The Fed's "Too Large & Too Illiquid" Bond Trap

Tyler Durden's picture

Submitted by Peter Schiff of Euro Pacific Capital,

The American financial establishment has an incredible ability to celebrate the inconsequential while ignoring the vital. Last week, while the Wall Street Journal pondered how the Fed may set interest rates three to four years in the future (an exercise that David Stockman rightly compared to debating how many angels could dance on the head of a pin), the media almost completely ignored one of the most chilling pieces of financial news that I have ever seen. According to a small story in the Financial Times, some Fed officials would like to require retail owners of bond mutual funds to pay an "exit fee" to liquidate their positions. Come again? That such a policy would even be considered tells us much about the current fragility of our bond market and the collective insanity of layers of unnecessary regulation.

Recently Federal Reserve Governor Jeremy Stein commented on what has become obvious to many investors: the bond market has become too large and too illiquid, exposing the market to crisis and seizure if a large portion of investors decide to sell at the same time. Such an event occurred back in 2008 when the money market funds briefly fell below par and "broke the buck." To prevent such a possibility in the larger bond market, the Fed wants to slow any potential panic selling by constructing a barrier to exit. Since it would be outrageous and unconstitutional to pass a law banning sales (although in this day and age anything may be possible) an exit fee could provide the brakes the Fed is looking for. Fortunately, the rules governing securities transactions are not imposed by the Fed, but are the prerogative of the SEC. (But if you are like me, that fact offers little in the way of relief.) How did it come to this?

For the past six years it has been the policy of the Federal Reserve to push down interest rates to record low levels. In has done so effectively on the "short end of the curve" by setting the Fed Funds rate at zero since 2008. The resulting lack of yield in short term debt has encouraged more investors to buy riskier long-term debt. This has created a bull market in long bonds. The Fed's QE purchases have extended the run beyond what even most bond bulls had anticipated, making "risk-free" long-term debt far too attractive for far too long. As a result, mutual fund holdings of long term government and corporate debt have swelled to more $7 trillion as of the end of 2013, a whopping 109% increase from 2008 levels.  

Compounding the problem is that many of these funds are leveraged, meaning they have borrowed on the short-end to buy on the long end. This has artificially goosed yields in an otherwise low-rate environment. But that means when liquidations occur, leveraged funds will have to sell even more long-term bonds to raise cash than the dollar amount of the liquidations being requested.

But now that Fed policies have herded investors out on the long end of the curve, they want to take steps to make sure they don't come scurrying back to safety. They hope to construct the bond equivalent of a roach motel, where investors check in but they don't check out. How high the exit fee would need to be is open to speculation. But clearly, it would have to be high enough to be effective, and would have to increase with the desire of the owners to sell. If everyone panicked at once, it's possible that the fee would have to be utterly prohibitive.

As we reach the point where the Fed is supposed to wind down its monthly bond purchases and begin trimming the size of its balance sheet, the talk of an exit fee is an admission that the market could turn very ugly if the Fed were to no longer provide limitless liquidity. (See my prior commentaries on this, including may 2014's Too Big To Pop)

Irrespective of the rule's callous disregard for property rights and contracts (investors did not agree to an exit fee when they bought the bond funds), the implementation of the rule would illustrate how bad government regulation can build on itself to create a pile of counterproductive incentives leading to possible market chaos.

In this case, the problems started back in the 1930s when the Roosevelt Administration created the FDIC to provide federal insurance to bank deposits. Prior to this,consumers had to pay attention to a bank's reputation, and decide for themselves if an institution was worthy of their money. The free market system worked surprisingly well in banking, and could even work better today based on the power of the internet to spread information. But the FDIC insurance has transferred the risk of bank deposits from bank customers to taxpayers. The vast majority of bank depositors now have little regard for what banks actually do with their money. This moral hazard partially set the stage for the financial catastrophe of 2008 and led to the current era of "too big to fail."

In an attempt to reduce the risks that the banking system imposed on taxpayers, the Dodd/Frank legislation passed in the aftermath of the crisis made it much more difficult for banks and other large institutions to trade bonds actively for their own accounts. This is a big reason why the bond market is much less liquid now than it had been in the past. But the lack of liquidity exposes the swollen market to seizure and failure when things get rough. This has led to calls for a third level of regulation (exit fees) to correct the distortions created by the first two. The cycle is likely to continue.

