Short End of the Stick, er… Curve

Read an article at Bloomberg the other day.  One of those stories that nobody probably pays any attention to until it’s too late.  Well in an attempt to make sure I see all of the trains that can hit me (Note: It’s always the train you don’t see that hits you), I thought I’d say something about it.

First, it starts off rather ominously:

The drop in the premium banks charge for dollar loans above the federal funds rate to pre-financial crisis levels may indicate investors are underestimating risk again, according to Macroeconomic Advisers LLC. 

 Ah, yes complacency.  Where have you been my long, lost friend?  Winter of ’07 seems so far away now.  You all remember then, right?  That was the around the time this place got started.

Plus, who are these know-nothing guys at Macroeconomic Advisers?  Umm, wait.  Oops!  These guys probably know something and if they don’t know, then we’re all screwed.  Anyway, let’s jump down a ways.

The Libor-OIS spread has narrowed to the least since 2007, prior to the collapse of the subprime-mortgage market and the global credit rout, amid government support to the banking sector, the firm headed by former Federal Reserve Governor Laurence Meyer wrote. Investors may be under-pricing risk if the gap doesn’t widen as government support wanes, said former Fed economist Antulio Bomfim, who co-wrote the report.

“We’ve seen a decline in risk premiums larger than we would expect for this stage of the cycle,” Meyer, vice-chairman of Macroeconomic Advisers, said in a Nov. 9 interview. “We have to appreciate the signal from these spreads that suggests that the prevailing level is unsustainable. While we don’t think that suggests a dangerous reversal, certainly some reversal will be likely.”

That’s pretty much a shot across the bow, folks.  Or at least as much of a warning you’re going to get from a guy who used to be a central banker.  But to illustrate what he’s saying, I have a chart for a reasonable proxy of the LIBOR-OIS spread below.  The spread is calculated by taking the difference between the 3-month LIBOR rate and the nearby 30-day Fed Funds futures rate, which shows the market’s expectations for Fed Funds.


Notice the spike starting in the ’07 timeframe. That was during the August of 2007. You know, when all hell started to break loose.  But there’s another way we can examine what happened by looking at where Fed Funds were trading themselves.

To paraphrase the Apple commercial, there’s a  chart for that.  And I have it right here.  This is a daily chart of the daily standard deviation in Fed Funds trading at the New York Fed.  You’ll see the same pattern as the chart above, but the chart only goes back 2 1/2 years. But you should still get the idea.

Fed Funds - std deviation

One thing I notice is this: volatility – as measured by standard deviation – is way lower now than even before August ’07.  Why? Part of it has to be due to the Fed Funds target is now a range – not a rate.  My theory is by allowing Fed Funds to trade in a target range, volatility is being dampened because you’ve changed what/how you will calculate a difference.  If you target a specific number, any number which is different from that target is in and of itself a variance.  But if you target a range, you will only measure moves that are outside of that target range.

Of course, there’s this whole other thing you have to deal called the Fed balance sheet.  Take a look at the following chart:

Fed Balance Sheet 10-09

A pretty graphic, stunning, and grotesque view of the balance sheet expansion the Fed has undergone to try and unfreeze markets.  I’m going to tell you right now I don’t think it’s worked one bit.  The Fed is essentially the only provider of liquidity right now, volatility is lower but that’s because interbank lending is still dysfunctional and banks still have billions waiting for them in charge-offs.  And given what the Fed said as they embarked on quantitative easing…

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I’m not sure a rate hike is going to be needed to raise rates.  Rather, I’m leaving the possibility we can see a rate increase merely as a function of a less-liquid Fed.  One that’s beginning to wind down purchases of Treasuries (I for one don’t see their purchases as being as big an issue as others.  Because the Fed had a huge outflow of Treasuries last year to ensure the market had ample supply to meet margin calls.  Treasuries are considered high quality collateral for margin loans), MBS, ABS, and other securities.  If I’m right, we could see Fed Funds and short-term rates in general move higher.  That will compress returns you can earn by borrowing short-term money to invest in longer-term assets.

If that happens, the market is not ready for that sort of outcome.  With a lot of investors borrowing short to invest long and earn the carry on the duration mismatch, a sudden move higher at the short end of the curve could leave them feeling like they got hit by a truck that they didn’t see coming.  Just like these guys in the armored truck:


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