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Here Is Why The Fed Can't Hike Rates By Even 0.25%
There was a time when Zoltan Poszar was the most important person at the Fed (and Treasury), because he was likely the only person in the government's employ who grasped the enormity and complexity of the then-$30 or so trillion US shadow banking system. A quick refresh of his bio from the Institute for New Economic Thinking:
Mr. Pozsar has been deeply involved in the response to the global financial crisis and the ensuing policy debate. He joined the Federal Reserve Bank of New York in August 2008 in charge of market intelligence for securitized credit markets and served as point person on market developments for senior Federal Reserve, U.S. Treasury and White House officials throughout the crisis; played an instrumental role in building the TALF to backstop the ABS market; and pioneered the mapping of the shadow banking system which inspired the FSB’s effort to monitor and regulate shadow banking globally. Prior to Credit Suisse, Mr. Pozsar was a senior adviser to the U.S. Department of the Treasury, where he advised the Office of Debt Management and the Office of Financial Research, and served as Treasury’s liaison to the FSB on matters of financial innovation. He also worked with the Federal Reserve Board on improving the U.S. Flow of Funds Accounts.
While Zoltan is currently working in the private sector at Credit Suisse, he is perhaps best known for laying out, back in 2009, the full topographical map of the US shadow banking system in all its flow of assets (or is that contra-assets when it is a repo) beauty.
Which is also why we bring him up, because in a much welcome follow up to his previous work title "A Macro View of Shadow Banking" which we will discuss further in the coming days because it is not only Zoltan's shadow banking magnum opus and must read for anyone who wants to get up to speed with all the latest development in the unregulated shadow banking space, but because Poszar also provides perhaps what is the most important chart which explains why the Fed is so very terrified of even the smallest possible incremental rate hike of 0.25%.
Specifically, we look at Poszar's findings about the implied leverage within the fixed income asset space in America's just a little levered buyside community. This is what he says:
Although no precise measures are available, the presence of leverage among hedge funds with credit and fixed income strategies has been recognized since the LTCM crisis (see Figure 21), as is leverage in separate accounts in the asset management complex.
While hedge funds and separate accounts are allowed to use leverage liberally – in fact, leverage is the sine qua non of these investment vehicles – it is widely underappreciated that bond mutual funds that are typically thought of as unlevered and long-only also have considerable room to use leverage.
The extent to which this room to use leverage is utilized is up to bond portfolio managers to decide, and it is not uncommon for the largest bond funds to maximize the leverage they may bear in their portfolio within the limits allowed by the Investment Company Act of 1940, and the SEC’s interpretation of the portfolio leverage and concentration incurred through the use of derivatives.
However, the creep of leverage into what are traditionally thought of as long-only bond funds was missed by the mainstream economics literature and textbooks entirely. For example, recent works that identify asset managers as the core intermediaries behind the “second phase of global liquidity” focus solely on indirect forms of leverage (FX mismatches) embedded in bond portfolios through holdings of dollar-denominated emerging market sovereign and corporate bonds (see Shin, 2013).
Other works state even more explicitly the widely-held assumption that fixed income mutual funds are unlevered, and analyze episodes of market volatility induced by redemptions without any regard to how direct forms of leverage embedded in fixed income mutual funds may amplify volatility during periods of rising redemptions (see for example Feroli, Kashyap, Schoenholtz and Shin, 2014, Chapter 1 of the International Monetary Fund’s October 2014 Global Financial Stability Report, Chapter 6 of the BIS’ 84th Annual Report, and Brown, Dattels and Frieda, 2014 (forthcoming)).
But all of these views sit uncomfortably with the hard evidence presented above, and recent revelations about “perceived” alphas (see Gross, 2014b) and price action in the interest rate derivative markets amidst soaring redemptions from the largest bond portfolio in the global financial ecosystem – the PIMCO Total Return Fund (see Mackenzie and Meyer, 2014). More concretely, a look at the portfolio of this specific fund provides good examples of the forms of leverage discussed above.
...
More broadly, the above example demonstrates the evolution of the traditional core product of the asset management industry – long-only, relative-return funds – as it came under pressure from two directions: from hedge funds, offering absolute return strategies, and from passive index-replication products in the form of low-cost exchange traded funds (ETFs). Core-satellite investment mandates became the trend, with hedge funds providing alpha and index-replication vehicles delivering beta at low cost. Traditional asset managers responded to this challenge a number of ways: some by launching their own, internal hedge funds, and some by incorporating into their core products many of the alternative investment techniques used by the hedge funds. These industry trends were the sources of competitive push that drove the above-mentioned creep of leverage into the industry’s traditional, long-only, relative-return bond funds (and hence the rise of levered betas), all designed to stem the flow of assets to the hedge fund competition and command higher fees as the profitability of traditional core products was squeezed (see Bank of New York, 2011 as well as Haldane, 2014).