The most disappointing thing is not that the Fed would be in favor of such an exit fee, but that the financial media and the investing public would be so sanguine about it. If the authorities consider an exit fee on bond funds, why not equity funds, or even individual equities? Once that Rubicon is crossed, there is really no turning back. I believe it to be very revealing that when asked about the exit fees at her press conference last week, Janet Yellen offered no comment other than a professed unawareness that the policy had been discussed at the Fed, and that such matters were the purview of the SEC. The answer seemed to be too canned to offer much comfort. A forceful rejection would have been appreciated. 

But the Fed's policy appears to be to pump up asset prices and to keep them high no matter what. This does little for the actual economy but it makes their co-conspirators on Wall Street very happy. After all, what motel owner would oppose rules that prevent guests from leaving? The sad fact is that if investors hold bond long enough to be exposed to a potential exit fee, then the fee may prove to be the least of their problems.

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fonzannoon's picture

This article makes me almost ill. I was an avid follower of Schiff for a while. To see him take the bait on this makes me wonder how much of this I really got wrong. 

Peter, if you are reading this...or if you have read ZH.....the article was bullshit. There is so much demand for USTs that they are using the exit fee bs in order to get some people to sell bonds and buy stawks. The fed no longer has to worry about a mutiny...they own almost the whole bond market. What they have to worry about is everyone else piling in and yields imploding down.

Wake up man!

Al Huxley's picture

Why wouldn't the FED just dump a bunch of theirs to meet demand if that was the case?  And why the big anomaly in Belgium?  I have no idea what the fuck is going on, but it seems to me it might be in the FED's interest to NOT own the entire bond market, unless they're planning to force default and collect the country as collateral.

fonzannoon's picture

well belgium might be a PD for the eurozone or maybe it is just a helpful part of the ponzi. But even if you take Belgium out foreign treasury holdings keep hitting ATH's each report.

You are right too, it's not in the fed's interest to own the whole market. Just enough to control it and keep the appearance of a real market. I do think they would dump some of theirs if need be. But why not play gimmicky games and get others to dump theirs? As of now I think they fed is threading the needle with both the bond market and the stock market. But either way my main point, and ZH's point when they referenced the article Schiff was referring to, was that the article was most likely put out there to get people to move out of bonds into stocks, not to let them know that they will be preventing them from doing so in the future. I mean if you are going with capital controls, you don't announce it in advance.

As for everything else, like you, I have no idea wtf is going on.

fonzannoon's picture

For my junkers, from Mr. Durden...

"So what is the obvious desired outcome, at least by the Fed? Why a wholesale panic withdrawal from bond funds now, while the gates are still open, and since those trillions in bond funds have to be allocated somewhere, where will they go but... stock funds.

In other words, now that the Fed is pulling away from injecting tens of billions of liquidity into the market every month, it is hoping the investing population will pick up the torch. And since it has failed to incite the mass reallocation of funds from bonds to stocks, the Fed is willing to use every trick in the book to achieve its goal."


kaiserhoff's picture

I see your point, fonz, and the Fed greatly prefers talk to action,

  but if they wanted higher rates, why not let Fed funds breath free?  I agree on the abuse of power by these clowns, but their luck so far has masked their ignorance of markets and human behavior.   This could easily get away from them.  It's not easy to reverse a bank run.

fonzannoon's picture

they don't want higher rates as much as they want the velocity of money moving a bit. That is their ultimate conundrum. They technically have done most of what they can do. The velocity has to come from fiscal policy now, and that ain't happening. They are just poking around and hoping to buy time. I am not defending them but as of now between their talk and action we have low yields and the dow at 17k. i'd call that a win if there ever was one.

kaiserhoff's picture

Yes, a win if it holds, but they are worried sick about a collapse, as well they should be.

A better move (after infinite abuse and stupidity)  would be to raise rates gradually and wean banks off the Fed's tit, but they  never think in terms of main street.

I think Yellen is desperately seeking an exit strategy, but she/it doesn't have one.

fonzannoon's picture

It all comes back to the currency. If the currency holds then eventually, over enough time, people will throw in the towel and flock to the almighty SPY. I do agree though that at some point demographics etc. wins out and the ponzi collapses. However that could be way the hell off.

kaiserhoff's picture

Well said, and we're the best horse in the glue factory;)

mkkby's picture

Best dead horse indeed... but this is critically important.  Watch for UK, France, Italy and Jap to "go Greece", before the US does.  That is our tell.

