Introducing the FED Carry Trade

“The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured--that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.” - Chairman Ben S. Bernanke At the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming
August 22, 2008. Reducing Systemic Risk.


Intervention into markets always has consequences. The interventionist has specific objectives and plans the intervention to achieve those objectives. The narrowly defined objectives are actually achieved more often than not but as “the market” is a collection of infinite variables and infinite interactions between those variables, it is a given that most consequences will never be known in advance. The interventionist will attempt to anticipate consequences and will mitigate in the planning against undesirable consequences. No matter how much care is taken, intervention always produces unintended consequences. Liquidity intervention suffers from the same unintended consequences as all interventions must. However, do not fall into the trap of believing unintended consequences were necessarily unknown or unexpected. Interventions are powerful counter forces inside a market already crowded with forces and counter forces. Picture exploding a bomb inside a SSHS code 5 tropical cyclone to alter some of the forces already unleashed. The monetary powers of the FED are similar when bombing market forces.

Let’s not hesitate to also describe the credit crisis as the spawn of previous monetary interventions. The credit bubble was anticipated and identified by many informed writers including this author. Systemic banking failure happened recently in Japan and was a known outcome of easy monetary policy. As such it should have featured as a known consequence of this monetary intervention in both the quantity and price of money. Most unintended consequences are known potential outcomes but dismissed as improbable.

We need to distinguish between unintended consequences which came as no surprise and unintended consequences which were truly not foreseen as a possibility. Can one really make the assumption that the FED and all the monetary policy hacks could not have contemplated a credit crisis outcome as a result of the applied monetary policies? I have read commentators claiming the credit crisis was a market failure. Which masters are they trying to please when clearly the Fed dictates the price of money (interest rates) and its supply (liquidity)? This policy failure can never by any stretch of imagination be called a market failure. Any analysis of the behaviour of the FOMC will show that it engages in price fixing based on an objective (intended consequence) as opposed to the market’s price discovery process derived from the behaviour of all market participants. They do not propose to guess at what the economic version of the price of money should be. They simply fix the price for a targeted outcome. The price fixing activity disregards market supply and demand for money as the FED has monopoly power on creating money and control money supply at the margin where it matters most. The FOMC even names the target FED rate as the “Intended Rate”. Price fixing is a particularly blunt policy approach and by application, disregards the known negative consequences of such blunt policy tools.

The following is a short summary of the interventions by the Fed since the collapse of the credit bubble.

Step 1: Reduce interest rates as fast and as low as possible. The FED reduced the FED rate by 3.25% from 18 September 2007 to 30 April 2008, over a period of only 5 months, in 7 increments ranging from 0.25% to 0.75% to the current 2%pa. That is an interest rate more than 3% below the inflation rate. It is important to place the reductions into perspective. There has been only one 0.75% interest rate adjustment in the 17 year period from June 1990 until September 2007; an increase of 0.75% on 15 November 1994. Two increments of 0.75% reductions in the FED target rate took place in the 5 month period of the latest down cycle; on 22 January 2008 and again on 18 March 2008.



Source: FOMC - Intended federal funds rate (Target Rate)

Step 2: Provide liquidity in conventional and unconventional ways in unlimited quantity (no FED internal constraint or limit) to conventional and unconventional participants against collateral where the quality terms and conditions of collateral accepted are expanded and the terms of collateralisation are eased to maximise liquidity distribution. The actual policy tools can be studied on the website of the FED as provided hereunder by those interested. The headings also provide us with a descriptive list of the policy tools which is reproduced hereunder with links to each.


The “Tools” can be found at http://www.federalreserve.gov/monetarypolicy/default.htm

Policy Tools
Open Market Operations
The Discount Rate
Reserve Requirements
Term Auction Facility
Primary Dealer Credit Facility
Term Securities Lending Facility

Lesser reported tweaks were driven by a very real desire to maximise the liquidity distribution impact. It includes measures such as reducing the System Open Market Account ("SOMA") securities lending program minimum fee by half and accepting securities maturing in more than 6 days from more than 13 days (that neatly brought 7 day securities into the discount window). How does these measures impact banks and can early unintended consequences be identified?

The basic operational premise of banks is often misunderstood. Lending out money (credit) is the product that banks sell. Turnover or Total Sales, as with any business, is very important to banks. Turnover growth is an important growth variable.