And visually:
In short, what Poszar is saying is that in a world in which the traditional broker-dealers and banks have indeed reduced leverage and instead use $2.5 trillion in Fed reserves as fungible collateral against which to buy credit derivatives (for example as in the case of JPM's CIO office and its attempt to corner the IG9 market) the buyside community, which as we have long discussed has largely avoided equities due to fears of a spectacular market implosion (and certainly minimized levered exposure in the space with the exception of several prominent HFT participants) has instead been forced to chase after fixed income products. And chase with leverage that would make one's head spin as can be seen in the outlier chart above.
And while Poszar may be quite correct in stating that most have missed the leverage creep he observes above...
Perhaps the key reasons why economists have missed the creep of leverage into the traditionally long-only world of fixed income mutual funds are the conceptual gaps in the way in which the U.S. Financial Accounts (formerly the Flow of Funds) depict the global financial ecosystem, and by extension, the limited mental map it gives to economists who use it to understand asset prices.
... one entity that does understand all this and grasps the momentuous implications of even the smallest quantum of interest rate increase, is the entity where Poszar previously worked: the US Treasury and the Federal Reserve itself.
And so, the next time someone asks "why is Yellen so terrified of even the smallest possible rate hike", show them this chart above and explain that the Fed vividly remembers what heppened when LTCM blew up. What the Fed doesn't want, is not one but one thousand LTCMs going off at exactly the same time in what is now the world's most levered trade...
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House of Cards
1.Hedge funds are popular because of the HIGH RISK/HIGH YIELD strategy.
2.Hedge funds evade the SEC rules by being a private club,and not being listed on exchanges,not having to cough up a balance sheet.
3.LTCM prided itself on having a large number of staff with Nobel prizes on their resumes.
Whether a Nobel should be issued in Economics as a field is a still debatable point.
If a firm with this pedigree can still find itself instantly insolvent,then one could make a case for serious future regulation and ENFORCEMENT.This was more than a five buck loss.However if people want Vegas rules,then they should eat the loss,and stop whining.
4.This was under Bill Clintons watch (1998?).Someone ruled this event as "Systemic".
This was the first of the Too Big To Fail. I will leave out the Chrysler bailout for now.
As the thrust of this article shows,Big profits come from leveraging up the bets.
As was shown,Big losses can also be realized with leveraging of the bet.
The modern (TBTF) philosophy is: I will get bailed out.This is moral hazard.
5. This firm recklessly invested in Russian bonds just prior to the collapse of the Russian economy.
Once a bet starts tanking it is hard to find a buyer for the now toxic security.
The highly leveraged bets are enabled by very low interest rates from the Central Bank (FED).
6.It is human nature to hide our mistakes. Waiting to call for help when you are going over Niagara falls is
not a wise policy. Also,in Finance areas, "Sharks smell blood in the water",margin calls happen,credit lines
dry up suddenly," options" disappear.
7.I would wager that the majority of this hedge funds' membership were north of $100k income per year.
If they are too cheap to do due diligence or pay someone else to check the books,I am not going to lose any sleep over them.
8.The failure of a large number of hedge funds would have a healthy effect on investment policy.
The honest,well managed firms survive and prosper.The fraudulent,mismanaged firms are allowed to fail. No Bailouts,ever...
9.Bring back criminal prosecutions for fraud.No more out-of-court settlements without admitting guilt.Jail time.Real prisons.
If the "in the know' crowd knows this (i.e. Jeb Bush, Hillary....hell even Romney) Why would you want to be the next President and preside over this nightmare?
Completely of topic, but very good article: http://www.thedailybell.com/news-analysis/36166/Real-Reason-for-the-Asia...
p.s. china playing a doule game? one game for a one world with equal power to the west and the other game for a multipolar world? either outcome would suffice, whichever has most benefit to china in the end...?
I know its of topic, but i just read it and wanted to post to exchange some opinions)!
Dont Forget the pension fund models on higher rates.....still waiting/hoping/praying/ignoring
Now this was some good stuff Tyler.
Janet Yellen farts, stocks smell a winner - futures surge on natural gas play.
Pretty good CNBC headline, no?
Institute for New Economic Thinking: A Soros Front.
If this is ever translated into English, please post again.
