Gyroscopic Investing

D1984, thanks for all of the detailed explanations.

I'm still puzzling about how treasury rates could rise much above inflation unless that comes after a good few years of severely negative interest rates to cut the value of the government debt down by a lot. I think if we get  sustained inflation and low rates for a number of years such that a Volcker style above inflation rate hike could be achieved, then I'll either switch to a 75% cash;25% stocks type portfolio or look into the swap idea you suggest.

I realize that it is rash to not guard against the unimaginable but for short term treasury (not LIBOR) rates to go and stay well above inflation from this starting point just looks to me more like a swan being able to fly faster than the speed of light rather than a black swan.

I actually think that LIBOR rates being very high whilst short term treasury rates were very low (such as in a banking crisis) could be very bullish for LTT and for gold (in GBP terms but probably fairly neutral in USD terms).

Stone,

Couldn't Treasury rates rise to a few percent above inflation if the Fed raises short-term rates and in order to make sure rates rise starts selling some of what's on it's balance sheet after all the QEs (since it buys securities to make rates fall and sells them to make rates rise). I know this could effect the Fed's balance sheet but it won't start hurting its solvency as long as they don't let rates get above the rates of whatever LTTs and MBSs they have on their balance sheet. Assume the LT treasuries and IT treasuries the Fed has on its balance sheet pay on average of 2.9% (since some would have been bought in 2008/2009 before LT rates were nearly as low as they were today) and the MBS pay an average of 5% (since they aren't all "prime" or FHA/FNM backed MBSs). The fed can currently borrow at nearly 0% or 0.25% and has thus had a huge "spread" over the past three years or so; it has turned over roughly $70 billion in profit each year since 2009 to the Federal Government (the Fed is required to rebate to the government all profits beyond its operating expenses, dividends to its member bank stockholders, and a small retained portion-about 2% of total profits IIRC-it is allowed to keep). An MREIT would kill for that kind of money on "playing the spread" and this profitably has in fact led some financial columnists to dub the Fed "America's biggest (and most successful) hedge fund".

Even if ST or overnight rates were raised to say 3.5% (if inflation was maybe 3%) the Fed wouldn't be LOSING money on a cash-flow basis if it's portfolio yielded roughly 3.9% or 4%. This is for three reasons:

One, so long as ST rates (the Fed's funding costs) are less than what is it earning on securities then they will at least break even,

Two, for all I know at least some of the Fed's portfolio is actually swapped with the f-for-f swaps this thread is about (I seem to recall that a significant minority of the Maiden Lane and Maiden Lane II portfolio had such swap protection),

Three (and most importantly) at least some of the Fed's ST funding is not subject to interest rate risk at all. The Fed's member banks are REQUIRED to keep a certain amount on deposit as reserves with the Fed. These reserves currently pay interest (0.25% or 0.5% IIRC) but the Fed isn't required to pay anything on them and even if it doesn't banks still have to keep at least the minimum amount of reserves on deposit. Last time I checked almost 40% of the Fed's funding came from such reserves. So the Fed could conceivably raise ST rates by, say, 300 basis points and still choose to pay nothing on reserves and the banks would be stuck having to keep at least the minimum deposited on reserve with the Fed.

I do acknowledge that selling securities might hurt (on a GAAP mark-to-market basis) the value of what the Fed currently holds but so long as they don't actually have to SELL them at a loss (or at least at enough of a loss to overcome what it makes on the spread on what it didn't sell) then they can "mark-to-magic" (i.e. carry them on their books not at mark-to-market values but at either mark to model values or at what they paid for them...i.e. they can value them at whatever the hell they please) their assets like every other large money-center bank has been allowed to do since early 2009.

Finally, even if the Fed did actually have realized losses for a year or two the Treasury could theoretically actually give them money to make up for it (I don't endorse this since it would be a roundabout bailout by the Treasury of the banksters because it would involve the Fed, now that it has bought assets from the banks at above market values, having to sell them at the correct value of less than what they paid for them...but I do acknowledge it could happen). Of course, it wouldn't be CALLED a "bailout of the Fed". What would probably happen would be that :

A. the Treasury would rebate some of the over $150 billion in profit in the last three years the Fed gave to them but as a loan on sweetheart terms (i.e. for twenty years at 0.01%) instead of as a direct cash infusion,

B. The government could pass a law declaring that the Fed was liable to pay income taxes on profits (and by extension, to write off losses and claim carryovers and carrybacks against past and future tax payments and profit payments to the Fed). If this was done as soon as the Fed started actually losing money it would conveinently let the Fed claim back the profit it has rebated to Treasury for the past decade or so. This was one of the ways the S&Ls were "helped" by the government in the late 70s through the mid 80s (the savings and loans had made mortagegs at 7% or less in the 60s and 70s while deposit rates in the late 70s and early 80s were upwards of 12% much of the time; the S&Ls were losing money hand over fist since they kept most of the mortgages on their books); they were given a (IIRC) ten-year carryback on current losses; this resulted in the government having to give back most of the money many of the S&Ls had paid in taxes. This helped restore some S&Ls to health; some still failed and had to be rescued by FSLIC anyhow.

C. The Fed is allowed to NOT rebate some or most of its future profits (and/or is given a sweetheart loan as above against those profits) to the Treasury and this is actually recorded on its balance sheets as a gain to offset the losses on securities sales...of course they wouldn't call it a gain or a below-market rate concessional loan; I believe the politically correct term is "change in deferred credit",

D. If push really came to shove there's always the platinum coin trick (the Treasury deposits a $1 trillion platinum coin with the Fed as non-interest bearing reserves); in this case it wouldn't be to allow the Treasury to write checks against the trillion to get around the debt limit (as was the hypothetical case last year) but simply to give the Fed $1 trillion more in reserves as interest-free funding. The Treasury would then not ask for its $1 trillion back until the Fed was again healthy and profitable. This would of course depend on having a cooperative POTUS and SecTreas (I can't imagine a President Ron Paul and Secretary of the Treasury Peter Schiff, for instance, allowing a stunt like this to continue...they'd immediately ask for the trillion back) but as long as we have have people like Obama and Geithner (or Romney and whoever he nominates to Treasury) who ask "how high" when the banksters say "jump" then the Fed would be in the clear.

