Today, our favorite IMF economist, and arguably one of the few people who sees the big picture, Manmohan Singh issued a paper titled "Money and Collateral", which, not surprisingly, deals with the issues of money and collateral. And while it provides an interesting read, we can jump to the conclusion which is, not surprisingly, that there is simply not enough collateral within the global financial system, which in turn inhibits the proper intermediation of banks in traditional monetary conduits (due to the need for central banks to intervene in the place of traditional banks and shadow banking entities), which keeps the money multiplier low. We have extensively covered the issue of collateral scarcity and encumbrance previously (read: "Encumbrance 101, Or Why Europe Is Running Out Of Assets", "No Record Profits For Old Assets: Jim Montier On Unsustainable Parabolic Margin Expansion For Dummies", "A Few Quick Reminders Why NOTHING Has Been Fixed In Europe (And Why LTRO 3 Is Not Coming)", "How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement") so the paper's conclusion should not come as a surprise: until cash is used to replenish a diminishing, cash-poor asset base, nothing can change. Unfortunately, in the ultimate Catch 22, under central planning companies are disincentivized from investing cash into CapEx and organic growth, and instead are spending it on M&A and dividends, the two worst decisions management can take over the long run. It was one of the tangential "boxes" in the Singh paper titled "Floating Rate Note “puts”—are they forthcoming?" that caught our attention because it reminded us that in all the distraction over the past 3 months, we had forgotten that probably the most important event of 2012 is about to take place, and it has nothing to do with Europe, or with a central bank's balance sheet. Namely: the imminent arrival of Floating Rate Note Treasurys, or Floaters. In reality, while we noted this very curious development before (here and here), we did not think too much into what the Treasury may be signalling. Which was a mistake, because if Singh is correct, the US Treasury may be telegraphing to the world that it, or far more importantly, the TBAC, is quietly preparing for a surge in interest rates. Which as everyone and the kitchen sink knows, is THE black swan event (or gray for you taleb purists).
But before we go there, let's take a tangent of our own to a point in history 61 years prior, known simply as The Accord of 1951. Here is how Wikipedia summarizes this footnote in history, which the Fed, the Treasury and any US administration would be delighted to have never been made public.
The 1951 Accord, also known simply as the Accord, was an agreement between the U.S. Department of the Treasury and the Federal Reserve that restored independence to the Fed.
During World War II, the Fed pledged to keep the interest rate on Treasury bills fixed at 0.375 percent. It continued to support government borrowing after the war ended, despite the fact that the Consumer Price Index rose 14% in 1947 and 8% in 1948, and the economy was in recession. President Harry S. Truman in 1948 replaced then Chairman of the Federal Reserve Marriner Eccles with Thomas B. McCabe for opposing this policy, although Eccles's term on the board would continue for three more years. The reluctance of the Fed to continue monetizing the deficit became so great that in 1951, President Truman invited the entire Federal Open Market Committee to the White House to resolve their differences. William McChesney Martin, then Assistant Secretary of the Treasury, was the principal mediator. Three weeks later, he was named Chairman of the Fed, replacing McCabe.
Few things to note here:
- The Fed keeping rates artificially low is nothing new - the Fed did it during and after World War 2, when the short end was anchored at ZIRP, even as inflation was soaring. So much for bonds indicating inflation.
- There was a time when the Fed was "reluctant" to monetize the debt. The result was a termination of the Fed head.
- There was also a time when the Fed was truly independent. That led to the Administration and the Treasury to force a coup at the Fed, and to put in a puppet regime which would monetize debt no questions asked. This in turn led to official media to proclaim that a thoroughly subservient Fed is now "independent"
- Nothing like naming the Fed's Washington D.C. HQ for the one man who dared to stand up to the president's demands for infinite monetization... and get sacked for it.
He hope this little incident that nobody talks about puts everything we live through nowadays with the Fed, and its endless appetite for US paper, in a far more comprehensible light.
Yet while entertaining, this historical incident also teaches us about the future, and what may be imminent. Here is Manmohan Singh:
Floating Rate Note “puts”—are they forthcoming?
At the time of the discussions leading up to the Fed-Treasury Accord of 1951 which ended an extended period of artificially suppressed interest rates on Treasury bonds, there was much internal debate about the potential deleterious impact on bondholders from a “surprise” rise in rates. There was also concern about a potential buyers strike and/or fear that a new market equilibrium would entail a sharp spike in rates. This discussion was conditioned by the similar situation faced by the U.S. Treasury in 1919 after it promised to stabilize bond prices during and after WWI. This policy caused conflict with certain Fed policymakers and the eventual losses on Liberty bonds were still remembered by Congress and the Treasury in 1951, 30 years later. As a consequence, at the time of the announcement of the Accord, buyback options were offered by the Treasury, that is the U.S. Treasury offered to swap the outstanding stock of long-term debt with new long term debt with higher coupons (coupled with restrictions on sales before maturity). The idea was to cushion the market from capital losses.