Until then, scared money will come here raising the spy even higher.  To those of us hoping for a reset to quickly end this ponzi shit show, unfortunately that is probably decades away.

Grande Tetons's picture

The Red Sox traded Babe Ruth and Buckner forget to put his glove to the ground...but they eventually won the World Series.  Just a matter of time...unless you are a Cubs fan. 

El Vaquero's picture

Like Al Huxley and you, I really don't know WTF is going on.  This is the kind of thing that you would expect them to do in a panic, but then again, I know there are things that I do not know about happening.  I can see the evidence that something has happened (i.e. Belgium,) but I don't know what happened.  We simply don't have the whole picture here.  The reflexive corruption and reflexive corruption is sickening.

Thomas's picture

Greenspan and Volcker were discussing an economic collapse in 2005. They are acting before the panic (like when they locked down student debt in, I believe, about 2007.)

CrazyCooter's picture

The question in my minds is the following:

  • Company/bank/whorehouse/whatever borrows short and goes long in US government bonds.
  • Company/bank/whorehouse/whatever profits for a while.
  • Yeilds finally break up, smacking down bond prices.
  • Because of the leverage, the company has to liquidate to cover their position (like any of these jackasses has enough capital to wipe their ass with)

At first, a gate will prevent selling (i.e. is my loss less than the gate penalty), so the party goes on a bit longer. Gate fees will probably go up once they are put in place. But WHEN (not if) rates finally move higher, the gate has created even bigger losses (i.e. they still have to sell and at a penalty to boot).

What a shit show ...



doctor10's picture

What's going on is that the fed is buying the world with its ponzi-bucks.The Belgium thingy is a cloak to that effect. 

When its all done-its not just the cows' farts that will taxed!

kaiserhoff's picture

More likely Abe.  What else can he do with all that printing?

Actually, that's what I would do, if the home land glows in the dark, but the fools still take your money.

Why not?

acetinker's picture

fonz, you know i love ya', but... so much demand for UST's.... ???? Really?  The Fed tapers and miraculously, someone in Belgium becomes intensely interested in US debt?  No fkn way, man.  No fkn way.

What's it called?  Euroclear?  Legalized money laundering is all it is.  Schiff is right, if incomplete in his understanding.

Disclaimer:  I got outta the game when the 401k's were introduced (a long time ago) so there may be 'innovations' I'm unaware of that make your criticism of this article cogent.

Ya' know that the banks are 'all in' on equities, so you should realize that the Fed is made from the banks and is also asshole deep (as are ECB, BOE, Bundesbank) in gilts as well.

It's just a ride.

fonzannoon's picture

Ace leave everything else aside for a second and take belgium completely out of the equation. Without Belgium foreign purchases of UST's keep hitting new ATH's.

Then add in that Dodd/Frank upped treasury holdings as collageral for large banks. Then add in Pension funds etc. Then throw in Pimco and finally grandma. Believe me it adds up.

Schiff's big mistake was thinking no one would want UST's. People want them so bad the fed can drop hints of capital controls and that is not good enough to get anyone to sell.

acetinker's picture

Brother, I don't doubt you-at all, but what data have you seen that I have missed?  I've seen Russia selling off and China holding pat, but I don't see anyone other than western CB's investing in treasuries.  Further, that which makes this tragedy worse than anything Homer could have dreamed, is that these 'sovereigns' have resorted to buying each other's debt with their own debt.

This can't end well.

acetinker's picture

That's firewalled, fonz.  Be careful of that which you pay for.  Honest folk don't hide behind such facades.

fonzannoon's picture

sorry about that. From the FT. ZH quotes them plenty...

"At a time when the Federal Reserve has steadily reduced bond purchases since January and announced a further reduction at Wednesday’s policy meeting, foreign buyers have effectively stepped up, followed by domestic banks.

All told, foreign investors account for a record $5.96tn or roughly half of the $12.1tn in outstanding US government debt, with official accounts such as central banks holding $4.067tn, according to Treasury data as of April."

acetinker's picture

I didn't mention Euroclear for nothing, fonz.  Our Fed is buying up its own debt via QE and foreign proxies to make it seem like all is well.

It's not.

