this buy treasuries at auctions, then that's one buyer base
Speaker 1: that goes away. If you're a bank and you cannot
Speaker 1: fund that the three month point in the CD and
Speaker 1: CP markets and buy treasuries at a positive carry, you're
Speaker 1: not that buyer base away. So you just basically start
Speaker 1: to eliminate all the buyers that have been coming to
Speaker 1: the treasury market. But then there's a very special buyer base,
Speaker 1: which is the dealers who by law have to buy
Speaker 1: if nobody else buys um and that's what you do
Speaker 1: as a primary dealer. That's by auctions don't fail in
Speaker 1: the US at least and if nobody else buys, but
Speaker 1: the dealers have to. You know, the dealers don't have
Speaker 1: the money. The dealers are funded entities. And if you
Speaker 1: end up in a situation where you have to take
Speaker 1: down a large chunk of treasuries unexpectedly because the auctions
Speaker 1: go bad, then you basically need a lot of repo
Speaker 1: funding to take those treasuries downe and finance them. And
Speaker 1: that's precisely what happened during the fourth quarter of last year.
Speaker 1: You had this shock where you know, hedging costs and
Speaker 1: all these other funding rates got to on economic levels.
Speaker 1: The dealers had no choice but to take down the treasuries.
Speaker 1: They had no choice but to fund it in the
Speaker 1: report market. And basically the way that transpired was they
Speaker 1: leaned extremely heavily to a handful of large banks, and
Speaker 1: into those large banks hqu a portfolio, and they completely
Speaker 1: stressed out the report market because of that. So I
Speaker 1: guess before we get further into the details, I guess
Speaker 1: you know what I just told you about how this
Speaker 1: impact is the FEDS a bit of the taper. The
Speaker 1: The important thing here to appreciate is that once you
Speaker 1: get into overnight markets where these dealers tend to fund
Speaker 1: their inventories if you lean very heavily onto the onto
Speaker 1: the overnight repo market and you stress out rates there.
Speaker 1: Basically the way that manifests itself is that report rates
Speaker 1: are going to trade our outside the fat's target range
Speaker 1: for the overnight funds rate. UH and you know, as
Speaker 1: they like to call it, the constellation of short term
Speaker 1: interest rates. And you know, as a central bank, UH,
Speaker 1: the FED cares deeply about where overnight rates print relative
Speaker 1: to the band because that's one of the most important
Speaker 1: mandates you have as a central bank to make sure
Speaker 1: that that overnight rates print print within the target. And
Speaker 1: once you have difficulty in controlling that, then you you know,
Speaker 1: open up a whole new kind of worms. And that's
Speaker 1: what basically forces you to rethink how much you can
Speaker 1: actually taper, because whether report rates print within the band
Speaker 1: or outside the band ultimately come down to how many
Speaker 1: reserves there are in the system. Yeah, no, this is
Speaker 1: this is the part I think I could use and
Speaker 1: maybe some listeners could use a lot of clarification about,
Speaker 1: because obviously the fact that the FED is going to
Speaker 1: halt its wine down of the balance sheet this year
Speaker 1: is a very a lot of people talking about it
Speaker 1: without much understanding, and people like, oh, they're they they
Speaker 1: were stopping. They think maybe there's some I mean, it
Speaker 1: feels like the debate is like, oh, is this some
Speaker 1: economic thing or is this some technical thing? And it
Speaker 1: feels like a lot of people think of some economic
Speaker 1: thing where something is telling the Fed, oh, you can't
Speaker 1: keep winding it down, and the Fed is trying to say, no,
Speaker 1: this is just sort of we wanted to be boring.
Speaker 1: This is more of just about the sort of technical stuff.
Speaker 1: So explain this further. What is going on in the
Speaker 1: market that requires them to, uh, you know, the demand
Speaker 1: for federal for reserves that they can't go below a
Speaker 1: certain level. Okay, So I know that question wasn't particularly articulate. No, no,
Speaker 1: it's it was. But I think it was a broad question, right,
Speaker 1: So I said, you know, how do you go from
Speaker 1: stresses in the report market to ending taper? So I
Speaker 1: think it was a little bit more complicated than there
Speaker 1: were actual reasons for it, and then there were technical
Speaker 1: reasons for it. I think the macro is that, you know,
Speaker 1: the period we're talking about the end of last year
Speaker 1: coincided with a global ip cycle. Slow down. You know,
Speaker 1: our economics team is quite prolific about you know, tracking
Speaker 1: all that stuff and and so. Um. Just you know,
Speaker 1: give you a nutshell version of this. You know, IP
Speaker 1: cycles are regular, and the Central Bank tends to overreact
Speaker 1: to them. Markets tends to be driven by them. Um.