Finally, I do have an idea (at least for those of us in the US....although something similar may work in the UK...check your local laws) that will help the PP (or any portfolio) if rates rise, that doesn't involve swaps, that does not even ever have to be activated if not needed, and is basically backed by the government and FDIC and can create a heads-you-win-tails-somebody-else-loses setup to benefit you. The downside is that it will only be of use if rates rise to more than about 8% or so. Let me know if you are interested.

D1984, what I was trying to puzzle out was how the Fed would raise rates. They can't just say rates are 6% and that is that. They have to operationally bring such rates into effect. AFAIK that either involves withdrawing so much bank reserves by selling treasury securities that the scarcity of bank reserves confers a value to those bank reserves (that was how Volcker did it) or buy paying banks interest merely for parking reserves at the Fed. Do you see where my puzzle lies? Your scenario relies on the Fed having funding due to the spread that comes from NOT paying banks to park reserves at the Fed and or having income from securities that they still hold. Selling off their portfolio to gather in bank reserves would obliterate their interest income. Paying interest on reserves the banks park with them, flat out costs them money.
I agree that in principle the treasury could pay the Fed to pay interest willy nilly but I presume the exponentially ballooning deficit from that would just cause an astonishing devaluation and so gold would be what you needed. If the platinum coin trick was used to pay 8% interest on all reserves parked at the Fed from tommorow onwards; then basically the USD would be dead. Everyone would see that sooner rather than later interest payments would be more than tax take and the currency was in free fall. Maybe I'm being naive about that

D1984, I found a link that describes the obsticals that the Fed would have to overcome in order to induce a rise in short term interest rates:
http://www.financialsense.com/contribut ... y-in-3d%20
" Charles Plosser of the Philadelphia Fed is quite correct that normalizing interest rates to about 2.5% would imply a reduction of nearly 50% in the Fed's balance sheet, but as I noted two weeks ago, the required cutback in the balance sheet is extremely front-loaded, as a non-inflationary move to a Fed Funds rate of just 0.25% would require a reduction in the monetary base from about 17 cents to less than 13 cents per dollar of GDP, taking the monetary base from $2.6 trillion to less than $2 trillion - effectively reversing QE2 in its entirety.
.......Even 0.25% of annual interest on reserves works out to about 12% of the Fed's total capital. The Fed is already in a position where a 35 basis point increase in long-term interest rates would effectively wipe out that capital. Though the Fed does earn interest on the Treasury debt it holds (which is remitted back to the Treasury for public uses), it would still take an increase in long-term interest rates of less than 1% to wipe out the Fed's capital as well as its entire net interest margin. So while the Fed might have the latitude to pay another 0.25% of interest on reserves, every extension of its present policy course, be it more quantitative easing, or paying interest on existing bank reserves, substantially increases its already untenable level of balance sheet leverage, and the likelihood that the public will quietly need to subsidize that balance sheet."

D1984, the "Volcker rate hike" scenario has been my main concern about the PP but the more I've tried to figure it out the more it has seemed as though that would be something that could only happen after the government debt had first been inflated (or taxed) away.

stone wrote: D1984, what I was trying to puzzle out was how the Fed would raise rates. They can't just say rates are 6% and that is that. They have to operationally bring such rates into effect. AFAIK that either involves withdrawing so much bank reserves by selling treasury securities that the scarcity of bank reserves confers a value to those bank reserves (that was how Volcker did it) or buy paying banks interest merely for parking reserves at the Fed. Do you see where my puzzle lies? Your scenario relies on the Fed having funding due to the spread that comes from NOT paying banks to park reserves at the Fed and or having income from securities that they still hold. Selling off their portfolio to gather in bank reserves would obliterate their interest income. Paying interest on reserves the banks park with them, flat out costs them money.
I agree that in principle the treasury could pay the Fed to pay interest willy nilly but I presume the exponentially ballooning deficit from that would just cause an astonishing devaluation and so gold would be what you needed. If the platinum coin trick was used to pay 8% interest on all reserves parked at the Fed from tommorow onwards; then basically the USD would be dead. Everyone would see that sooner rather than later interest payments would be more than tax take and the currency was in free fall. Maybe I'm being naive about that

Stone,

In my scenario I was assuming the Fed would sell Treasuries and MBS in order to rise rates to somewhere between 3 and 5%  but would continue paying little or no interest on reserves deposited with it. I do agree that 8% would be fairly difficult unless the government was willing to bail them out or allow the Fed to run a loss for a few years but lend them the money to tide them over.

The platinum coin trick is NOT so the Fed can afford to pay 8% on reserves; it is to tide the Fed over with a cheap source of funding (0%) for a few years when rates rise. Once the Fed is profitable again Treasury would ask for its trillion back (maybe in increments...perhaps there were ten $100 billion coins instead of one $1 trillion one?), the Fed would give them the coin/s (and borrow the trillion elsewhere....which it could afford to do once its portfolio is paying decent rates again), and the coin would be stamped with "$100" like every other legal tender platinum coin. Honestly, it quite possibly (see below) wouldn't even come down to something like this.

