TSP Smart: The Fed Bailed out Buddies

Excerpts from Doug Noland’s article posted below:

Rather than tolerate a much overdue – and greatly needed – adjustment for a dangerously over-leveraged marketplace, the Fed resorted in September 2019 to so-called “insurance” stimulus – QE in the face of near-record stock prices and multi-decade low unemployment. This is key, and I doubt history will get this right. The Fed used extreme monetary stimulus to bolster an increasingly fragile leveraged speculating community – not to support either a weakening economy or a problematic Credit slowdown. Simply, the Fed moved to sustain the Bubble.

…Too many times over recent decades my worst fears have been realized. And over the past 15 months, the worst-case scenario has materialized. The Fed’s March 2020 system bailout reversed speculative deleveraging, and then almost $4.0 TN of QE fueled historic Bubble blow-off excess.

“The March 2020 shock to the UST market was unprecedented in scale, but due to the speed and extent of Federal Reserve interventions, relatively short-lived.”

TSP Smart: The Fed is patting its own back for saving hedge funds engaged in extreme leverage by acting so fast. They do not seem to bat an eye that it took $2 trillion in 5 weeks or that their previous interventions led to destabilizing the Treasury markets on assurances that the Fed would be there to rescue malinvestment.

The Fed should not be in the business of managing financial conditions through market liquidity injections. QE has significant effects on market perceptions for both the risk and potential return from leveraged speculation – therefore should be employed only temporarily for system stabilization in the most extreme crisis backdrops. Open-ended QE is reckless. So-called “insurance” QE is policy negligence. Sticking with $120 billion of QE in today’s circumstance of robust economic recovery and manic market Bubbles is a policy abomination.

Where would yields be today without Trillions of levered hedge fund and derivatives trades? Without QE? Without the emboldened leveraged speculating community fearless that the Fed will have no alternative than to move immediately with massive support in the event of market instability?

TSP Smart: Historically the 10-year Treasury yield came in near nominal GDP which would mean 3% higher than the suppressed 1.5% yield today. The price of money would be double and all the financial assets would be halved in a heart-beat.

As for my title, the hedge funds the Fed bailed out employ former Federal Reserve members. And did I mention the Federal Reserve is a unique private corporation with Citibank and JP Morgan owning over 70% of their shares. In other words, the cartel of bankers will of course bail themselves out with Treasury money every time.

Doug Noland’s title is more professional…


Hedge Fund Treasury Trading and Funding Fragility

by Doug Noland

Last week’s CBB focused on a fundamental flaw in contemporary central bank doctrine – using securities markets as the primary mechanism for managing system financial conditions. What began with Greenspan’s liquidity assurances following the “Black Monday” 1987 market crash – soon stretching in the early-nineties to interest-rate and yield curve manipulation to bolster market-based Credit – has morphed into $120 billion monthly liquidity injections in an environment of manic securities, housing and asset markets.

Greenspan’s policy shift was instrumental in generating extraordinary returns and rapid growth for the hedge fund industry, and leveraged speculation more generally. Fed and GSE backstops were key to the leveraged speculating community surviving the 1994 bursting bond/derivatives Bubble. Speculative leverage expanded rapidly, ensuring only greater backstops and bailouts during the 1998 Russia/LTCM fiasco.

Following the “tech” Bubble collapse, the Fed aggressively slashed rates and resorted to stoking unprecedented mortgage Credit growth and associated leveraged speculation in the name of system reflation. The resulting Bubble collapse in 2008 was met with the introduction of QE to the tune of $1.0 TN. There’s been no turning back, as Federal Reserve holdings have surpassed $8.0 TN – ballooning almost ten-fold since 2007.

This week saw an interesting addition to the Federal Reserve staff working papers in The Finance and Economics Discussion Series: “Hedge Fund Treasury Trading and Funding Fragility: Evidence from the COVID-19 Crisis” (Mathias S. Kruttli, Phillip J. Monin, Lubomir Petrasek and Sumudu W. Watugala).

I noted last week the omission of hedge fund leveraging in Loretta Mester’s “Financial Stability and Monetary Policy…” presentation. This week’s Fed paper helped fill in a few analytical holes.

“Hedge fund gross U.S. Treasury (UST) exposures doubled from 2018 to February 2020 to $2.4 trillion, primarily driven by relative value arbitrage trading and supported by corresponding increases in repo borrowing… Since 2018Q2 there has been a significant increase in repo borrowing, indicating a marked increase in long UST securities holdings.”

