I Love Inflationary Environments. I'd Love to be Part of One Someday.
How Bonds Became Central Bank Insurance Policies
It’s been a wild week. So the best hot take I can muster is that no one should buy bonds. Ever. That is, if you buy bonds for wealth growing purposes, you are an idiot. Cool, you have a piece of paper from the government telling you that with inflation you’re getting robbed. Who cares? No one. Why? Because bonds are not what they used to be. Once upon a time, you could get by on having a significant amount of your portfolio taken up by bonds.[1] But those were simpler times. Back when people believed fairy tales about value stemming from future cashflows, clipping coupons was an honorable profession. But now it’s all hokum – at least for the average person.[2]
While you might be thinking that my position stems from the abysmal yields on government and corporate bonds, it actually has to do with something else. That is, the meaning and purpose of bonds have changed. Bonds are not investment assets in the way that you or I think of them. In aggregate, investment-grade bonds are not meant to be a source of wealth generation. They are instead shiny certificates that act as ‘get out of jail free’ cards in financial crises. Follow along.
In the Global Financial Crisis major institutions learned an important lesson. Non-cash assets are useless during a crisis if normal market participants are the only ones involved. Exhibit A of this was Lehman Brothers. At no time prior to declaring bankruptcy at 1:45 AM on September 15th, 2007 was the firm insolvent.[3] Sure, assets were overpriced, but even then the firm was sitting on $600-billion in assets that could have been used as collateral for near-term liquidity.[4] The issue with Lehman was that seemingly every other major financial institution decided that the rules of the game were null and void. Suddenly, the likes of J.P. Morgan started to suck Lehman dry by demanding increased collateral as Lehman’s liquidity position deteriorated which caused a vicious spiraling of cash out the door. Morgan alone demanded $11.5-billion in collateral on September 9th.[5] Now, Lehman could have met many – if not all – of its obligations using short-term assets, except, for the fact that liquid assets suddenly became illiquid, or undesirable as collateral. For example, by September 12th, around $7.0-billion in short-term securities suddenly had no market, despite legitimate reasons for being tradable.[6]
So, if the normal folks are not willing to play with you, who does that leave you with? Oh right, the central bank. In the case of the Americans, they were left with having to haggle with the Fed. Now, in the financial crisis, the Fed became the great source of liquidity. Through processes such as the Primary Dealer Credit Facility (PDCF), selected institutions were able to exchange certain securities for cash. At the time of Lehman’s bankruptcy, $114-billion worth of its assets qualified as acceptable for the PDCF.[7] So why didn’t Lehman tap the facility? Because the Fed purposefully excluded Lehman from accessing the facility on September 14th when they loosened the eligibility requirements for everyone else.[8]
Let’s be clear here. What occurred in September 2007 was the lifting of the curtain on the great secret of finance, which is that marketable assets require a market, and good luck finding one in a crisis. By all reasonable accounts, the failure of Lehman was a mistake. Sure, Dick Fuld was an asshole, but so are most people. The lesson that the Fed, and central banks around the world, took away from the Lehman debacle was that no major financial institution was ever going to be allowed to fail because of liquidity concerns. In order to facilitate this axiom, central banks became the provider of liquidity to the market. However, central bankers demand some form of collateral. What separates the Fed from J.P. Morgan is that the Fed does not care if the collateral is trash in the current market, they only care about what value they can slap on it in theory. It’s performative on their end. The Fed can’t go bust if they’re the ones changing the ones and zeroes in everyone’s accounts. This development ruined the bond market.
Why buy a bond? Well, because you need cash to pay your bills. However, all your current bills have been paid and you are currently sitting on excess cash. Buying a bond consists of swapping excess cash today for theoretically risk-adjusted guaranteed cash in the future when you will need it for paying bills. You are paying for future liquidity. But what if your central bank will swap cash for bonds if you get into a pinch? Then the cashflows don’t really matter. Because you’re not holding onto the bond for the purposes of receiving cashflows from the issuer. You’re sitting on that piece of paper because it’s an insurance policy. So, let’s say that liquidity is actually quite tight in the system? Would you not be willing to pay through the nose for that insurance policy given the devasting outcomes associated with a crisis? Put differently, the only cashflow that matters is the one from the Fed to the institution in a crisis.
But aren’t we supposed to be living in the age of ‘money machine goes brrrrrrrr?’ How could it be that liquidity is tight? Well. Let’s vibe with Joe Weisenthal from Bloomberg for a moment. A couple of weeks back Weisenthanl – in Bloomberg’s market newsletter – argued that monetary policy in the US has been tight since 2007.[9] His argument is that low inflation is indicative of tight monetary policy – if we were swimming in cash then we would see it reflected in rising prices. This has not been the case over the past decade. Instead, what we have had is a wealth-neutral policy of quantitative easing across the board. If you have a 10-year treasury – or commercial mortgage-backed security – that has a theoretical value of $980 and the Fed gives you $980 in cash today, then your balance sheet is the exact same as it was before. No asset delta was created. You simply realized the theoretical value of the asset – not the market value – the theoretical one. The market did not want your trash so don’t yammer on to me about how the Fed is the market.
Hence why bond yields are garbage. Major financial institutions buy bonds because they know that in a squeeze bonds are a method for magically garnering liquidity from central banks. That is, major institutions do not necessarily care about yields. They just have to have appropriate collateral sitting around, waiting to be posted someday at a Fed facility.
Beyond 2007-2008, one could look to the Fed’s QE programs but also the central bank’s actions in September 2019 when it stepped in to provide $75-billion in liquidity each morning for a week to ensure that the overnight repo market continued to roll over.[10] This cash was provided on the basis of treasury and agency MBS collateral. Thus, assets – which were theoretically liquid but became illiquid due to a cash squeeze – were made liquid once more by the Fed. This was not the market acting. This was the Fed stepping in and paying out insurance policies. While we might all laugh at this particular action given that the Fed was taking treasuries and agency debt as collateral, it set yet another liquidity-providing precedent. One which added credence to the Fed’s decision to create a liquidity backstop for corporate bonds during the COVID-19 crisis.[11] Suddenly the Fed was accepting bond ETFs and investment-grade bonds as collateral for cash. Far from being the lender of last resort, the Fed is now the “market maker of last resort.”[12]
What this state of affairs means is that bonds are not investment vehicles. Because of this, one should not expect yields to rise extraordinarily unless inflationary concerns pick up. If inflation were to pick up, then the insurance policies would need a little *oomph* to satisfy institutions. Thus yield would rise. In light of the expansionary fiscal policy of the United States in the past year and a bit, this could very well happen. But there is something bigger going on.
Specifically, the bond market is mispricing risk because – as Alex Veroude, CIO at Insight Investment, put it – “the Fed has created an expectation of a bailout.”[13] If the bond market tanks, don’t worry about it because the Fed will artificially raise bond values by buying them up. This is insanity. This signals to institutions that they can make all the shitty decisions in the world, but so long as they all do it together, the Fed won’t let anybody lose liquidity.
So, let’s wrap this thing up here. I have long advocated for the failure of financial institutions in times of crisis. Why? Because, in the words of Dave Chapelle, ‘Fuck ‘em, that’s why.’[14] If the issue is that deposits are lost in a crisis, I think we can all believe that governments have the capacity to step in, set shareholder equity to 0 and then befuddle their way to a ‘normal’ where nominal deposits are protected. Take over the firm, take long-dated assets, swap them at the Fed for liquidity, recapitalize the bank, go from there. At least then the Fed would be serving the people as opposed to bankers and shareholders who currently ride fare-free on the back of federal governments.
Completely Unrelated:
The Race is On by Sawyer Brown
Waterloo Sunset by The Kinks
Believing in Order to See by Jean-Luc Marion
The Hebrew Republic by Eric Nelson
[1] Obviously, I am receptive to the claim that bonds provide a risk-free floor in a portfolio that can be utilized for risk management purposes. But then the matter is not about returns – but risk.
[2] Traders are a different story given relative rises and falls. But that’s a different discussion all together about intra-market attractiveness.
[3] Laurence Ball, The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, Kindle ed., (New York: Cambridge University Press, 2018), xxiv.
[4] Ibid, 65.
[5] Ibid, 87.
[6] Ibid, 91.
[7] Ibid, 99.
[8] Ibid, 151.
[10] https://www.federalreserve.gov/econres/notes/feds-notes/what-happened-in-money-markets-in-september-2019-20200227.htm#:~:text=What%20Happened%20in%20Money%20Markets%20in%20September%202019%3F,-1&text=In%20mid%2DSeptember%202019%2C%20overnight,increases%20in%20net%20Treasury%20issuance.
[11] https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-market-crises-and-the-government-response-20201007.htm
[12] https://voxeu.org/article/subprime-crisis-what-central-bankers-should-do-and-why
[13] quoted in https://www.ft.com/content/7fa7e230-5a8f-4a65-b8b7-ecd603a2a3d1