Perhaps what you don't understand is that the Fed could theoretically quite easily pay 0% on reserves while ordinary ST rates were at 3 or 4%. The banks are REQUIRED BY LAW to keep a certain portion of assets and/or Tier I capital as either "vault cash" (i.e. folding money-actual physical cash itself) or as reserves on deposit with the Fed. They don't have a choice. They can't keep it in t-bills or as commerical paper like they can the rest of their capital. All the government would have to do is amend Federal law to raise that reserve requirement (ifor instance, if it is now 10% of Tier I capital then make it, say, 30%). The banks could choose to hold it as vault cash instead (although the government could change the law as well to only allow a certain amount to be held as cold hard cash) but that has two problems: One, even if in $100 bills several hundred billion in vault cash is a lot of money to store, hold, and secure safely. Two, if the Fed paid, say, 0.10% on reserves and folding cash paid nothing (as it does), they might still choose to hold the required reserves as reserves with the Fed instead of physical cash. The abovementioned idea...changing reserve requirements to make banks (and perhaps make their depositors-see below) hold instruments paying zero or negative real rates is basic Financial Repression 101.

This might ultimately be taken out on depositors (who continue receiving next to nothing like they do now on CDs and savings acounts as the banks are receiving next to nothing on their reserves parked with the Fed and thus pass on their interest earnings-or lack thereof-to depositors). Of course, if enough despositors get tired of receiving nothing on their savings when t-bills are paying, say, 3% then they might be buying t-bills instead (or maybe they won't...the amount of depositors who still stick with institutions like Chase and Bank of America and pay monthly fees to the bank for the privilege of loaning the bank their money at 0.01% in a savings account and being charged 4% on a mortgage or 17.99% on a credit card is astounding and puzzling to me when there are decent reward checking accounts paying 2% or so and paying back ATM fees to boot). If enough of them choose t-bills and thus withdraw their money from banks the banks could even go under (not enough funding because they don't have enough deposits and they can't raise deposit rates enough to compete with t-bills and attact deposits because they are stuck keeping much of their money in near-zero yielding reserves with the Fed) and be taken over by the FDIC. Whether this would be a bailout to bank bondholders, preferred holders, and management (I'm assuming the common stockholders get their interest liquidated in either case) or a total loss to them would depend on whether the FDIC did what needed to be done (like they did with WaMu in 2008 or Sweden did with its banks in the 90s...bondholders and preferred holders lost everything just like the common stockholders did; only depositors were protected) or actually made bondholders and preferred holders good at 100% or near 100% of the value of their investments (boooo! hissss!). Actually I don't think the FDIC could AFFORD to do the latter (make bondholders and depositors whole instead of just the depositors) in the case of a large money-center bank like Chase or Bank of America.

Alternately, the banks could just keep the 30% or 40% or so with the Fed earning next to nothing and still pay their depositors near T-bill rates by jacking up rates on loans somewhat (if every or almost every bank was doing this-because all banks have to keep a certain amount as either vault cash or reserves with the Fed-there would be little competition to worry about charging lower rates).

Say you are a bank and you have liabilities (where you get your money funded from) of the following: deposits of $800 million, $100 million borrowed as bonds, and $100 million of equity (which isn't really a liability since equity can be wiped out in bankruptcy and even if your company isn't bankrupt you aren't OBLIGATED to pay common stockholders a single cent...but the $100 million of equity is still a source of funding and so is listed here). Assume you are paying 4% on the bonds ($4 million), 1% on deposits ($8 million), and a 5% dividend on the common stock ($5 million) plus you have salaries, rent, overhead, etc or $10 million (it's a small bank, OK). That's $27 million yearly in liabilities (or $22 million since the dividend doesn't HAVE to be paid)

Now let's assume you have your $1 billion in assets from above invested as follows: Ten percent ($100 million) is in Tier I capital (banks are supposed to have at least 6% in Tier I capital; the more Tier I capital a bank has above 6% the stronger and better capitalized it is). Tier I has to be invested in safe assets like short-term Treasuries, FDIC insured short-term loans/deposits to other banks, Fed balances, vault cash, high quality short-term corporates, and a little of it can even be legally invested in gold bullion (don't ask me why; gold is volatile as heck and other volatile instruments like equity common stocks are officially NOT allowed in Tier I). Your Tier I is half in ST Treasuries ($50 million) and almost all the rest is in Fed balances earning next to nothing ($49.5 million); you do keep a small amount of physical cash ($0.5 million) as part of your Tier I capital. The rest ($900 million) of your assets can be invested in anything you want that will make enough to meet your liabilities provided the FDIC allows you to invest in the asset (also note that assets held as Tier I and IIRC Tier II are "risk-weighted" if you want to some hold gold bullion and short-term corporate bonds in Tier I you are required to have more of them for a given risk weighting than you are of riskless assets like T-bills or Fed balances). Much (say $770 million) of this remaining $900 million is invested in loans (car loans, business loans, personal loans, mortgages, credit cards, etc) and the rest is in corporate bonds both LT and ST and GNMAs (say $50 million) with the remaining $100 million invested either in ST treasuries ($30 million, let's say) or held as reserves at the Fed ($49 million) or vault cash ($1 million). 10% of your total deposits is $80 million so this gives you more than the required 10% of total deposits held as Fed balances or vault cash. Since you have $100 million in total assets held either as vault cash or Fed balances and the minimum required based on the amount of deposits you have is $80 million everything is fine.

Assume that your assets above earn you the following:

Loans of $770 million earn 6.5% on average so $50.05 million

STTs ($50 million in Tier I and another $30 million in regular assets) earn maybe 1% so $0.8 million

Corporate bonds and GNMAs ($50 million) earn 5% so $2.5 million

Vault cash and Fed balances of $100 million earn nothing (or so close it may as well be nothing...I'm assuming the Fed isn't paying much on reserves)

That's total earnings of $53.35 million. After paying expenses and dividends from the paragraph above you are left with around $26 million. Some of it goes to retained earnings, some goes to pay taxes, maybe you pay a special one-off dividend, or maybe it goes to pay for bonuses/hookers/cocaine/etc for c-level officers.