Data in the report are illuminating (i.e. “exposures doubled from 2018 to February 2020”), while corroborating the Bubble Thesis. Still, the research only covers a segment of the global leveraged speculating community. “The hedge fund data used in this paper are primarily from Form PF. In our analysis, we use the set of qualifying hedge funds (QHFs) that file this form quarterly.” Unregulated and “offshore” entities are excluded, including the massive “family office” complex.

Clearly, the past few years have witnessed a tremendous expansion in leveraged speculation. While this paper focused on levered trading in Treasury securities, March 2020’s volatility throughout fixed-income (i.e. high-yield and investment-grade corporate Credit, MBS, municipal bonds…) indicated the historic Bubble in speculative leveraging has seeped into every nook and cranny.

This particular Fed research focused on hedge fund activity in the Treasury market and, more specifically, in the popular “basis trade” strategy (leveraging long cash Treasuries primarily financed in the repo market, while simultaneously shorting Treasury futures/derivatives). With meager spreads/arbitrage opportunities available in these types of Treasury trades, they become enticing only through significant leverage. And extreme leverage creates fragility and vulnerability to systemic shocks and market dislocation, as was experienced early in the pandemic.

“In March 2020—as investors around the world engaged in a flight to cash and liquidity amid an unprecedented, sudden economic shutdown—there was a sharp divergence in the UST spreads that hedge funds generally bet will converge.”

“While UST securities play a vital role in the global financial system, hedge funds’ impact on UST market functioning is not well understood because they are less regulated than traditional broker-dealers and provide few disclosures. Further, compared to other asset managers, hedge funds employ substantial leverage coupled with investment strategies that are less liquid.”

“Compared to other UST trading funds during the March 2020 turmoil, the subset of UST hedge funds that predominantly engaged in the cash-futures basis trade faced greater margin pressure stemming from their short futures positions, requiring immediate liquidity infusions or position liquidations.”

This Fed paper included a number of illuminating charts that confirm the extraordinary increase in speculation that commenced in 2018 – in hedge fund “Gross Assets,” “Long Exposures,” “Repo Borrowing,” “Brokerage Borrowing,” and “Repo Securities & Other Collateral.” The most dramatic growth is displayed in the parabolic rise in “Basis Traders” “US Treasury Exposures” and “Repo Borrowing” – with Treasury exposures and repo borrowings more than doubling in 2018 to almost $750 billion (“Gross Assets” doubling to about $1.7 TN).

Recall the new Fed Chair’s hope for normalizing interest rates and somewhat weening the markets from Fed backstopping was DOA following the late-2018 eruption of market instability. Powell’s dovish “pivot” reversed what would have been a destabilizing de-risking/deleveraging episode. The Fed’s charts confirm that speculative leverage was expanding again by early-2019, only to begin a downturn during that summer’s bout of repo market instability.

Rather than tolerate a much overdue – and greatly needed – adjustment for a dangerously over-leveraged marketplace, the Fed resorted in September 2019 to so-called “insurance” stimulus – QE in the face of near-record stock prices and multi-decade low unemployment. This is key, and I doubt history will get this right. The Fed used extreme monetary stimulus to bolster an increasingly fragile leveraged speculating community – not to support either a weakening economy or a problematic Credit slowdown. Simply, the Fed moved to sustain the Bubble.

The predictable outcome is apparent in the Fed’s charts. Hedge fund Long Exposures, Repo Borrowing, and Brokerage Borrowing all quickly recovered and inflated to record highs right into the March 2020 crisis. Ditto for “Basis Traders” Treasury Exposures and Repo Borrowing.

From the Fed paper: “Compared to these [“tech bubble”, August 2007, September 2008] crisis episodes, the March 2020 shock is unprecedented, particularly in the speed at which extreme moves occurred and in its impact on otherwise safe and liquid markets such as the UST market.”

This indicates that during the COVID-19 crisis in March, these hedge funds were under a significant amount of stress, to a greater extent than at any point since Form PF reporting started in 2012. Clearly, the current crisis unfolded more precipitously than the global financial crisis in 2007-2009, which was characterized by relatively longer periods of a buildup of uncertainty from 2007 onward.”

Recall that the Federal Reserve’s initial March 2020 crisis measures failed to reverse a powerful “risk off” de-risking/deleveraging dynamic. The Fed was forced to rapidly employ open-ended QE, increasing holdings by over $2.0 TN in five weeks ($2.85 TN in 12 weeks). In addition to massive liquidity measures, the Fed established numerous financing vehicles (i.e. PMCCF, SMCCF, MMLF, CPFF, MSBLP, TALF…) to direct liquidity to specific markets. Moreover, the Fed announced it would take the leap into corporate debt and fixed-income ETF purchases.