Speaker 1: So every time you have these episodes where the IP
Speaker 1: cycle is troughing and things get dark, you know, people
Speaker 1: blues confidence about you know, the genevity of the cycle
Speaker 1: and uh and whatnot. So so that was one one
Speaker 1: part of it. The other more technical part of it
Speaker 1: would be that, you know, the fact that we had
Speaker 1: this sell off and risk assets during the fourth quarter. Okay, um.
Speaker 1: Some of it again has to do with the IP cycle,
Speaker 1: but some of it also has to do with the
Speaker 1: fact that if you think about a dealer's balance yount
Speaker 1: given house Air's balance sheets are post basal tree. If
Speaker 1: you are a dealer that by law has to now
Speaker 1: absorb two hundred billion of treasuries during the fourth quarter
Speaker 1: because there's nobody else's buying it, you have to make
Speaker 1: room on your balance sheet to absorb all that paper. Okay,
Speaker 1: So if your balance sheet is limited and you have
Speaker 1: no choice but to buy this stuff, you have to
Speaker 1: make room by selling other stuff. And when you look
Speaker 1: at dealer inventories by component during the fourth quarter, as
Speaker 1: they were absorbing the two hundred billion dollars worth of treasuries,
Speaker 1: they were trimming their inventories in virtually all other asset classes.
Speaker 1: So whether you look at I G or high yield
Speaker 1: or UM, you know, any any imaginable form of risk assets, equities,
Speaker 1: if you think about the amount of balance sheet that
Speaker 1: you want to deploy to I don't know, equity futures
Speaker 1: and funding you know, hedge funds, long positions in in
Speaker 1: the equity market, you have to tream all that stuff.
Speaker 1: When you trim it, it doesn't do anything good to
Speaker 1: equity valuations or credit spreads, right, So you know, George
Speaker 1: Source would say that things are reflexive. So sure, you
Speaker 1: have an IP cycle making people feel dead about the world,
Speaker 1: and then you actually have these technical adjustments that have
Speaker 1: to go through dealer balance sheets, which it's probably informed
Speaker 1: by the I P cycle, but it's also making the
Speaker 1: IP cycle's perception worse because you risk assets are doing
Speaker 1: ugly things. So you know these things are there. They
Speaker 1: were basically happening all at the same time to get
Speaker 1: into the super technical aspects of this. Why do reserves
Speaker 1: and balance sheet taper matter? Well, they they matter because
Speaker 1: you know, post puzzle three, I think an important feature
Speaker 1: of the system is that every possible trade or flow
Speaker 1: inter bank or dealer to bank or non bank to
Speaker 1: bank settles through the movement of reserves. Okay, And so
Speaker 1: that's point number one. Point number two. It used to
Speaker 1: be the case that before Basil three, non banks leaned
Speaker 1: heavily on clearing banks for intraday credit, and then the
Speaker 1: clearing banks and the large banks leaned on the ft
Speaker 1: for interday credit. Uh, And that intraday credit provision doesn't
Speaker 1: really happen anymore simply because there is stigma associated with
Speaker 1: tapping the FED for credit even on an intraday basis,
Speaker 1: and the price of interey credit provision between non banks
Speaker 1: and and clearing banks has gotten a lot more expensive.
Speaker 1: So basically, the system is trying to get trades and
Speaker 1: flows done with the amount of reserves that are in
Speaker 1: the system. Taper, for all intents and purposes, is impacting
Speaker 1: that quantity of reserves, right because every time bonds come
Speaker 1: into the system and the FED takes cash out, you
Speaker 1: just reduce the amount of reserves in the system. So
Speaker 1: the s degree if you will, that settles all the
Speaker 1: flows is getting, you know, scarcer and scarcer. And you know,
Speaker 1: days like December thirty one, when report rates popped four
Speaker 1: basis points outside the target band happened precisely because when
Speaker 1: it comes to clearing some of these trades, uh, there's
Speaker 1: just not enough tokens in the system to get this
Speaker 1: stuff done. And you know, December thirty one and the
Speaker 1: fourth quarter of last year was a particularly bad kind
Speaker 1: of quarter end because not only was it a year end,
Speaker 1: but also you had this outright inversion that the system
Speaker 1: had to deal with, and the dealers had to fund
Speaker 1: the inventories they got backed up with. December thirty one
Speaker 1: was also a settlement date, so everything that could possibly
Speaker 1: go wrong went bad. But you know, funding a bank
Speaker 1: and financial markets are not a science. I mean, bad
Speaker 1: days happen. And the important thing that we've learned on
Speaker 1: December thirty one is that really there's one or two
Speaker 1: large banks that have the amount of reserves ready to
Speaker 1: help the report markets clear. And then those one or
Speaker 1: two banks reached the amount of reach the limit of
Speaker 1: how much reserves they can lend into the market, bad
Speaker 1: things happen, and I think it's just not good policy
Speaker 1: and not good for financial stability when you have one
Speaker 1: or to private institutions like that and you have no
Speaker 1: formal backstop provided by the FAT for example, that would
Speaker 1: you know, preclude the system from having to deal with
Speaker 1: days like that. Again, So here's something I always wonder.