OK, now say that the Fed mandates that 40% of all bank assets equal to bank deposits have to be invested in Fed balances earning 0%. Your bank has to invest $320 million (40% of the $800 million deposit liability you have) in something that earns 0% or next to it. You have to sell off much of the GNMAs, corporates, STTs, and most of the loans and reinvest the proceeds in Fed balances; this serves to help raise rates (like the Fed wanted) since every other bank is doing this too and flooding the market. Also, as your loans mature you (and every other bank in the country) raise rates (again helping the Fed with its goal of increasing rates throughout the economy) on the new loans in order to offset the fact that roughly 2/5ths of your assets are stuck earning nothing and that you took something of a bath on all the other assets you had to sell since rates had risen and the assets were thus worth less. Your new balance sheet (Tier I plus regular assets) looks like the following:

Loans of $560 million earn 8.5% on average so $47.6 million

Corporate bonds and GNMAs of $20 million earn 7% so $1.4 million

STTs of $20 million earn 3% so $0.6 million

Fed balances and vault cash of $321 million earn nothing

This only totals out to $921 million when you previously had $1 billion but you did lose some money when you sold off some of your loans and bonds to have the required 40% to put in Fed balances.

You earn a gross profit of $49.6 million from the above and after paying expenses, interest (your bonds carry a fixed rate but you have to pay more on deposits-say $24 mil instead of $8 mil-since rates have risen, remember?), taxes, etc maybe you only have around $16 million in net profit. You could still meet your dividend, though, and even afford to pay dividends on more stock if the FDIC makes you "become more adequately capitzalized" (since you now only have $921 million of assets vs $900 million of non-equity liabilities instead of the previous $1 billion of assets) by issuing more shares.

Your borrowers do have to pay somewhat more on loans, though (to make up for the fact that almost half your assets are invested at the Fed paying nothing) but so do every other bank's borrowers (since every other bank is stuck investing 40% of their assets as non-interest bearing Fed balances as well)...and besides, the Fed in this scenario wanted higher rates throughout the economy anyway. It got them.

I know the above is kind of long and tedious to read but I hope I've showed one possible scenario where the Fed could both raise rates in the economy at large (and on t-bills and other ST government securities) and keep its own funding costs reasonably low.

stone wrote: D1984, I found a link that describes the obsticals that the Fed would have to overcome in order to induce a rise in short term interest rates:
http://www.financialsense.com/contribut ... y-in-3d%20
" Charles Plosser of the Philadelphia Fed is quite correct that normalizing interest rates to about 2.5% would imply a reduction of nearly 50% in the Fed's balance sheet, but as I noted two weeks ago, the required cutback in the balance sheet is extremely front-loaded, as a non-inflationary move to a Fed Funds rate of just 0.25% would require a reduction in the monetary base from about 17 cents to less than 13 cents per dollar of GDP, taking the monetary base from $2.6 trillion to less than $2 trillion - effectively reversing QE2 in its entirety.
.......Even 0.25% of annual interest on reserves works out to about 12% of the Fed's total capital. The Fed is already in a position where a 35 basis point increase in long-term interest rates would effectively wipe out that capital. Though the Fed does earn interest on the Treasury debt it holds (which is remitted back to the Treasury for public uses), it would still take an increase in long-term interest rates of less than 1% to wipe out the Fed's capital as well as its entire net interest margin. So while the Fed might have the latitude to pay another 0.25% of interest on reserves, every extension of its present policy course, be it more quantitative easing, or paying interest on existing bank reserves, substantially increases its already untenable level of balance sheet leverage, and the likelihood that the public will quietly need to subsidize that balance sheet."

Stone, this http://www.frbsf.org/publications/econo ... 11-11.html seems to contradict what Hussman is saying

D1984, I have to digest this but to me that bottom line is if there are short term treasuries out there paying 5% and money out there (as bank reserves or whatever) paying 0%, then the bank reserves will get tossed back and forth like a hot potato bidding up the price of the treasuries until the treasuries also pay 0%. Someone always has to be left holding the bank reserves.

D1984, I'm finding it hard to think straight because there is very loud music here . The issue as I see it is that banks individually do not have to hold deposits. Northern Rock was a UK bank (that died in 2008) that had a massive loan book but little in the way of deposits. They used interbank lending for settlement rather than using deposits. So banks would probably just charge customers significantly for making deposits if reserve requirement were increased so much. You would probably just make the process of bank credit creation unprofitable and so speed up private sector deleveraging and shrink the banking sector. The difference between treasury rates and the rates at which you could get a loan would widen a lot. So customers would be charged 2% for the service of having a deposit, they would be charged 15% for taking out a loan and short term treasuries would yield negative 2%. It still wouldn't make anyone want to hold bank reserves. Basically to get short term treasury rates up people have to want to hold bank reserves more than they want to hold short term treasuries.

 

stone wrote: D1984, I have to digest this but to me that bottom line is if there are short term treasuries out there paying 5% and money out there (as bank reserves or whatever) paying 0%, then the bank reserves will get tossed back and forth like a hot potato bidding up the price of the treasuries until the treasuries also pay 0%. Someone always has to be left holding the bank reserves.

It won't be bid down to 0%.  It will be bid down to what the rate is that Fed is currently paying on reserve balances, a relatively new power.  AFAIK, bank reserves and Treasuries are the same thing.  The Fed holds the illegal non-Treasury junk off the balance sheet similar to what Enron did.

MG

MG, the problem is that the Fed needs a source of funding for paying the interest on reserves. The Fed can only get so much money from its holdings in order to fund that interest payment. You could say that they would simply "mark up" the accounts of banks inorder to create the interest payments but I think that that would be a radical development requiring new laws.