The March 2020 extreme market stress period lasted less than three weeks until the Fed’s intervention, too brief a period for hedge fund investors to redeem their shares at a significant scale during the stress period itself, given the share restrictions of the typical fund.”

In my March 20, 2020, CBB, I wrote: “I understand we can’t allow the system to collapse, but Please Don’t Completely Destroy the Soundness of Central Bank Credit and Government Debt. Does anyone realize what’s at stake?”

Too many times over recent decades my worst fears have been realized. And over the past 15 months, the worst-case scenario has materialized. The Fed’s March 2020 system bailout reversed speculative deleveraging, and then almost $4.0 TN of QE fueled historic Bubble blow-off excess.

“…Although there is no evidence of significant deleveraging, the results suggest that hedge funds actively managed the risk of their portfolios in March 2020. Despite significant negative returns depleting NAV, hedge funds held leverage ratios unchanged by scaling down their gross exposures proportionately to their capital base.”

The March 2020 shock to the UST market was unprecedented in scale, but due to the speed and extent of Federal Reserve interventions, relatively short-lived.”

Rather than self-reinforcing and destabilizing outflows from an impaired leveraged speculating community, booming markets and strong performance spurred inflows, risk-taking and only more speculative leverage.

Our findings indicate that the quick intervention of the Federal Reserve to stabilize Treasury markets likely prevented a deleveraging spiral where hedge funds further sold off exposures in a declining market, realizing more losses and further depleting their equity. Compared to previous crisis episodes, the March 2020 shock was unprecedented, particularly in the speed and scale at which extreme moves occurred and in its impact on otherwise safe and liquid markets such as the UST market.”

In contrast, we show that hedge funds, while experiencing large losses in March, experienced relatively low outflows and shored up the liquidity of their holdings. Their use of long share restrictions were largely stabilizing.”

It is a central tenet of Credit Bubble Theory that unchecked speculative leverage has a propensity to turn highly destabilizing. And it is a grave development when liquidity associated with a Bubble in levered speculation becomes the marginal source of system liquidity.

The Fed should not be in the business of managing financial conditions through market liquidity injections. QE has significant effects on market perceptions for both the risk and potential return from leveraged speculation – therefore should be employed only temporarily for system stabilization in the most extreme crisis backdrops. Open-ended QE is reckless. So-called “insurance” QE is policy negligence. Sticking with $120 billion of QE in today’s circumstance of robust economic recovery and manic market Bubbles is a policy abomination.

It’s being called a “mixed” June payrolls report. With a stronger-than-expected 850,000 jobs added – strongest in 10 months – I’ll downplay the bump in the unemployment rate (and small decline in Average Weekly Hours) and label this robust data. It follows on the heels of the lowest weekly Initial Jobless Claims since before the pandemic; the Challenger, Gray & Christmas job cuts report at the “lowest level since June 2000”; and Wednesday’s much stronger-than-expected ADP employment gain (692k).

Meanwhile, 10-year Treasury yields dropped 10 bps this week to a near four-month low 1.42%. Where would yields be today without Trillions of levered hedge fund and derivatives trades? Without QE? Without the emboldened leveraged speculating community fearless that the Fed will have no alternative than to move immediately with massive support in the event of market instability?

July 2 – Bloomberg (Simon Kennedy): “Former Treasury Secretary Lawrence Summers said the surge in U.S. house prices is ‘scary’ and questioned the wisdom of the Federal Reserve continuing to purchase mortgage-backed securities as part of its stimulus campaign. Three days after data showed home prices jumped the most in 30 years in April, Summers told Bloomberg… that such gains are inflationary and would likely drive other prices higher. ‘This is scary,’ said Summers… ‘Rising house prices in most people’s common sense of the world represents inflation… I cannot understand why the Federal Reserve, in the face of this, continues to be every month a major buyer of mortgage backed securities…”

When it comes to today’s scary markets, housing is but one of many. And this notion gaining traction associating the Fed’s MBS purchases with surging home prices is misplaced. It is the awry Treasury market – the foundation of market prices – that has become the epicenter of dangerous levered speculation and epic market distortions that feed through to asset market Bubbles.

I just can’t shake the notion that Treasuries have one eye on Chinese financial fragility. It’s worth noting that Chinese stocks took it on the chin late in the week after the communist party’s 100-year anniversary powwow. From my vantage point, it sure appeared hubris aplenty for a system hoisted by one of history’s most spectacular Credit Bubbles (with cracks abounding).

Original Post 3 July 2021


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Categories: Doug Noland