Most people generally accept and understand that the Fed
executes its monetary policy operations through the FOMC by purchasing or
selling US Treasury securities and, in doing so, adding or removing reserves
from the banking system. It isn’t controversial or insightful to say that an
increase in the supply of reserves causes rates to come down, and vice versa
when supply decreases. Per the Fed’s website:
“To raise the FFR, the Fed decreases the supply of
reserves by selling U.S. Treasury securities in the open market. The decrease
in reserves shifts the supply curve left, resulting in a higher FFR.
To lower the FFR, the Fed increases the supply of
reserves by buying U.S. Treasury securities in the open market. The increase in
reserves shifts the supply curve right, resulting in a lower FFR.”
However, what most people do not understand and/or
acknowledge is that US budget deficits (i.e. Treasury cash outlays exceed
inflows) are achieved by the Fed adding reserves to the banking system, and
budget surpluses (i.e. Treasury cash inflows exceed outlays) are done by the
Fed removing reserves. A 2018 paper
released by the Chicago Fed makes this explicitly clear:
“When the U.S. government makes a payment, funds are
withdrawn from the TGA [Treasury General Account] and sent to the bank accounts
of individuals or businesses. These transfers increase the reserves of the
commercial banks that hold the private accounts. Similarly, when the
government receives a payment, the source of the payment is an individual or
business account at a commercial bank and, ultimately, the reserves of the
commercial bank.”
Orthodox economics tells us that a government which runs
chronic budget deficits will eventually be forced by the bond market to pay
higher interest rates as punishment for “profligate spending.” One of the
critical insights of MMT is that, by looking at the order of operations of our
monetary system, this “bond market vigilante” theory is complete nonsense. Per
the above, budget deficits increase the supply of reserves in the banking
system, and increasing the supply of reserves in the banking system leads to lower
rates.
This is overwhelmingly supported by empirical evidence.
Consider Japan. Like the US, the Japanese government issues debt in its own
currency, and has been running large fiscal deficits for the last 30 years.
Over that time, the interest rate on the 10yr JGB has gone from 5% to basically
0%:
Same goes in the US. Aside from a short period in the late
1990s/early 2000s, the US has been consistently running budget deficits for the
last 30 years. As MMT would predict, rates have been falling over that same
period:
Notice, too, how a recession followed shortly after fiscal
year 2001 budget surplus. When the US government runs a budget surplus, that leads
to the Fed removing reserves from the banking system. It is a de facto
rate-hike, and takes away financial resources from the non-government sector. The
weakened financial position increases the likelihood of a recession.
I bring this up because the BLS recently released the
January budget figures, and it turns out the US government ran a budget surplus
of $119 billion, the first since September 2019 ($83 billion), and an unusually
high amount for the month of January. Market participants might recall the big
Repo market blow-up that took place in September 2019, where stress in
overnight funding markets caused the Secured Overnight Financing Rate to spike
unexpectedly:
As the Fed explains,
this was basically a timing issue: there was an insufficient supply of bank
reserves due to higher-than-expected tax collections by the Treasury on
September 16, which coincided with a $54 billion Treasury debt sale settlement,
both of which caused a rapid $120 billion decline in bank reserves. This
brought the aggregate level of reserves down to its lowest level since 2012. The
lack of reserves increased bank borrowing needs, which spooked lenders (mainly
Federal Home Loan Banks or FHLBs) and caused them to pull back on collateralized
loan advances.
Let me repeat: insufficient reserves caused overnight
rates to spike. That is precisely what MMT predicts! More reserves lead to
lower rates, less reserves lead to higher rates. Given that fiscal deficits add
reserves, that means that fiscal deficits lead to lower interest rates, and
surpluses lead to higher rates. This stands in direct contrast to the mainstream
view that fiscal deficits will (eventually) lead to higher rates. It’s all a
gigantic lie/myth/fraud, perpetuated for decades by Wall Street, the media, policymakers,
and academics.
So what happened in January 2022 when the Treasury ran a
budget surplus, removing reserves from the banking system? Exactly what we
would expect to happened: rates rose! This past January saw the largest fiscal
surplus ever for the month of January. Lo and behold, the rates on US Treasury
securities exploded. The secondary market rate on the 3 month US T-bill went up
by 4x in a month, from 6bp to 24bp:
This unexpected event caused funding stress in money markets
(as evidenced by the rapid rise in rates) which subsequently caused a decline
in the stock market, as leveraged traders (read: HFs) had their margin loans
called by banks and were forced to de-gross their portfolios. As a result, the NASDAQ
had its second worst January performance ever (January 2008 was the worst) and
the S&P 500 and Dow Jones Indices each had their worst overall monthly
performances since the pandemic-induced panic in March 2020.
But not all stocks were treated equal over this period. “Growth”
funds got absolutely slaughtered: Whale Rock Capital lost 15.9%, Tiger
Global lost 14.8%, and Melvin Capital and Light Street Capital each lost 15%.