D1984, thinking about your post I'm getting my head around your idea that specifying that the banks have to hold lots of capital in the form of bank reserves is a way to bring reserves out of circulation, give reserves scarcity value and so raise short term interest rates even when the bulk of the government debt is in the form of bank reserves. I suppose in principle any size of government debt could be sequestered away like that. So as the debt to GDP ratio went to 10000000...%, almost all of the treasuries could be QE'ed onto the Fed balance sheet and banks would hold all of the bank reserves yielding zero% inorder to meet the 1000000...% tierI capital requirement before they could make loans. The small amount of treasuries circulating (ie not held by the Fed) would yield 6% or whatever. Have I understood you correctly?

I guess logically it works out exactly the same as simply taxing the bank reserves such that they no longer exist. If banks are told that they must hold a monstrous amount of unused bank reserves then they might as well be told that they need to turn them over to the tax man to be placed in the trash.

Edit:- on reflection, it still doesn't make sense to me. All banks would simply decide to become "treasury bond holding companies" rather than being banks and would take all of their bank reserves and use them to bid up treasury prices.

stone wrote: D1984, I'm finding it hard to think straight because there is very loud music here . The issue as I see it is that banks individually do not have to hold deposits. Northern Rock was a UK bank (that died in 2008) that had a massive loan book but little in the way of deposits. They used interbank lending for settlement rather than using deposits. So banks would probably just charge customers significantly for making deposits if reserve requirement were increased so much. You would probably just make the process of bank credit creation unprofitable and so speed up private sector deleveraging and shrink the banking sector. The difference between treasury rates and the rates at which you could get a loan would widen a lot. So customers would be charged 2% for the service of having a deposit, they would be charged 15% for taking out a loan and short term treasuries would yield negative 2%. It still wouldn't make anyone want to hold bank reserves. Basically to get short term treasury rates up people have to want to hold bank reserves more than they want to hold short term treasuries.

   

Stone, I know Northern Rock did at least have SOME retail depositors (else all those people we saw on the news in 2007 lined up to withraw their money were an optical illusion), didn't it? We had some banks here that mostly relied either interbank lending, repurchase agreements (the famous "repo 105s" ) or brokered deposits and had little in the way of true brick and mortar retail deposits (or even online retail deposits). IndyMac (now dead) was a good example of relying on "hot money" like brokered deposists and people who put money in its online savings account because IndyMac was paying more than almost everyone else at the time. Bear and Lehman (both also dead now) both relied heavily on short-term interbank lending, commercial paper, and repurchase agreements. I think there is a good reason a lot of banks (and their regulators) don't want funding heavily or mostly in the form of hot money like short term interbank loans or repos.

I don't think rate spreads between deposits and loans would widen quite as much as you suspect unless the Fed tried to raise rates to maybe 9 or 10% (or unless it made banks hold 60 or 70% of reserves in non-yielding balances with the Fed). Oh, and if the Congress wanted (and could get the votes) to it could make it illegal for any large national bank (or really any bank under FDIC/OTS/OCC jurisdiction) to charge someone for having a basic checking or savings account. It would merely require changing a few lines in the USC and the relevant Federal regulations related to it. Whether or not they could get the votes is an open question but after the big banks pulled that stunt a few months ago trying to charge people for debit cards a lot of folks aren't too happy with said banks and might probably be like "stick it to 'em".

Edit:- on reflection, it still doesn't make sense to me. All banks would simply decide to become "treasury bond holding companies" rather than being banks and would take all of their bank reserves and use them to bid up treasury prices.

Not as easy as it sounds....in doing so, they would give up all FDIC protection and as such would probably see a majority of their deposits flee. This would be even more true if they invested not only in t-bonds and t-bills but also kept some of their investments in stocks, loans, and corporate bonds...who wants to loan money to someone to invest in assets that have credit risk and/or interest-rate risk unless they know their money is liquid and can be had back at any time?

Any bank that tried to become a "Treasury holding company" would probably find itself paying out most of what it earned to its depositors (although since it wouldn't be a bank anymore I guess you'd call them creditors or lenders, not depositors) like Treasury MMMFs (or any other mutual fund) pay to their shareholders. The bank would probably be better off being stuck keeping its reserves 40% in Fed balances and the other 3/5ths in whatever but only having to pay maybe 0%, 1%, or 1.5% to depositors (who would be willing to receive this rate since unlike lending money to a Treasury fund or bond fund their money was FDIC insured and guaranteed liquid at what they put it in at...before you ask me who would keep money in a bank at 1% when ST treasuries were paying say 4 or 5% consider that in 2006-2007 banks had trillions in checking accounts paying nothing and savings accounts paying 1 or 2% while STTs did yield around 5%).

Finally, a nationally or state-chartered bank can't just decide one day to convert to a non-FDIC insured security holding company or mutual fund. The state or Federal government chartered them as a bank and regulators might not give permission if the bank tried to become something else (plus by not being a bank they would lose official access to the discount window and the liquidity that saved many banks' bacon in crisis times like 2008). Even if the regulators weren't opposed in principal what would the bank do if it had some deposits as five or ten year FDIC insured CDs but decided maye a year from when the CDs were issued that it wanted to be a non-FDIC insured holding company? It can't just give the depositors their money back; that would be breaking the CD...but it can't force them to accept becoming unisured creditors since the CD was originally FDIC insured...and the erstwhile bank can't stay FDIC insured if it is just a holding company or a Treasury bond and/or corporate bond mutual fund because the FDIC only insures banks...and if it stays a bank, then it is stuck having 40% or therabouts of its capital tied up in zero or near zero yielding Fed balances.

Honestly, this whole discussion seems kind of academic at this point because the OP's (my) original assumption was an environment of rising rates brought on by decreasing unemployment and increasing prosperity (and maybe moderately rising inflation). What you and I seem to be discussing now is whether (and how) rising rates can be brought about by the Fed on purpose in a time of low inflation and a decided lack of prosperity for many people. I would like to think that the Fed's officials are responsible enough that (even if they could snap their fingers and magically raise rates to 5 or 6% without it affecting the Fed's portfolio at all) that they don't wake up one morning and say "you know what we need when we have nearly 9% unemployment, moderating inflation, and massive unused or underutilized capacity? Positive real rates on risk-free instruments so people with surplus cash will have even LESS incentive to invest it in real, productive enterprises".