Speaker 1: Do you think that in the course of creating, you know,
Speaker 1: post financial crisis regulation like new basil requirements, like the
Speaker 1: High Quality Um Liquid Assets Rule h q l A,
Speaker 1: this this notion that banks had to hold a bunch
Speaker 1: of you know, liquid and top rated stuff, and in
Speaker 1: the core formulating unconventional monetary policy. Do you think the
Speaker 1: Fed ever thought what it would look like if those
Speaker 1: two things sort of collided together. Do you think they
Speaker 1: were thinking that much about the interplay between the new
Speaker 1: regulations and what was happening to their balance sheet. I'm
Speaker 1: sure they were thinking about it. I think no one
Speaker 1: really knew what this what this tipping point was, you know,
Speaker 1: so everybody knew that basil she was out there. Everybody
Speaker 1: knew that banks have to hold h q l A.
Speaker 1: What does that standford high quality liquid assets reserves and treasuries.
Speaker 1: I think where where people get a bit fuzzy was that,
Speaker 1: you know, the conventional wisdom was that, okay, well there's
Speaker 1: h l A and there's level one H and level
Speaker 1: two H. So when we taper, all we're really doing
Speaker 1: is we are taking away one type of level one
Speaker 1: h l A, which is reserves, and we are replaced
Speaker 1: seeing it with another which is treasuries, which is fine,
Speaker 1: but from A. And this is actually very interesting, right
Speaker 1: because all these lcrs, the liquity coverage ratios that require
Speaker 1: the banks to hold the liquid assets are based on
Speaker 1: end of day balance sheet snapshots. Okay. So that means
Speaker 1: that if your liabilities are this and x amount of
Speaker 1: these mature within dirty days, you need to hold um
Speaker 1: level one h q A against them to back them
Speaker 1: up and to comply with your liquidity coverage ratio. But um,
Speaker 1: you know end of DAI liquiity snapshots that require you
Speaker 1: to hold liquid assets that will cover your outflows over
Speaker 1: the next dirty days. None of that requires that your
Speaker 1: asset has to be able to provide intra day liquidity. Okay.
Speaker 1: And and this is where this is where things get complicated,
Speaker 1: because reserves are basically my for banks that banks keep
Speaker 1: at the FED. And every time flows happened between banks
Speaker 1: during the day, literally reserves go from one bank's account
Speaker 1: at the FED to another bank's account at the FED
Speaker 1: a million times a day. And the only instrument that
Speaker 1: you can take that that you can use to take
Speaker 1: care of these intra reserve account flows are reserves. You know,
Speaker 1: treasuries you can sell today, but you only get liquidity tomorrow.
Speaker 1: And if you land in the report market today, you
Speaker 1: will only get your money back the next day. Right, So,
Speaker 1: so I think where things got complicated and where things
Speaker 1: where the market? And and I guess um the Central
Speaker 1: Bank wasn't thinking too clearly about is that these intra
Speaker 1: day flows matter. And for some of these flows you
Speaker 1: can only use reserves. And when you cut too deep
Speaker 1: into the reserve needs of the system for inter day purposes,
Speaker 1: you have you have hiccups like December thirty one. December
Speaker 1: thirty one is a day where interday liquidity needs are
Speaker 1: especially high. But again, you know, bad days can happen anytime,
Speaker 1: and and and the December thirty first episode just tells
Speaker 1: us that, you know, we are quite close. We are
Speaker 1: basically two hundred billion away from from having these bad
Speaker 1: days potentially be more regular. So in theory, reserves and
Speaker 1: treasuries should they should be essentially the same quality asset
Speaker 1: um on the bank's balance sheet, but because of their
Speaker 1: different daily liquidity or intraday liquidity characteristics, they don't exactly
Speaker 1: serve the same purpose. So what is there something that
Speaker 1: should be done from a regulatory basis to avoid days
Speaker 1: like December thirty one or other periods in which it's
Speaker 1: essentially the stress imposed by the regulations itself that caused
Speaker 1: the tension. Well, I think it's it's a philosophical question.