Meanwhile, so-called “value” stocks performed exceptionally well. In fact, quant
fund giant AQR’s
value fund posted its best month ever this past January. The
media has dubbed this the “great rotation” into value stocks. While I would love to see a secular rotation into value stocks, I am skeptical of this explanation. The more rational reason for this performance discrepancy is that for years, by far the most consensus trade for HFs has
been “long growth, short value.” So, as reserves were transferred out of the
banking system, margin lenders were forced to call in their loans, forcing HFs
to de-gross their portfolios. By de-grossing, they sold their “growth” stock
longs and covered their “value” stock shorts. And given that all these HFs have
piled into the same names, there is very little liquidity from buyers. We are
routinely seeing companies report earnings after hours and immediately go down
by double-digits. As mentioned in a prior post,
Meta Platforms (formerly Facebook) set a record for largest market cap loss in
a single day.
This sequence of events is shockingly similar to what
happened in September 2019. As mentioned before, September 2019 was the last month
that the Treasury ran a budget surplus, causing stress in overnight funding
markets. I distinctly remember that period because in the span of a few days,
the portfolio of stocks I was helping manage at the time had the most
ridiculous three-day stretch of performance I’ve ever seen, returning ~15%,
including 7% on a single day. I remember chatting with friends in the industry who
said many people’s portfolios were blown up from this, just like they are today.
The move was so swift and severe that the
media started writing about the beginning of a great “rotation” out of growth
into value. You can’t make this stuff up. Rinse, cycle, repeat.
There are other examples of stress occurring in the markets
today. We already wrote about the yield curve flattening/inverting, and how the
mortgage market is expected to slow down dramatically compared to the last two
years. Clearly, that is a sign that demand for mortgages is slowing. And yet, mortgage
rates have experienced the largest monthly jump in 9 years. If mortgage
rates are spiking, that is a sign that lenders are nervous about underwriting
new loans. Think of a mortgage rate spike like the yield on a corporate bond:
if yields explode, that is a sign of stress in the markets. Under healthy
financial conditions, lenders feel confident and compete with each other, causing
rates to go down. When they become nervous, they either pull back on their
lending activities (leading to less competition) or demand higher rates to
compensate for the perceived risks. High rates are an indication of fewer suppliers
of credit, assuming demand is flat. But we know for a fact that demand is
actually down, based on the outlook for mortgage originators like LDI. If
demand was down but financial conditions were strong, lenders would be forced
to lower their rates. The fact that demand is down and yet rates are spiking is
a bad sign.
It is insane that nobody on Wall Street or the media
connects the dots between the Treasury running a budget surplus causing stress
in the markets. January 2022 and September 2019 share striking similarities. All
the pundits insist the recent rapid rise in rates is because of the market’s
perception that the Fed will adopt a more hawkish stance and hike rates
multiple times in 2022 in order to “fight inflation” (I used quotation marks
because, as argued previously,
the notion that rate hikes slow inflation is questionable at best). And as a
reminder, nobody updates their DCF model with a higher discount rate because
the yield on the 10yr went from 1.5% to 1.8%. This is all just a narrative
created by the media and Wall Street. In reality, the jump in yields is due to
reserves being removed from the banking system thanks to the Treasury’s unexpectedly
large budget surplus. Treasury flows affect real economic outcomes. Perhaps
there is some marginal impact by speculative macro hedge funds laying on curve
steepener trades. Indeed, after failed
iterations of this trade in 2021 caused huge losses at big macro HFs, they
have once again been piling on the steepeners in 2022:
And yet the results have been the same.
The fact that Wall Street and the media sticks to these
false narratives just shows they have no idea what they’re talking about. When
one understands the monetary operations of our financial system, it is easy to connect
the dots between the Treasury running a budget surplus, removing reserves in
the banking system, causing yields to spike, stress in funding markets, and forcing
leveraged traders who have piled into the same trades to de-gross their
portfolios. Using an MMT lens allows us to better see and understand this happening
in real-time.
As for trade ideas to take advantage of these conditions, I
have been adding the long-bond to my personal account. Treasuries have gotten
hammered recently, so they offer higher yields. Their special legal status as HQLA
means there will always be a bid for them when markets become stressed.
Opportunities are created when changes in price are inconsistent with their
fundamentals, which is exactly what’s happened. Additionally, the Treasury has gone back to running a deficit in February, and I expect that to continue until taxes are collected in April. Deficits add reserves, so we should expect rates to come down. Investors also might want to
consider looking at Virtu Financial (VIRT), who is a specialist market-maker in
equities and derivatives. When markets become stressed, volatility goes up and trading
spreads widen, which are a benefit to VIRT’s bottom line. The VIX is up +72%
YTD:
At 9x LTM P/E, VIRT looks reasonably priced (albeit not "pound-the-table-cheap") if the
volatility continues.
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