D1984 wrote: Honestly, this whole discussion seems kind of academic at this point because the OP's (my) original assumption was an environment of rising rates brought on by decreasing unemployment and increasing prosperity (and maybe moderately rising inflation). What you and I seem to be discussing now is whether (and how) rising rates can be brought about by the Fed on purpose in a time of low inflation and a decided lack of prosperity for many people. I would like to think that the Fed's officials are responsible enough that (even if they could snap their fingers and magically raise rates to 5 or 6% without it affecting the Fed's portfolio at all) that they don't wake up one morning and say "you know what we need when we have nearly 9% unemployment, moderating inflation, and massive unused or underutilized capacity? Positive real rates on risk-free instruments so people with surplus cash will have even LESS incentive to invest it in real, productive enterprises".

I totally agree that it makes no sense to me to raise treasury interest rates on purpose at this point. My point is that treasury short term interest rates are whatever they are as a rate set on purpose by the Fed. The natural rate of treasury interest is zero. There could be <2% unemployment, everyone finding it easy to afford university fees, go on vacation etc etc and a short term treasury interest rate of zero. England had a fiat currency with a zero rate of interest for centuries from 1100AD onwards. Japan has had low(ish) unemployment and zero interest rates for a couple of decades. That all is why I'm not so sure that a costly insurance against an event such as a Volcker rate hike at this point is worth taking.
My point is that significantly above inflation treasury interest rates may not even be something that the Fed could achieve at this point even if it were to want to. Let us imagine that a recovery does kick in and prices do inflate. Perhaps raising short term treasury interest rates above inflation simply will no longer be an available response. Perhaps the price increases themselves will have to be what dampens the economy down. It looks to me that that was what happened in the tentative "recovery" in 2010 when commodity prices soared.

About your other point about banks having to remain as banks. The deleveraging we are seeing since 2008 equates to banks becoming less of banks than they were. A bank can choose not to make any new loans. If the requirement you set was for tierI capital to be held as bank reserves and for a capital ratio of say 10% of the size of the loans outstanding, the bank could let the loans get paid down and then trim back the tierI capital and instead use that excess money to buy treasuries or do whatever it wants with it.  The examples of liquidity crises for banks without deposits in 2008 were from before the system was flooded with excess bank reserves. I guess part of the rational for flooding the system with bank reserves was to reduce such problems.

The bottom line is that, as HB said, one rising asset class can completely carry the entire portfolio. Many times, this one asset has gains greater than the 2 classes that may be falling. Please listen to HB's second broadcast, the one that explains the PP. Near the end of the broadcast, Mr. Browne covers this subject nicely.

stone wrote:
I totally agree that it makes no sense to me to raise treasury interest rates on purpose at this point. My point is that treasury short term interest rates are whatever they are as a rate set on purpose by the Fed. The natural rate of treasury interest is zero. There could be <2% unemployment, everyone finding it easy to afford university fees, go on vacation etc etc and a short term treasury interest rate of zero. England had a fiat currency with a zero rate of interest for centuries from 1100AD onwards. Japan has had low(ish) unemployment and zero interest rates for a couple of decades. That all is why I'm not so sure that a costly insurance against an event such as a Volcker rate hike at this point is worth taking.
My point is that significantly above inflation treasury interest rates may not even be something that the Fed could achieve at this point even if it were to want to. Let us imagine that a recovery does kick in and prices do inflate. Perhaps raising short term treasury interest rates above inflation simply will no longer be an available response. Perhaps the price increases themselves will have to be what dampens the economy down. It looks to me that that was what happened in the tentative "recovery" in 2010 when commodity prices soared.

About your other point about banks having to remain as banks. The deleveraging we are seeing since 2008 equates to banks becoming less of banks than they were. A bank can choose not to make any new loans. If the requirement you set was for tierI capital to be held as bank reserves and for a capital ratio of say 10% of the size of the loans outstanding, the bank could let the loans get paid down and then trim back the tierI capital and instead use that excess money to buy treasuries or do whatever it wants with it.  The examples of liquidity crises for banks without deposits in 2008 were from before the system was flooded with excess bank reserves. I guess part of the rational for flooding the system with bank reserves was to reduce such problems.

Stone, perhaps you are right about ST Treasury rates remaining at or near zero for an extended time into the future. But what if you aren't (a rapidly picking up economy would lure a good bit of money out of Treasuries and into other investments and that potentially could raise yields)? The whole PP is based on a defensive investment strategy so that if unlikely things (by unlikely I mean black swan unlikely...five or six sigma events that weren't SUPPOSED to happen at al) do come to pass then you'll be OK.

Honestly, I'm not hugely worried about a Volcker-type rate hike. The result of that (even if it was only to the low double digits) would be awful for the PP (and probably everything else investment-wise that wasn't cash or ST bonds)....down 30-35% of more in real terms is possible...however it would also result in a "reset" as we rebalanced out of cash to buy stocks that now yielded probably 6-7%, gold that was much ceaper than it had been, and Treasury bonds or zeros yielding 10% or more. Getting into assets at the prices caused by the abovementioned "portfolio reset" could provide decent real gains fro years as yields went back down and stocks again benefitted from falling rate tailwinds.

What concerns me is a death of 1000 cuts grind of slowly rising rates that doesn't offer any chances for volatility capture like the above sharp hike would. That's what the swaps/swaptions/swap roll were designed to protect against.

As regards the banks and Treasuries: Yes, banks COULD choose to make less loans and buy more Treasuries (at least with the money that they weren't theoretically forced to "invest" in zero-yielding balances at the Fed)...but they can do that now if they wanted to. In an environment where the economy was picking back up, loans/stocks/convertible bonds/other "risk on" assets would be most likely be more attractive on a risk-adjusted basis than Treasuries even if STTs were paying 4 or 5%.

