One of the most significant, if underrpeported stories of the week, was the announcement from Monday that in order to "prevent" bank runs, the Fed is preparing to impose "exit fee" gates on bond funds, in what, the official narrative goes, is an attempt to prevent a panicked rush for the exits. Of course, this is diametrically opposite of what the truth is.
This is what we said: "it goes without saying that "discouraging investors" from withdrawing funds is the last thing on the Fed's mind, which knows very well that when it comes to investor behavior all that matters is how the Fed's future intentions are discounted. And with this unprecedented step, the Fed is sending a very clear message: it may be next year, or next month, or next week, but quite soon you, dear retail bond-fund investor, will be gated and will be unable to pull your money.... 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."
But wait, this would mean that instead of attempting to prevent a rush for the exits, the Fed is in fact doing the opposite, and is seeking to force investors to sell those sticky bonds they are holding on to and destroying the propaganda of a recovery (remember: you can't pitch a stable inflation-driven recovery fable when the 10Y is trading at 2.50% in the process launching the very run for the exits it is supposedly trying to avoid.
Pure conspiracy theory right?
Well, maybe. But that doesn't explain why someone else who agrees with our assessment is none other than... the Fed?
That's right: here is what a recently released research paper by Cipriani et al of the New York Fed titled, "Gates, Fees, and Preemptive Run" found:
Our paper is the first to show that the possibility of suspending convertibility, including the imposition of gates or fees for redemptions, can create runs that would not otherwise occur. This contrasts with the existing literature, which focuses on whether suspension of convertibility can prevent runs. In other words, we show that rather than being part of the solution, redemption fees and gates can be part of the problem.
... we show that there can be preemptive runs that occur only because an intermediary has the ability to impose "standby" (liquidity-contingent) gates or fees. Second, we show that for an intermediary that maximizes the expected utility of its own investors, imposing a gate or fee can be ex-post optimal. Hence, for an intermediary that can restrict redemptions in a crisis, a policy of not imposing such restrictions may be time-inconsistent. The financial intermediary might like to commit not to restrict redemptions, so that preemptive runs would not occur. Absent a means of ensuring commitment, however, the intermediary will find it optimal to suspend, confirming the beliefs of informed investors who withdrew preemptively.
Stated far more simply: the mere prospect of gating creates a self-fulfilling prophecy that results in the very bank run the gate was designed to prevent.
One can be sure that the same Fed, which is proposing "exit fee" gates is quite aware of this paper's conclusions. In fact, one can be certain that the Fed is imposing said gates precisely due to the findings of this paper.
In other words, the Federal Reserve, tasked with preserving financial stability, because not even the Fed pretends to be in the inflation and unemployment dual-mandate business any more - it is all about the "not a bubble" valuation of the S&P 500 - is actively seeking to create a bond run panic!
We wonder just which part of the Fed's "financial stability mandate" covers the Fed's attempts to spark a bond sell off.
Ironically, subversive intentions aside, as usually happens with the Fed when the intended theoretical outcome comes crashing down in the real world, an attempt to created a "controlled" panic, limited solely to bonds may very well backfire and result in a paniced withdrawal of other asset classes, including the most precious one of all to the Fed - equities.
Our results have broader policy signicance. Rules that provide intermediaries, such as MMFs, the ability to restrict redemptions when liquidity falls short may threaten financial stability by setting up the possibility of preemptive runs. Much of the wider policy signicance of that risk is beyond the scope of this paper, since our model does not incorporate the large negative externalities associated with runs on financial institutions, including MMFs. But one notable concern, given the similarity of MMF portfolios, is that a preemptive run on one fund might cause investors in other funds to reassess whether risks in their funds are indeed vanishingly small.
Example of the above: the S&P downgrade of the US which was supposed to drive investors out of bonds (and into stocks), had precisely the opposite effect.
But more importantly, now that the Fed has explicitly said in no uncertain terms that gating bonds funds will likely result in a loss of "financial stability", the next time there is a mandated market crash originating from either a bond run, or wholesale liquidity extraction panic, the world will know just who the guilty party is: the Fed.
Full paper below (link)