Bingo: "prevent capital losses" by way of the modern version of 1951's Treasury puts. In a day and age, i.e., now, when investors generate the bulk of their wealth from capital appreciation (thank you ZIRP), and in which capital losses would be the deathknell for a US market in which the bulk of consumer and non-financial cash is already invested in the capital markets (recall "This Is Where The Developed World's Households Have Invested Their Money"), capital losses within the one asset that has been a cash magnet ever since the Second Great Depression, would be devastating. How devastating? Simple bond math: since a bond's yield is determined by its fixed cash coupon and its price, in an environment of rising interest rates (especially on the short-end which are duration magnified exponentially by the time they reach the long end) when the coupon can not be changed (or is 'fixed' as stated), the price of the bond has to drop to keep the yield rising. A good example are the new Greek 10 Year bonds, which because of their ~4% cash coupon, and 20% yield demanded by the market, are trading at just about 20 cents on the dollar.
Needless to say an 80% capital loss on the 10 Year Treasury would be cataclysmic for all those who believe their money is "safe." Also for America, and for modern capitalism.
So what is a Treasury to do? Well, unfix the fixed portion, or the cash coupon, so that rapid moves in interest rates are absorbed not by the capital loss to keep the yield higher, but by a spike in the variable interest margin over Libor. That way even if the Fed were to lose control of both the long and the short end, capital losses would be minimized, something of absolutely critical value in a society transfixed with capital preservation.
In other words, the market under the guise of the TBAC will provide the instrument, or product, that will be best suited to buffer a surge in interest rates. Ironically, the very act of rolling out this product is thus the alarm bell that higher rates are a-comin'.
This is how Singh sees the current comparable event, the imminent launch of FRNs, as comparable to the bond swap of the 1951 Accord:
Might the U.S. Treasury go down a similar path again in conjunction with an eventual Fed exit strategy? In the current environment, markets have witnessed a 30 year secular decline in bond market yields. Serious market turbulence might result, significantly greater than that associated with the February 1994 “surprise” rise in rates initiating a tightening cycle, were the market to believe it were embarking on a steady (or rocky) rise in rates from near zero to a “neutral” fed funds rate of 400 bps and a "normal' 5 percent yield on 2-year U.S. Treasuries. The recent TBAC’s proposal for floating rate notes (FRNs) seems an obvious option to cushion the transition for the market. As an indication that the eventual unwinding and normalization of the yield curve will take time and inflict pain on holders of fixed income debt, the market appears already to be requesting such "puts". In this context, it is useful to quote from recent TBAC report (Jan 31, 2012)
“… ways to explore the viability of Treasury issuing floating rate notes (FRNs). In particular, the presentation [attached] assessed potential client demand, optimal maturity, reference index, and reset frequency. The structural decline in the stock of global high-quality government bonds, coupled with an increase in demand for non-volatile liquid assets, should make U.S. government issued FRNs extremely attractive. Pricing for a hypothetical two year FRN was estimated to be in the arena of 3 month Treasury bills plus 8 basis points.”
What is also obvious is that if the TBAC is quietly shifting the market into preparation mode for "a steady (or rocky) rise in rates from near zero to a "neutral" fed funds rate of 400 bps and a "normal" 5 percent yield on 2 year U.S. Treasuries" as the IMF warns, then all hell is about to break loose in stocks, as by now everyone is aware that without the Fed liquidity, and not just liquidity, but "flow" or constant injection of liquidity, as opposed to merely "stock", VIX will explode, equities will implode, and all hell would break loose.
It is not yet certain if the TBAC will proceed with implementing FRNs. Although, since the proposal came from the TBAC, read Goldman and JPM, and what Goldman and JPM want, they get, it is almost certain that in about a month, concurrent with the next quarterly refunding, America will slowly but surely proceed with adopting Floaters.
The second charge was to explore the viability of Treasury issuing floating rate notes (FRNs). In particular, the presentation [attached] assessed potential client demand, optimal maturity, reference index, and reset frequency. The structural decline in the stock of global high-quality government bonds, coupled with an increase in demand for non-volatile liquid assets, should make U.S. government issued FRNs extremely attractive. Pricing for a hypothetical two year FRN was estimated to be in the arena of 3 month Treasury bills plus 8 basis points.
A discussion then ensued over whether 3 month Treasury bills or Fed Funds Effective was the more appropriate floating rate index. In conjunction with fixed-rate issuance, FRNs give Treasury an attractive alternative to increase the average maturity of its debt. While more analysis on the specifics of the program must be done, the Committee was unanimously in favor of Treasury issuing FRNs.
As a reminder, this is what Treasury's Mary Miller said earlier:
Treasury continues to study the possibility of issuing Floating Rate Notes (FRNs). The Treasury Borrowing Advisory Committee suggested in its February 2012 charge that FRNs could complement Treasury’s current suite of products.
Treasury recognizes that FRNs may provide a number of benefits to government finance, and plans to announce a decision regarding whether or not to introduce an FRN product at the May 2012 Quarterly Refunding.
What happens once we get Floating Treasurys nobody knows. But if 1951 is a precedent, when the unstoppable force of central planning finally rammed right into the immovable wall that is reality, it may be time to start heading for the cliffs.
Finally, here is the TBAC's FRN presentation: