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Quarrel With Quarles Over Too Little, Not Too Many

Summary:
It wasn’t the first time the ground had already been eroding underneath his feet. Randall Quarles took at turn at the Treasury Department during the Bush Administration, rising to Undersecretary for Domestic Finance during the most maniacal part of the eurodollar-fueled housing bubble. Not surprisingly, among the last things he did there was tell the public how great everything was going.But then Quarles jumped from Treasury to…Carlyle. Because everyone has been told 2008 was about subprime mortgages, this one name just doesn’t register the way it really should – subsidiary CCC, in particular. However, to anyone who paid attention to repo in the months and weeks leading up to Bear Stearns, Quarles’ new firm had been seen everywhere for all the wrong reasons.I recalled a few years ago:

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It wasn’t the first time the ground had already been eroding underneath his feet. Randall Quarles took at turn at the Treasury Department during the Bush Administration, rising to Undersecretary for Domestic Finance during the most maniacal part of the eurodollar-fueled housing bubble. Not surprisingly, among the last things he did there was tell the public how great everything was going.

But then Quarles jumped from Treasury to…Carlyle. Because everyone has been told 2008 was about subprime mortgages, this one name just doesn’t register the way it really should – subsidiary CCC, in particular. However, to anyone who paid attention to repo in the months and weeks leading up to Bear Stearns, Quarles’ new firm had been seen everywhere for all the wrong reasons.

I recalled a few years ago:

CCC had invested in “highly rated mortgage instruments”, a fact which scared the pants off everyone for good reason. If “highly rated” meant little against illiquidity and insolvency, then everything was fair game; or, the exact opposite of what Randal Quarles assured everyone was the case in 2006. The system wasn’t resilient at all but fraught with risks no one seemed to able or even interested enough to understand even from the inside, let alone officials who could offer no answers about anything.

Liquidity is not solvency, and solvency doesn’t guarantee liquidity especially in the repo market where the ability to sell collateral tomorrow without any prior notice is paramount above everything – especially the Fed’s worthless bank reserves. If the repo market lending you cash and accepting your collateral isn’t assured that a liquidation can be done on predictable terms tomorrow using that class of collateral, repo as a whole is going to go bonkers.

The inability to post any other acceptable collateral in March 2008 spelled CCC’s demise leading directly to the same problem at Bear Stearns. And while Ben Bernanke declared victory in Bear’s aftermath, it had instead been the point of no return for the entire system.

They really have no idea what they are doing. True story.

But, as is usually the case, the well-connected like Randy Quarles found himself right back on the job as one of the pedigree-d few. Appointed to the Federal Reserve’s Board of Governors (of course) in 2017, the guy was right back at it in February 2018 telling everyone how great things were:

I am fairly optimistic about the current state of the economy. Along many dimensions, it has been quite some time since the economic environment has looked as favorable as it does now.

And at the very moment he was making the claim, just as in 2006, the situation had already shifted significantly toward the highly unfavorable. One way we could tell was, among others, the Japanese leaning heavy into selling a lot of their considerable stash of US Treasuries.

Because Economics has done such an atrocious job of keeping up with how the system actually works, what should have been a bright flashing warning (about liquidity) was instead misinterpreted as something it absolutely wasn’t. The Wall Street Journal (of course) reported on February 27, 2018:

Japanese investors may be America’s bond bears.

They are shifting toward selling U.S. Treasury bonds and other dollar-based debt after fears have picked up in recent weeks that the Trump administration’s budget and other policies add up to a weak dollar.

Ridiculous, demonstrably so (see below). So much for that weak dollar nonsense, too. This assumption dates and traces back to a larger one about the US government’s fortunes. Unlike Japan, “they” always said, the US Treasury market wasn’t self-funded in that foreigners are required to lend it money otherwise it’s lights out at Treasury; BOND ROUT!!!! with ten instead of the usual four punctuating exclamations kind of thing.

While that sounds right, it isn’t. History has conclusively shown that in the eurodollar tightening era (since August 2007), the conventional narrative gets it all wrong. When foreigners buy fewer or outright sell their US Treasuries, the yields on them over not too much time especially at the longer end will fall significantly.

Not rise. No rout.

Quarrel With Quarles Over Too Little, Not Too Many


Using TIC data, it isn’t a perfect correlation but it’s damn near close just outside the short run. Foreign holders buy less or sell (especially the official sector since 2014) yields are going to be overall falling. When overseas pockets are adding to their Treasury holdings, yields are almost always rising.

The conventional narrative has it entirely backward, coming as well as going.

What that can only mean is that the narrative is missing something big. Of course, we know exactly what since we aren’t forced into tunnel vision like Randall Quarles and his followers in the financial media. Repo collateral is one thing, but more so the net results of these eurodollar episodes which are marked by bouts of serious, systemic illiquidity showing up all across bond markets.

In very simple high-level terms, when the eurodollar system is going wrong that means a global dollar shortage. Banks in foreign locations dependent upon a constant stream of dollar financing (through repo, loans, swaps, etc.) find it difficult to source what they need and either liquidate any dollar assets they have in hand or turn to their government/central bank which ends up doing the same.

When the squeeze ends, it’s because more system “dollars” become available (not bank reserves) allowing the foreign sector to buy and hold more Treasuries (and other US$ assets) once again.

Thus, foreign liquidations of US Treasury assets are a liquidity signal in the same way as falling Treasury yields more generally are, too. The one doesn’t lead to the other’s opposite, rather both are very different symptoms of the same dysfunctional monetary background. The repo market – on its collateral side – is usually central to that background.

This brings us back to…Randall Quarles. Earlier this month, Governor Quarles gave a speech which the media took, as expected, the exact wrong way; which is at face value. The former Carlyle exec told the public that the domestic banking system is as strong as ever, and that was the key reason why March (in his tunnel view) went so well (I know).

There weren’t any new Lehman’s, you see.

If there was anything bugging him about it (and, you know, the whole rest of the world), it was once again pesky problems in funding markets even all these years later.

It appears that these short-term funding markets remain an unstable source of funding in times of considerable financial stress. The Fed and other financial agencies have accomplished a lot in requiring or encouraging market participants to rely less on unstable short-term funding, but it is worth asking whether there may be other steps needed to secure these very important sources of liquidity.

That’s the part I previously highlighted because it was the only part worth highlighting. Now, what Quarles further said, and what the media focused on, was that “considerable financial stress” had also been applied to the Treasury market itself. Treasuries! The deepest, most sophisticated financial palace had also experienced severe disruptions during the otherwise well-handled (Quarles’ view) March dysfunction.

So, this is the part which has captivated everyone since:

Treasury market conditions deteriorated rapidly in the second week of March, when a wide range of investors sought to sell Treasuries to raise cash. Foreign official and private investors, certain hedge funds, and other levered investors were among the big sellers. During this dash for cash, Treasury prices fell and yields increased, a surprising development since Treasury prices usually rise when investors try to shed risk in the face of bad news or financial stress, reflecting their status as the ultimate safe asset…The intense and widespread selling pressures appear to have overwhelmed dealers’ capacity or willingness to absorb and intermediate Treasury securities. [emphasis added]

It was taken to mean, dum dum dum, “too many Treasuries.” Yes, this again. Talk about the undead monster that you just can’t get rid of no matter how many stubborn contrary facts.

Let’s unpack what Quarles is trying to allege. Because the government’s debts have ballooned so much (echoing February 2018’s “weak dollar” argument) the Treasury market has expanded to the point that maybe there’s too much for any system to handle when that system is experiencing a dislocation. Dealers just couldn’t take on all the securities being sold to them by especially foreign sellers (we’ve heard this all before).

But why, Randy, why were foreigners (and others) being forced into such massive sales to begin with? Had the federal government auctioned off one-too-many long bonds triggering the market’s reverse?

Obviously no. What we’ve observed time and time (and time and time) again is that when global dollar liquidity is highly impaired, the subsequent shortage leads to foreigners, in particular, selling their foreign reserve assets (US Treasuries primary among them). And in the worst of those undeclared global dollar shortages, who might also suffer from them, too?

The very dealers who are also expected to intermediate in each and every market including the Treasury market. Is it any wonder they stepped away from taking especially off-the-run issues which were increasingly non-negotiable in repo? The very “considerable financial stress” Randall Quarles was otherwise talking about includes a lot more than Randall Quarles knows enough to talk about.

It’s not just that he and others like him have the cart before the horse here; they don’t even know which is the cart and what’s the horse.

In other words, the Treasury market didn’t grow too big – the global dollar shortage did! That not only precipitated the heavy selling (fire sale liquidations) in Treasuries and elsewhere, in repo it also handcuffed dealers’ collective ability to intermediate that very Treasury selloff.

This not exactly in keeping with the Fed’s finest hour narrative, is it?

The Fed claims the domestic banking system is fine – which it is, but so what? – and so because there wasn’t another Bear or Lehman (or Carlyle) like 2008 the central bank did its job to perfection. Never mind that the banking system had already begun to clean itself up long before the Fed knew what was happening, this view leaves out exactly the same issues as had come up before, during, and after Carlyle,

Is the Fed a central bank, responsible for the dollar system? Or is it instead a domestic bank regulator which looks at the world from the perspective of domestic banks and therefore anything that goes on in the rest of the dollar system is left outside its worldview? From this one speech alone, you can easily see it is the latter.

Not just Quarles’ words, though, everything the Fed has done and does comports with this incomplete picture of how things really work. Officials claim how from the point of view of the domestic banks March wasn’t so bad, but, man, everything else got really, really screwed up for almost an entire month.

Must be too many Treasuries, or something. What else could it be?

No, Aristotle. There weren’t enough dollars. This rather than the size of the Treasury market explains the selling in Treasuries (as it has for years), the intensity of it, as well as why dealers had so much trouble handling the dislocation. The level of bank reserves, like the Fed in general, was absolutely no help which only helped further reinforce the downward spiral of liquidations and fire sales.

Just like we warned last October at Repo-ween:

In other words, don’t look to the level of bank reserves or regulations. I kinda like the way Bair put it, a bunch of risk-averse scaredy-cats who sat there in the middle of September [2019] despite adequate levels of reserves (as Powell admitted) and let money rates skyrocket because they openly, publicly refused what would’ve been enormous profits…

Therefore, the whole issue, the entire thing in a nutshell, is why they became so risk averse in the first place! None of the rest of that stuff matters. And, unlike Powell and probably Bair, we know, because we’ve been chronicling it the whole time, they didn’t just suddenly break out in a desperate risk-off sweat completely out of the blue on September 16…

The good news for Jay Powell if not the whole world was that mid-September had been nothing more than a dress rehearsal. It was not what central bankers would classify as a “market event.”

The bad news, potentially, is what happens if or when it is and no one has addressed the scaredy-cat issue.

Bingo. No one had addressed the scaredy-cat issue. Instead, Jay Powell thought it’d be a good idea to make it all worse (by not-QE stripping T-bills available for use in repo emergency in order to, once again, raise the systemic level of useless bank reserves).  And when the time came, dealers were leaving huge profits on the table in every market including the Treasury market (unusually wide bid-ask). What I wrote beforehand, not what Quarles meekly alleges long afterward, explains March. All of March. And a lot more than March.

Global dollar shortage. Global dollar shortage. Global dollar shortage. Domestic banks play a surprisingly (to mainstream convention) small role in it. Therefore the Fed does, too, including how it tries, and fails, to explain what keeps happening. It never works out the way they tell you it will because it never happened the way they want you to think it might have. 

They really have no idea what they are doing. At least in Europe, authorities are making the tiniest sliver of an effort to correct this.

Quarrel With Quarles Over Too Little, Not Too Many

Jeffrey P. Snider
As Head of Global Investment Research for Alhambra Investment Partners, Jeff spearheads the investment research efforts while providing close contact to Alhambra’s client base. His company is a global investment adviser, hence potential Swiss clients should not hesitate to contact AIP

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