Debt piled upon debt- none of which can possibly be paid, is not a solution.  When confidence fades- and no one knows when this day will fall-  all that re-hypothecated wealth will vanish in an instant, and men will finally be free.

fonzannoon's picture

i think i agree with every word u just said i'm just a bit skeptical about the last 5 words.

acetinker's picture

As you should be friend, as you should be.  You see, the only way we can ever be free is to disconnect from the system that seeks to control us.  I've done that, and lemme tell you, it's a hard ride.  I dunno if there is a God, but I thank that God I dunno every day for my existence.

I said a long time ago that you were 'good people'.  That hasn't changed.

fonzannoon's picture

the last part is good to hear. same goes both ways.

acetinker's picture

I have a unique perspective on this world.  It is not kind, it is not respectful.  I found my mother dead from a single .22 shot to the heart when I was 15.  The cops eventually charged my dad, and to this day, I cannot say with full clarity that he didn't do the deed.

So, being considered a ward of the state  I had to become a nomad, for about three weeks.

This being so,  I can only imagine the plight of the children of the nations we've attacked.

Thomas's picture

The bond crisis will not be a shortage of bonds but rather a shortage of buyers. QE-WTF on its way.

teslaberry's picture

they are collecting the entire country as collateral through their give-away of free money to the ever smaller class of oligarchs that buy everything. and to ALL the old people who have savings that should and would have vaporized in 08. 


old people feel entitled to their savings. they shouldn't. if those savings aren't in their possession, and cannot be made to result in productive uses, they are toy trinkets held in someone's custody. 


stocks bonds---all confetti that should be worthless if the fed didn't print money. 


the YOUNG and LABORING classes are being screwed and everyone knows it. forced into ever shittier jobs doing ever more pointeless tasks, all while paying less and less. 


orangegeek's picture

Fed doesn't set rates, markets do.


Fed is a big buyer of bonds, so while they continue to print like animals they can hold down rates - see $4.5T balance sheet, up from $600B in 2009 if in doubt.


Taper in July should bode interesting.

I Write Code's picture

That's cute.  The one with the gold (or in this case printing press) makes the rules.  That's what a market is, at least it's subject to being abused and overwhelmed.

kaiserhoff's picture

Great piece.  The leverage makes this an incredibly dangerous time, and yes, by what color of authority do the Jews of the Fed have any damn thing to say about exit fees.  These critters are not just criminals and tyrants.  They are profoundly stupid.

Like many others, I think Japan will go down first.  There is no reason for any sentient being to hold yen, but as GHW liked to say, doo doo happens, and these fools are shovelling no end of it.

disabledvet's picture

This is definitely "textbook." Rush for yield causes risk that cannot be quantified...classically illustrated by the Great Depression Double Dip, Japan's "fail 2.0" and what is currently going on in Europe (yields are lower there than here. A fact unmentioned in this very good article.)

The fact of the matter is this article should have been written two years ago...when even MBS's were reaching stupendously low yields and high valuations...let alone treasuries.

Someone is sitting on some huge losses from that time frame forward.

It's not Bill "nothing but Net" Gross though. He warned the White House about grave dangers in Housing Bubble 2.0...and was summarily given the boot. The fact remains however "that which was smashed to pieces remains smashed to pieces."

Washington DC's housing market is doing great.

This is not true for the rest of America as "Fed stimulus wanes."

The question therefore becomes TWOFOLD...not just one. "Where is the bubble" (Peter Schiff et al did not see the bubble in gold last year) "and what do I do about it" (real estate this year.)

Given the enormous surge in equities you could argue "buy equities" actually...something Mr Schiff has studiously ignored as well.

At great personal pain (for I do not have to have explained to me what the meaning of long treasuries in fact is) I remain a treasury uber bull however.

A "true samurai bond"...meaning "move number two" is in fact TWO moves not just one. The "first second move" is simply a calculation of risk...the huge move higher in equities demands a rebalancing of risk towards debt.

The "second second move" (or DV's ooooo in "uber") is issuance.

The fact that massive amounts of issuance is coming is beyond all doubt true...but what I still am addicted to...for worse relative to my personal relationship to "the recovery" the theory that "greater issuance means greater demand."

The textbook response is to say the opposite...that the spread that currently exists between the short and long end (the "TED" spread) will be maintained thus providing ample opportunity for liquidity creation and a "recovery thesis."

The problem of course lays in the type of this instance one that is being led by the Government itself.

It is ironic indeed that a "free market guy" such as Peter Schiff cannot see a tree through his own forest! "What says recovery" better than a huge surge in inventories! That is "economics 101"!