Where does a bank get “product” to sell? Money placed with a bank on deposit is the undifferentiated answer. One step deeper is a differentiation on four levels. Retail deposits, wholesale deposits, interbank liquidity and FED liquidity. Retail deposits are usually a stable source of liquidity but not readily available in quantity. Wholesale deposits are available in quantity but can be more unstable and movements have more liquidity risk effects. Large single deposits can be fatal. Banks have each other on radar in the interbank market all the time and any increased funding requirements by an individual bank is cause for suspicion. Suspicion very quickly turns into a loss of interbank limits. Bank defaults inevitably follow this sequence:

1. Loss of interbank funding.
2. Loss of wholesale funding.
3. Loss of retail deposits. A classic “run” on the bank is an extreme development in banking and supposed to be an extremely rare occurrence.

It becomes vitally important, for understanding FED activity, to know the process of “product” distribution. Banks use the absolute levels of existing deposits and their maturities only as a guideline for new loans. Capital constraints would dictate absolute size of asset portfolios. Liquidity provision is a dispensation entirely attributable to the “lender of last resort” function inherent to all central banks. There is a timing disconnect between granting a loan and when such a loan is drawn down. Consider for example your credit card. You will normally use your credit inside a “limit” as and when you wish to access your credit. The bank has no knowledge in advance of such a drawdown or even repayments. The bank would only know that you have the ability to use a certain quantity of credit at any time over the next 12 to 24 months. Generally a bank would advance all requests for money and attempt to manage liquidity in such a way as to always be able to meet any drawdowns. The fact is that a bank will never balance its books without a balancing mechanism. The balancing mechanism is located in the interbank market and access to FED liquidity.

The bottom line is that a bank would on any given day be short (lacks sufficient deposits to cover drawdowns) or long (have taken in more deposits than is required to provide product). The extent to which a bank is short or long will directly impact profitability. The marginal funding required to cover a shortfall is inevitably a little more expensive than retail or wholesale deposits. Still, banks prefer to be marginally short provided that they can cover the shortfall with relative inexpensive interbank money or with the FED at an interest cost lower than the interest rate to be earned on the loan. This is the crux of the matter.

The presence of cheap FED money allows banks to push credit with inherent protection against the risk of being unable to fund a shortfall. The cheaper the FED money and the more ready the availability, the more credit will be pushed. The consequence is a credit bubble.

The opposite is expensive money at the FED. We all know that the outcome of providing expensive liquidity to banks is rising interest rates. The FED has to supply commensurate liquidity when the FOMC fix the price of money low.





The second round (September 2007 to April 2008) in doing more of the same introduces some complications. The first round of approaching the zero bound was from January 2001 (6.5%) to June 2003 (1%). The advent of the busting credit bubble normally grinds the interbank market to a halt. A dysfunctional interbank market drives banks to balance their books with the FED rather than amongst themselves. The credit tap is forced wide open when the FED lowers quality standards for collateral to access FED liquidity. One very undesirable consequence originates from the principle that access is indiscriminate with regards to purpose. Therefore banks can use the liquidity for any purpose, for instance to fund losses, while unsecured creditors (read retail deposits and wholesale deposits not covered by deposit insurance) are compromised with a FED holding all potential collateral. Contemplate the quality of assets that unsecured depositors must collect to achieve repayment in case of a bank’s failure and understand why wholesale money runs fast. The lower the liquidity access standards fall, the more other creditors will be compromised when banks are allowed to carry losses via the FED.

The income search alternative is that banks will look for new asset classes (other than already deflating credit bubbles) within which to deploy the cheap liquidity and turn a profit. The greater the margin, the more encouraged banks will be to take up cheap funding and distribute it. Selling credit is a bank’s reason for existence. The best outcome is distribution against credit which will be in a form acceptable as collateral to the FED with perceived acceptable credit risk. Say welcome to emerging market debt.

Investing in emerging market debt is not without problems but easy options exist. Emerging countries will often obtain funding by selling US$ denominated securities. These have lower currency risk and interest rate risk but margins are not nearly as attractive as those issued in their own domain and currency. These are more challenging investments where the most obvious risks are exchange rate movements and interest rate mismatches. These risks would be considered manageable and capable of managed hedging by any fair sized multinational bank. Even smaller banks would not be without skills in managing these risks and may take on the challenge. The temptation is huge when margins as high as 8-10% can be achieved.