ALso, the capital ratio was not based on the size of loans outstanding (at least under US banking law). It was and still is based on the size of DEPOSITS (i.e. based on how much the bank or financial institution borrowed from depositors), not on the size of what the bank loaned out. A bank could have 100% of its non-Fed assets in 30-day Treasuries and none in loans but the ratio (the percent it had to have in Fed reserve balances paying nothing or 0.25%) would still be based on how much it had borrowed in deposits (and in a pinch this could be extended to how much it had borrowed via repos or commercial paper as well).

Yes, a bank COULD convert to a mutual fund/RIC/CEF/BDC and have stockholders (equity capital) and not depositors (debt)...at least after all its CDs matured and it got rid of FDIC insurance if the FDIC let it not be a Federally-insured bank any more. However, in doing do it would be out of the frying pan and into the fire because:

A. All of the above are required to pay out 90% or greater or face losing tax exemptions (for all practical purposes they typically have to pay out 97% or greater because there are excise taxes and tax surcharges they have to pay if they retain too much earnings even if it is below the 10% income tax threshold),

and

B. Even if they WEREN'T required by tax law to pay out almost all earnings the fact that they have stockholders and not depositors means that they would have to pay relatively much higher yields to attract capital (since being a shareholder is riskier than being an FDIC-insured depositor...even if it isn't "riskier" per se-I'm thinking about a Treasury MMMF-the MMMF still pays out almost all its earnings to its shareholders...banks do NOT pay out almost all their earnings to their depositors...at least relative to what mutual funds/BDCs/CEFs/MMMFs etc pay out) and would lose one of the main advantages of being a bank, the chance to leverage your original equity capital 8 or 9 (I know some leveraged more than that but I'm for the moment ignoring the idiots who did it 40 to 1...they would have been bankrupt if they weren't allowed to have been become banks/bank holding companies for Fed window borrowing purposes) times via taking deposits at a lower rate and lending them at a higher one (the "3-6-3 spread"...borrow at 3%; lend at 6%, and be on the golf course by 3 PM). As an RIC instead of a bank, almost all of their earnings would go to their shareholders (assuming their depositors stuck around to become shareholders and didn't say "no FDIC insurance; see ya" ). Even if a bank is forced to deposit 40% of its borrowed capital with the Fed and earn 0% on it they will still be able to keep more than if they become an RIC and have to pass through almost all their earnings to their former-depositors-now-shareholders.

As regards excess liquidity now vs in 2008: Yes, there is more excess liquidity now. The issue is: if a bank decided to "de-bank" itself as above would enough of the excess liquidity find its way to said institution if it got in a jam? Banks have the privilege of Fed borrowing but I can't imagine that a bank that had chosen to disbank itself just to avoid having to deposit the 35 or 40% of its money at the Federal Reserve would find much sympathy from the Fed if the former bank got in hot water. That leaves the option of relying on excess liquidity in the free market and non-Fed lenders and I doubt in a real crisis they'd be willing to lend much to an institution on the verge of failure either if things got tough like in 2008...or if they did, the former bank would face such harsh terms (warrants, dilution, PIPEs, convertible preferreds yielding 15%, etc) that having to keep 40% of its money in a safe, liquid place that yielding nothing (or yielding 0.25%) wouldn't seem like such a bad deal in hindsight.

Reub wrote: The bottom line is that, as HB said, one rising asset class can completely carry the entire portfolio. Many times, this one asset has gains greater than the 2 classes that may be falling. Please listen to HB's second broadcast, the one that explains the PP. Near the end of the broadcast, Mr. Browne covers this subject nicely.

I guess if by "completely carry the portfolio" you mean "have the whole PP just keep up with inflation" or "yield maybe 1-2% real" then the above is correct. Japanese PP investors who didn't own any foreign stocks treaded water vs inflation for roughly ten years. US PP investors in the 50s and 60s might well have made just shy of 2% real if gold had been free-market priced and fallen then like it did in every other episode of non-inflationary prosperity.

D1984 wrote: I guess if by "completely carry the portfolio" you mean "have the whole PP just keep up with inflation" or "yield maybe 1-2% real" then the above is correct. Japanese PP investors who didn't own any foreign stocks treaded water vs inflation for roughly ten years. US PP investors in the 50s and 60s might well have made just shy of 2% real if gold had been free-market priced and fallen then like it did in every other episode of non-inflationary prosperity.

Well then, just add some least correlated foreign stock exposure.  It seems like that would deal with the issue as it is the primary driver of the PP.

MG

D1984, when you say other lucrative investment opportunities may lure money "out of" short term treasuries, for me the critical issue is that in the treasury secondary market etc, M0 money is still there regardless of what people want to hold. It can be passed back and forth but it can not be transformed into anything else within the private sector. To raise short term interest rates you have to raise the value of M0. I hope I'm not either stating the obvious or in a muddle but I don't see a way around that bald fact.

About your second point, I thought reserves needed to be held as a certain proportion of deposits under US law (not for UK or Canada or for the Basel II international standard where there is a zero reserve requirement). That was the reserve requirement. By contrast the capital requirement was as a ratio to outstanding loans under Basel II and US etc law. Under Basel II the capital can be held as bonds etc. It does not need to be in the form of bank reserves. I thought you were suggesting a change so that capital did have to be held in the form of bank reserves. I hope I'm not in a muddle about this.
http://en.wikipedia.org/wiki/Basel_II

D1984, maybe I need to polish up my understanding of what bank deposits are. My impression was that bank capital was the wealth that the bank had at its disposal. The loans and deposits were entries on a spread sheet that largely netted out to zero across the banking sector as a whole with the discrepancy (excess deposits) being the M0 bank reserves. If a bank makes a loan and that loan gets deposited in another bank, then every few days any shortfall gets amended by the banks lending bank reserves to each other. As such, deposits don't seem to me to really be "net worth" that the bank has at its disposal in the way that bank capital is.