Hey look, all them hedgies is supposed to be so smart and they had to know this is coming and anything and anybody has a problem with a few small bumps in interest rates, fuck'm if they can't take a joke.
If you are so blind that you cannot see that the size of government debt is why the interest rate won't be raised any time soon then you need a cane.
At basically zero percent interest they are paying half a trillion in interest. The debt would grow explosively if the interest rate was raised by a quarter or a half point.
How could you continue attacking every country that looks at you sideways if you had to pay more for your interest? How could you grow . gov if you actually had to justify the cost with real money? How in god's name could you make sure that the bankers were getting ever wealthier if you couldn't just hand them sacks of free cash?
That is why the interest rate won't be raised in my life time. 55
the 10, 20 and 30 year bonds are NOT paying anywhere near 0% interest. More like 2 to 2.5%. That is not zero.
Those bonds are debt.
And the interest rates on those bonds varies quite a bit.
So, if interest rates on those bonds were raised .25% or .5%, that would not be that big a deal. In fact over the last month or two, interest rates on those bonds has already varied by .25% or so.
So, your turn....
When the Fed raises rates, that's the floor NOT the spread. So if they raise it .25% and then normal fluctuations occur that's now .5% or more in the aggregate. That's a huge discount on the face of a bond that is only giving 2.5%. The real issue, the primary issue is the greed of the elites who would loose 50% of their network in one fell swoop if bonds climbed to 5%. The people who control the Fed and the government leaders are all in bed with each other and hence they are NOT going to allow their networth to be affected. While rational people believe in the importance of spiraling interest rate costs to the government balance sheet, these people are on the other end of that equation.
However, this is only one issue, the article indicates these greedy elites are neck deep in derivatives, any small movement costs huge amounts of money if you bet the wrong way.
Amen, brutha. Preach it!
Impeach all 535 + ICiC for fraud, treason
First you'll have to wake up and impeach the 8 billions dumb, ignorant and fucking useless sheeple for being so useless and ignorant - since thousands of years (despite history) ... since Stonage in fact.
Or do you think the 535 + ICiC will impeach themselfs?
The whole ZH crowd is a whining crowd of sheeple - still (playing and begging) on the table of the banksters and fedsters.
They have never taken things and change into their own hands. Or how many of you have been out in the streets yet - protesting against the bankers and fedsters and corruption and imbalances and all the shit you complain day in and out???
Blind and dumb and ignorant sheeple here and elsewhere are just fiddling their one-eyed and likewise ignorant puppet masters instruments.
Nothing will ever change for another zillion of Stonages with that kind of animals.
Humans are a failed experiment. Completely useless. Just a pest for the planet. Nothing else.
For much more than just one reason.
Why is the article significant:
they /gov. fed/ know it from the beginning and they have been playing this game from the beginning purposedly.
Implication: They are criminals. They deserve a 2m rope, each of them.
boy - talk is sooo cheap.
learn to spell before pronouncing death sentences, dipshit
Leverage everything! Casino Capitalism at its finest...
Rates will only rise on their own; not via the FED.
The trades and conclusions should be obvious once you understand that.
Why does US media listen to Yellen/Obama - cretins
why does anyone listen to them?
Would have been helpful if you had defined what LTCM is. I'm guessing it's Long Term Capitol Management. Now you could explain how these investments are typically levered up and therefore extremely sensitive to even the slightest .25% rate hike.
You are writing to a laymans audience and you make no attempt to clarify your terms to the man on the street. I'm assuming you're trying to communicate to the widest audience available.
This is a Financial Website.
If you do not understand leverage then you do not belong here.
This is not College.
This is not Finances 101.
This is not Economics 101.
This is not Accounting 101.
There are Business Colleges where you can attend to learn about that. Of course that costs TUITION.
Or you can READ BOOKS on your own and learn about it.
You are not ENTITLED to anything here. You are not entitled to an education. Neither am I for that matter.
Lose your fucking entitlement mentality and attitude and quit demanding...
Then people may help you out of kindness...or stupidity as they can be using their time...TO MAKE MONEY.
A small increase on the yield on near Zero Interest Rates Bonds will have the affect of destroying in the Asset Base of Financial Institutions in the Fractional Reserve environment.
People will sell existing Bonds, en masse, in order to garner higher yielding bonds. If a bond is currently yielding 2% and the Interest Rate increase is "just a 0.25% increase" then the difference of percentage gain of annual income yielded from selling current bonds and purchasing newly issued bonds is a whopping 12.5%. That is a damned good incentive to dump existing, lower yield bonds.