A prime target in the current economic environment would be resource based economies. Sovereign risk is the defined credit risk for “other countries”. The same principles that encouraged and perpetuated credit deployment in mortgage bonds are driving credit into emerging debt. Well known historical rules of deploying credit to emerging countries are ignored. One of the most reliable and time tested measures is limiting debt deployment to countries with significant trade deficits. The economic ratio is expressed as the size of the Current Account of the balance of payments expressed as a percentage of the GDP of that country. This is in theory much the same as the loan to income (LTI) ratio applied to mortgage debt. Bankers ignored the safe levels of LTI and even accepted unreliable “proof” of income to overcome prudent credit deployment based on safe LTI ratios. We now see the same development taking place on Sovereign risk with regards to the Current Account deficit to GDP ratio. Observe how far the “safe” deficit limit of 3% of GDP is exceeded by the following countries. Access to “international” funding is the only way in which such excesses can be financed.



Source: International Monetary Fund (IMF) *IMF estimates.

It is clear that the tried and tested ratio of 3% of GDP is not applied in the above cases. The temptation is also very clear. Accept the Sovereign risk of for instance South Africa and earn the interest rate differential on assets priced around a 12% Central Bank benchmark rate. Ignore the danger signals of a 7.3% CA deficit to GDP ratio. Turkey at 16.75% Central Bank benchmark rate and “only” a 5.7% CA deficit to GDP ratio must be an attractive target. Pushing current account deficits into danger territory can only be blamed on the availability of easy credit. Japan and the USA share a need to encourage their banks in need of income margin to finance such Current Account deficits. This encouragement may be an unintended consequence but surely cannot be an unexpected consequence. However, where will today’s troubled banks with access to cheap credit turn to for “yield pick-up”, if not to emerging markets?

The Current Account surplus developing countries are not necessarily “safe” or excluded form this process. They are, for now, producing the income to provide for repayment of debt channelled into their economies. How long will it take before the access to cheap and easy credit is tied up in malinvestment? How long will reliance on a high commodity prices allow the Current Account surpluses to be maintained? Take a look at the graphic depiction of the US$ carry trade and note the bubble blowing cycle inherent to this development.


The US$ Carry Trade Cycle




The four steps in the cycle will be self reinforcing. It is no wonder that the level of international reserves have been sky rocketing. The new zero bound unlimited liquidity monetary policy has added the USA as a significant player in the carry trade where previously only Japan engaged in the this banking rescue by stealth activity. It did not work particularly well for Japan. The final verdict is still out on Sovereign risk as Sovereign defaults and debt standstills are long forgotten concepts. Where will the financiers of carry trade stand when the 3% of GDP deficit rule re-asserts itself? Who and by what means will a new round of Sovereign defaults and debt standstills be mitigated? Already the first warning bells are ringing in Eastern Europe.




Cheap and easy money as a policy tool to repair the ravishes of a previous monetary policy of cheap and easy money will not heal the income streams of banks, nor will it heal the capital destroyed by bad debts. A repetition of such a policy will blow new credit bubbles in expected but ignored and unexpected places and repeat another cycle of bad debt explosions. The credit crisis outcome of easy monetary policy is known and probable and therefore should never be granted the status of an unintended consequence. A mature credit bubble already exists in emerging market debt. The Fed may bail out Freddie and Fannie but who will bail out emerging markets? Nobody.




Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
September 2008




References:

1. Reducing Systemic Risk. Chairman Ben S. Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming. August 22, 2008.
2. Economic Projections and Rules of Thumb for Monetary Policy. Athanasios Orphanides and Volker Wieland. Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 307-24.
3. Open Market Operations in the 1990s. Cheryl L. Edwards, of the Board’s Division of MonetaryAffairs, prepared this article. Gerard Sinzdak provided research assistance. Federal Reserve Bulletin November 1997, pp. 859-74.
4. Alternative Instruments for Open Market and Discount Window Operations. Federal Reserve System - Federal Reserve System Study Group on Alternative Instruments for System Operations. Board of Governors of the Federal Reserve System, Washington, D.C., December 2002.


Comments are welcome. E-mail me at ccpt@iafrica.com or comment on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster 2008.