D1984, perhaps if the USA started running a truly massive trade surplus (exporting much more than was imported) then your scenario might come about?

stone wrote: D1984, maybe I need to polish up my understanding of what bank deposits are. My impression was that bank capital was the wealth that the bank had at its disposal. The loans and deposits were entries on a spread sheet that largely netted out to zero across the banking sector as a whole with the discrepancy (excess deposits) being the M0 bank reserves. If a bank makes a loan and that loan gets deposited in another bank, then every few days any shortfall gets amended by the banks lending bank reserves to each other. As such, deposits don't seem to me to really be "net worth" that the bank has at its disposal in the way that bank capital is.

Deposits and Accounts Payables are Liabilities.  The bank's capital is the Bonds and Equity on the Asset side of the balance sheet.  All the ruckus over the past few years has been because the banks do not want the equity wiped out and the bonds to take a haircut, even though it will not effect depositors or vendors.  A bunch of spoiled brats, if you ask me.

MG

Stone, the reserve requirement (how much they had to hold as either cash or reerves with the Fed) I was talking about was indeed as a certain proportion of deposits (what the bank borrowed from depositors...and if you wanted to make the law apply to the "shadow banking" system as well then make it include what the bank borrowed via interbank loans, repos, etc) and not a certain proportion of capital. Bank capital (Tier I and II) can in fact be held in bonds (but no common equity stocks in Tier I capital) although if you wanted to make banks further fund the Fed's portfolio I suppose one could also mandate that they hold a certain proportion of capital-in addition a certain proportion of deposits as specified in this thread above-as balances with the Fed earning virtually nothing.

When you say "m0" are you using the British definition or US definition? To me as an American M0 is coins and bills only, not bank deposits or other forms of liquid cash. By "m0 money is there regardless of what people want to hold" do you mean that after the QEs there is so much excess liquidity around that even if it has to go into SOMETHING...and that even if it bids up the prices of, say, commodities, or high-yield bonds, or equities, or even labor (rising wages) up when people buy those commodities/equities/bonds/labor the sellers of them will have to put the money they got for their commodities/equities/junk bonds/work/whatever somewhere. They can put it in a bank (but the bank will just have to buy either Treasuries or leave it on deposit as Fed balances....of course the bank could also buy equities/commodities/junk bonds/corp bonds etc but that only passes the buck and starts the whole process over; the excess money still ends up somewhere and someone has to hold it), they could buy short-term Treasuries with it, or they could leave it on deposit with the Fed. If they choose to buy Treasuries then this will keep Treasury prices low (A lot of money and buyers sloshing around equals lots of demand equals high prices and high prices equal low yields) until EITHER:

A.The Fed starts selling some of its excess QE1 and QE2-purchased Treasuries off (and taking the resulting money it gets and doing Bernanke's famous "printing press" in reverse i.e. "we have a paper shredder or its electronic equivalent" so the excess liquidity just disappears), or,

B. The government taxes the money away (income tax, payroll tax, asset tax, VAT, etc) and destroys it while spending less than it takes in in the form of said taxes.

Is this why you think Treasury yields will stay low for the forseeable future and why they will only rise when the Fed wants them to?

Also, how exactly does the trade surplus effect Treasury yields? If we export more than we import then we have bunch of foreign currency from selling all those exports. Are you saying we have in effect we have then chosen to hold wealth as foreign currency and not as Treasuries? But doesn't Japan have a massive trade surplus and rates still stuck in a very low rut? I'm confused now. Perhaps you can explain it better or maybe I'm missing something obvious I should have spotted?

MachineGhost wrote:

D1984 wrote: I guess if by "completely carry the portfolio" you mean "have the whole PP just keep up with inflation" or "yield maybe 1-2% real" then the above is correct. Japanese PP investors who didn't own any foreign stocks treaded water vs inflation for roughly ten years. US PP investors in the 50s and 60s might well have made just shy of 2% real if gold had been free-market priced and fallen then like it did in every other episode of non-inflationary prosperity.

Well then, just add some least correlated foreign stock exposure.  It seems like that would deal with the issue as it is the primary driver of the PP.

MG

Adding foreign stock exposure saved a Japanese investor's bacon in the period from 1990 to the present; this was true whether he invested in "100% stocks" like Dave Ramsey or some Bogleheads suggest, had a PP, or used a Swedroe-type FTM portfolio (the Japanese FTM portfolio was saved by EM stocks and Europe/Canada/Australasia/US value stocks; with just Japanese SCV stocks-held as DFA's Japan smallcap fund in yen-denominated terms-and IT treasuries it did even worse than the Japanese PP IIRC...let's just say that small cap value stocks do NOT do well in a deflationary environment like Japan after 1990...they didn't do so well in the US from 1929-32 either).

I don't know if you could have seriously invested in foreign stocks in the 1950-67 period as a US investor. I am under the impression that the first foreign stock fund (TEPLX) came out just before 1955 and it didn't do any better-in fact somewhat worse-than US stocks during this period (I do know that German and Japanese stocks did quite well from 1949 to the eighties, though). Even if one could have bought foreign stocks during this time frame the issue remains that the PP performed poorly not because the US economy from 1950-1967 was in slow-growth mode like it was in Japan in the 90s and 2000s (roughly the time period when the Jap PP stumbled but could have been rescued by foreign stocks); no, the US economy in terms of GDP growth, per capita income, corporate profits, stock prices, etc did swimmingly during these eighteen years. The issue was that with bonds falling due to rising yields and gold falling due to non-inflationary prosperity (with decent real inflation adjusted rates available on savings) stocks alone couldn't power up the PP and cash was an eighty-pound weakling in upside volatility compared to the other assets.