Instead however "we will have a huge surge in debt issuance"...and that to me means only one thing...and has remained only one thing for over a year now...namely "a double dip recession."

If Wall Street is going by the book...and this is pure speculation on my part...but not "stupid speculation" in my view...then Wall Street remains "all in on the spread" and should that thing start flattening AGAIN (it's been doing so all year) both the long equity and the short treasury bettors will be forced to cover...which as we have seen in equities can be VERY painful indeed.

In short "if the entire Middle East is about to explode" (along with North Africa and "Russia") you will be an actual "item" for all that debt.

I believe the not so technical term is called a "Warpig."

kaiserhoff's picture

Sitting on losses, soon to be realized.

Nearly all financial institutions will soon be upside down on rates, which will then lead to being tits up!

Kprime's picture

I liok money, is 80 billion a lot?

Ness.'s picture

I'm no expert, but the GC repo rates on the 10yr last week were 'trading' at nearly fail rates (-3.00) for several days.  The 5 yr had the same experience.  Just for context, shorting the 10yr overnight normally runs about $75/mm and the 5 yr about $45/mm.  The last week has seen rates of $145/mm on the 10 yr, and $110/mm on the 5 yr.


I recall reading that the FED is considering turning more attention towards the overnight repo markets. Hmmmm?


I'm not sure how this filters down to 'Joe the Plumber', but even Joe would know something is wrong with the plumbing in the UST market.

kaiserhoff's picture

Thanks Ness, and please let us know when you write something in your real area of expertise;)

Ness.'s picture

tou·ché :)

Somebody really doesn't want "folks" to short this market and they're finding new ways to prove that point.

Prices down, yields up... I learned that from Steve Liesman.


Mr. Yellen earlier mentioned no aversion to neg. rates.


Tread carefully.


Salah's picture

Robert Prechter made a prediction about this very thing years ago....saying runaway inflation could come about after the Fed had destroyed the bond mkt.  That in itself would set off a chain of events that would result in an uncontrollable spiral of pricing panics, all acting simultaneously.  Might be good to revist his premonitions.

RaceToTheBottom's picture

The EXIT FEE is a direct result of the FEDs Failed research into SHAMWOW.

They were hoping on creating a new super sucker and it failed.  Now they need to penalize Bond sellers

AdvancingTime's picture

Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? We are abusing the large amount of wiggle room in our economic system and our ability to put off the day of reckoning only proving that we will until we can't!

Modern society has become very good at kicking the can down the road and delaying the consequences of bad policy.  This means that at some point the return on loaning money is simply not worth the risk! When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants. More on this subject in the article below.

fonzannoon's picture

deleted, moved above

thesecondslowestantelope's picture

Negative interest rates in Europe = exit fees in the US

6 of one, half a dozen of the other


ENTP's picture

Gee whiz....I wonder if the Exit Fee will apply to Belgian investors.....

I Write Code's picture

Well of course it sounds bad, but a thought here - if it's a small exit fee, like that everyone proposes to hinder HFT, might that not be a good thing?  I mean, under the circumstances, which are already far from good but aren't about to get much better.

El Vaquero's picture

Considering the Fed's and the government's track record, you can expect any actions taken to have no effect at best or the opposite effect of the stated intent at worst.  Their actions could actually create a financial contagion that they cannot control.  Think about what happens if they break the bond market and that shit spreads to the OTC derivatives markets. 

Lady Jessica's picture

Children.  Always remember that printing makes the spice flow.  Love LJ.

buzzsaw99's picture

@ 19:09 fonzannoon wrote: ...they don't want higher rates as much as they want the velocity of money moving a bit. That is their ultimate conundrum. They technically have done most of what they can do. The velocity has to come from fiscal policy now, and that ain't happening.


this and only this. they like low rates, they like the stock market high. what they can't stand is watching their maggot friends the big banks wither on the vine because everyone is camped out doing nothing. i don't care what they say or what they do, i ain't selling jack shit. they can't scare me with their hourly (and often conflicting) jawbones of doom, because they are full of crap, and the whole world knows it.

Hubbs's picture

but I remember Bernanke said the Fed has "tools" in it's "tool box" to stimulate the economy.. "We have tools at our disposal to get the economy going. " Tools, tools, tools.". That's all I ever heard from the Fed. "We have fucking tools." Like a crobar to fix a Swiss watch.