This collapses the price of existing lower yield bonds due..TO LACK OF DEMAND, which, in turn, creates insolvency for institutions, who HOLD CURRENT BONDS AS RESERVES, because the VALUATION of current bonds declines. This is so damned simple. It is so damned BASIC.
It is a fucking waste of time for me to write it YOU LAZY FUCK.
If you do not know this then GET THE FUCK OFF MY PORCH. YOU DO NOT BELONG HERE.
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Thank you for your description of what this article is talking about, as I was attempting to parse it’s meaning for my mother, and found it just incomprehensible.
You’re grasp of finance is truly impressive.
Despite this, you are an asshole.
You are the problem with the financial world.
I’ve been on Hedge for years, and I’ve learned a ton.
I also have learned a lot about advanced physics and black holes, without needing advanced physics and math. Let me school you in my metaphor.
Here is what you need to know to fly by a black hole:
#1. Black holes really, really suck. The sucking is referred to as gravity.
#2. There’s something called an ‘event horizon’ that we define as the point that not even light can escape from, behind that sucking.
#3. That ‘event horizon’ varies upon the size of the black hole/gravity well.
#4 Know how powerful your space ship is, how big the gravity well is, leave plenty of margin for error and safety, (don’t get too close) and enjoy your flight.
That’s how finance should work if people truly want to get their ideas across.
Otherwise, it becomes a closed community for the elite, who I’m sure would like this, and purposely obfuscate and hence, hide the true intentions of their machinations.
This is not about financial acumen, it’s about conveying an idea in common English, not like some fucking Noam Chomsky Bot of Finance.
Why couldn’t the article just say what you did, in this manner?
Your criticism is completely uncalled for and unjustly applied.
A lot of people, who aren’t in the finance world, come here as one of the premier finance resources in the world, to read what they can, and don’t need to be criticized, or talked down to, from the exclusive financial club members of the world.
Try to moderate your arrogance the next time, but please do contribute, as you appear to have a good grounding in finance, and an ability to explain it in layman terms, as it should be.
•J•
V-V
In summary - if I got this right - the reason interest rates cannot go up is because the debt instruments (treasuries et al.) are used as collateral in a 3-to-4 digit Trillion shadow Ponzi that would topple instantly if said collateral became worth less... The problem: The collateral IS worthless.
Another thought to consider about why the FED is very hesitant to raise over night rates: if the US$ remains less odious than the EU and the US$ keeps on strengthening, even the smallest increase in rates would lead to an explosion of the U$ against the EU, would it not? This would hamper the balance of trade between America and Europe in ways that will probably hurt both sides. Would it not put immediate pressure on Europe to immediately match the rate increase so as to keep an even playing field? I would think that any rate rise would also trounce the C$, which remains America's largest trading partner. This too would cause havoc, would it not?
Well, the way i look at it, the fed cannot raise rates, because the govt would not be able to pay the interest on the new debt. It immediatey causes all the existing lower-rate bonds to be discounted as folks scramble for the higher rates. Maybe not a meltdown, but volatility and confusion would reign. Just like now maybe.
I'm so fucking glad the Fed printed trillions so barristas at Starbucks can start a conversation with me about race. What an insane crock of shit.
If a horse can't run, and a horse can't walk, or turn, or back up, eventually the horse will die. The Fed is the stopped horse: no path, no real action, no options. Our economy slowly starves...
Gonna blame my foggy comprehension of this article on my mug being still warm.
It’s simple really. Bond funds that once returned their customers 6% on risk free assets now must take enormous leverage (risk) to do the same. Otherwise their customers only see a 1.5% return and leave. It’s similar when companies use debt borrowing to buy back their stock and juice the price. Investors see the returns and cap appreciation and love it. But, they don’t see the increased risk used to make it happen. Ergo, it’s the perfect management scam. It keeps working until the cost of leverage exceeds the return on assets, then the whole thing implodes.
so what if it does implode? How would that stop the Fed from raising rates?
2011? Isn't it 2015.
Debt is like an assasin with many faces, many weapons, and many ways to kill you.
OMG, I must have turned into a prophet when I lost my profit.
Great piece, thank you.
Or....................they can and will raise rates when they are ready for the plug to be pulled. Combined with some false flag incident that will be blamed on Russia, China, Iran, or whatever boogeyman they are lining up to point the big statist finger at when the whole enchilada goes up in smoke..............
I have found that I am not so good at keeping up with psychopathic reasoning and actions, so maybe taking my opinion with a grain of salt is a wise idea.