Speaker 1: I think I think the superstructure of of the regulatory
Speaker 1: a work is correct. I think, um, you know, the
Speaker 1: rules are clear, banks are living with those rules. I
Speaker 1: would say that what's needed is not a tinkering with
Speaker 1: the architecture of bottle tree or the interpretation of it.
Speaker 1: But what's needed is is a is a simple plumbing
Speaker 1: fix where if you have some days where reserves get
Speaker 1: scarce for whatever reason, you should have an entity in
Speaker 1: the system that is going to put those reserves into
Speaker 1: the system on a temporary basis to control prices staying
Speaker 1: within the target band. Um. So I think that's the
Speaker 1: that's the path of least resistance, and that's that's where
Speaker 1: the should that's where the solution should be coming from.
Speaker 1: So basically, I think, you know, it's it's either providing
Speaker 1: more balance sheet elasticity for the private system through tinkering
Speaker 1: with regulations, or having a central bank that's willing to
Speaker 1: ride that balance at elasticity because they can and because
Speaker 1: that's their job and roll. Basically, so I think the
Speaker 1: path of these resistance politically and technically and from all
Speaker 1: sorts of angles is is a central bank doing what
Speaker 1: a central bank golf to do. All right, Sultan, I
Speaker 1: think we're going to have to leave it there. Sultan
Speaker 1: Posar from Credit Swiss, thank you so much. That was fantastic.
Speaker 1: Thank you very much. Thank you for having me. Joe.
Speaker 1: I've really enjoyed that conversation, if only because it really
Speaker 1: puts the yield curve inversion from the past few weeks
Speaker 1: in perspective, like everyone is going nuts because the old
Speaker 1: curve has inverted, and Sultan comes on and he's like, no, no, no,
Speaker 1: it's been inverted since October. Yeah. I really like that conversation. Actually,
Speaker 1: it was exactly what I needed. I just think that
Speaker 1: you know, as I said in my intro, I really
Speaker 1: didn't know very much about this topic, and I think
Speaker 1: my sort of incoherent questions sort of proved that. But
Speaker 1: it was exactly the sort of very clear conversation that
Speaker 1: I needed. And now I'm going to like read much
Speaker 1: more note and actually have some sort of understanding of
Speaker 1: what this is all about. Yeah, I think it's a
Speaker 1: really good reminder that often the way a lot of
Speaker 1: people talk about the market isn't necessarily reflective of the
Speaker 1: way that market actually functions. And I mean there's a
Speaker 1: reason we do it, because if we started talking about
Speaker 1: demand for U. S. Treasuries in FX hedge terms and
Speaker 1: things like that, I think, you know, we would never
Speaker 1: get a full sentence out. But it's actually really really
Speaker 1: important to consider things like currency hedging costs when we're
Speaker 1: talking about demand for U. S. Treasuries, And so rarely
Speaker 1: do we hear the thing I think that we do,
Speaker 1: or maybe I'm just projecting and I do it's just
Speaker 1: sort of abstract away um various technical factor that could
Speaker 1: be impacting the market. So even something like that last point,
Speaker 1: where in my mind I tend to think of reserves
Speaker 1: held at the FED and treasuries as being equal quality assets,
Speaker 1: the fact that under the current regulatory system, because of
Speaker 1: their different liquidity characteristics, they are different and there are
Speaker 1: times when they are not substitutes for one another that
Speaker 1: that is going to have an impact on things that
Speaker 1: show up in the market. So, in other words, all
Speaker 1: these things, like you know, the basil requirements, like the
Speaker 1: sizes of the balance sheet, like they're real and we
Speaker 1: can't just sort of um abstract them away, and I
Speaker 1: sort of think that they don't really matter. Yeah, absolutely,
Speaker 1: But if anything, you know, the next time you hear
Speaker 1: that primary dealer inventories of U S. Treasuries are at
Speaker 1: an all time high, you shouldn't necessarily see that as
Speaker 1: the sort of end of the world, but as a
Speaker 1: function of some of the big changes in money marks
Speaker 1: markets that we have been discussing. Should we eve it there?
Speaker 1: We've got there, and you know, like I still have
Speaker 1: a lot to learn, but I do feel after this
Speaker 1: conversation maybe I'm getting a little bit more understanding. We'll
Speaker 1: have Sultan on again. I'll talk more in the meantime.
Speaker 1: This has been another edition of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me on Twitter at
Speaker 1: Tracy Alloway and I'm Joe Wisintho. You could follow me
Speaker 1: on Twitter at the Stalwart, and you should follow our
Speaker 1: producer on Twitter. He's told for Foreheads. His handle is
Speaker 1: at foreheads T, as well as the Bloomberg head of podcast,
Speaker 1: Francesca Levi at Francesca Today. Thanks for listening.