Author : John E. Charalambakis
Date : September 24, 2013
It seems that the Latin phrase Crescit Eundo (it grows as it goes) fits well into the Fed’s modus operandi. In its latest attempt to justify the non-tapering, the Fed told us that fears of slowing growth, interest rate rising, and Washington infighting about the budget and the debt ceiling, prevented the central bank from initiating a slowdown in its “asset” buying program. Certainly all three could be perceived as logical reasons for postponing tapering. The problem is that the path paved by the multiple quantitative easing programs (QEs), has lost its significance and efficiency as well as its stochastic nature. It has been converted into a tool that superficially inflates paper assets while it has paved the way to a deterministic path that makes the next collapse inevitable and very harsh (absent a deus ex machina). The reason for the latter is the ultimate degradation in collateral velocity (due to an inverted pyramid credit structure, as explained below) which in turn undermines the prospects of growth, employment, and incomes.
The unwinding of the QEs involves the normalization of interest rates, the removal of reserves created by the Fed, and the winding down of securities holdings, among other things. The pre-announcement of tapering last May started the rates’ normalization process, but already had its first collateral damage in developing markets. Possibly then the Fed in its international mindset postponed the inevitable tapering and allowed international markets to buy more time (recalling the days of the mid 1920s when it followed an expansionary policy in an attempt to accommodate the central bank of England to restore gold convertibility at pre-war parity). A better explanation might be that the Fed was not ready with its repo agreements to unleash the financial collateral it holds as explained below.
The Fed is facing a potential reversion problem as it prepares for the tapering: While it desires the reserves to be converted partially into money supply (which will alleviate part of the debt hangover if inflation can be kept at around 4-5%), banks need to continue deleveraging by reducing their assets, while they need to meet tighter regulatory leverage ratios. Hence, tapering may be followed by credit contraction and deflationary pressures. Therefore, the Fed may be preparing term deposits facilities where banks place funds into term deposits, and hence reserves are removed from Fed accounts and the drainage of reserves takes place. Alternatively, the Fed may be preparing repo facilities where bonds are sold to Fed’s primary dealers with the understanding that it will buy them back in the future, at a slightly higher price (crescit eundo).
If such repo facilities are provided, the objective of the Fed will be to remove “dead” cash from accounting systems and replace them with acceptable collateral, therefore creating a portfolio effect that can stimulate credit in the economy, mitigating in the process rising rates, and possibly igniting – what is thought to be – controllable inflation (that will in turn reduce the amount of real debt), through effects on the collateral chain. Welcome to a new round of re-hypothecation in the brave new world of shadow banks that are responsible for credit creation. My prediction is that such facilities will uplift markets in the short to medium term but will undermine paper assets in the long term and hence the sub-title of this commentary “logical irrationality”.
Let’s not forget who the primary (nonbank) suppliers of financial collateral are: hedge funds and their likes globally; custodians of securities (on behalf of pensions and insurers among others); and large banks through their dealers. In the Post-Lehman world the velocity of collateral declined due to declining asset prices as well as due to deleveraging and some limitations on re-using the same collateral (the latter two shorten the length of the collateral chain). It is interesting to note that the velocity of money has been declining at about the same pace as the velocity of collateral. Therefore, if the repo facilities of the Fed materialize, then as collateral velocity rises so will money velocity (I have written before that the reversal of the latter will be a significant step toward a trajectory of nominal higher growth rate).
As the Fed tapers through repo agreements, the supply of financial collateral received by the collateral desk of the Fed’s primary dealers rises too. The dealers (both US and non-US) re-hypothecate that collateral and as re-hypothecation rises the collateral chain expands and thus the financial system’s demands are met. Therefore, both the size of financial collateral (due to Fed’s repo agreements), as well as its length (due to re-hypothecation) rise also, which temporarily could become a major boost for the markets. From that perspective the whole process seems to be logical.
Why then should we be concerned? Simply because the whole process is based on two very fragile premises, namely: the asset released and pledged is a third-party liability and has no intrinsic value, and most importantly is re-pledged numerous times which undermines the whole credit structure/pyramid which is turned on its head.
How long could that be going on? Let me answer that by a question: Could that last more than the velocity of the pledged collateral?