Perspective on Risk - Sept. 10, 2022
Let’s Play - Poszar or Putin?; Fed Stuff; Liquidity Issues Hit European Electricity Providers; Accounting Observations from the PCAOB; Existential Risks
Let’s Play - Poszar or Putin?
Inflation today is simply everywhere. It’s plain impossible to talk to anyone who doesn’t complain about rising prices, or to read the financial press without articles about inflation.1
Under the cloud of inflation, many developing nations are asking a good question: why exchange goods for dollars and euros that are losing value right before our eyes? The conclusion suggests itself: the economy of mythical entities is inevitably being replaced by the economy of real values and assets.2
[A] conversion of global reserves will begin just because there is no room for them with such shortages. They will be converted from weakening currencies into real resources like food, energy commodities and other raw materials.3
Food and energy shortages are looming, and commodity inventories will take off like FX reserves after the 1997 crisis, and will involve not just food and energy but also some industrial commodities.4
A shortage of fertilizer means a lower harvest and a higher risk of an undersupplied global food market. Prices will go even higher, which could lead to hunger in the poorest countries.5
Underinvestment means supply constraints, and geopolitics means even more supply constraints: resource nationalism means that the supply you think is there to meet the surge in demand isn’t there: prices can thus surge.6
President Trump’s immigration policies to appease nativists has cost the U.S. two million jobs, which is driving the current labor shortages and wage pressures.7
Once again, the world is going through an era of drastic change. International institutions are breaking down and faltering.8
Changes in the global economy, finances and international relations are unfolding at an ever-growing pace and scale. There is an increasingly pronounced trend in favor of a multipolar growth model in lieu of globalisation.9
Fed Stuff
Pat Zobel, the System Open Market Account Manager at the NY Fed gave a nice talk at Cato: The Ample Reserves Framework and Balance Sheet Reduction: Perspective from the Open Market Desk10 Most of us were raised, and taught in our Money & Banking classes, that the Fed operated with a 'scarce reserve' framework. The dynamics of how markets work will change, and again, past will not be prologue.
Beginning this month, the Fed has accelerated its balance sheet reduction. As such, this speech is definitely worth reading, Some of my highlights:
How does the Fed determine success?
The success of any implementation framework depends on its ability to work within the money market ecosystem to achieve interest rate control.
How will balance sheet run-off proceed?
[T]here are several differences between the current environment and our prior experience (2017-2019).
The composition of liabilities is also different. ON RRP balances of around $2.2 trillion currently comprise about a quarter of the Federal Reserve's liabilities. In contrast, when the prior period of balance sheet reduction began, ON RRP balances averaged less than $125 billion, accounting for only 3 percent of liabilities. This different composition of liabilities will necessitate a more complex set of adjustments in private-sector balance sheets than during the last episode.
This different composition of liabilities will necessitate a more complex set of adjustments in private-sector balance sheets than during the last episode.
The speech details numerous moving parts, concluding:
Overall, as the Federal Reserve's balance sheet declines, I expect money market interest rates to rise relative to the ON RRP rate and for market participants to shift investments away from the facility over time, moderating the decline in reserves. This will necessitate significant adjustments across a wide range of private-sector balance sheets.
When will the Fed slow or stop the run-off?
Ultimately, the Committee has stated its intention to slow and then stop the decline in the Federal Reserve's balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves. As I noted before, the level of reserves needed to maintain ample conditions is uncertain and varies over time.
The NY Fed seems to be doing research on this exact point. On their Liberty Street blog, they posted the following: How Can Safe Asset Markets Be Fragile?11 (Liberty Street). This post references a staff report Fragility of Safe Asset Markets12. The geekier of us will want to read the 2nd link.
Using a theoretical model, we show that markets for safe assets can be fragile due to strategic interactions among investors who hold Treasury securities for their liquidity characteristics.
We model a safe asset market with investors valuing safety, investors valuing liquidity, and constrained dealers. While safety investors and liquidity investors can interact symbiotically with offsetting trades in times of stress, we show that liquidity investors’ strategic interaction harbors the potential for self-fulfilling fragility. Surprisingly, standard flight to safety in times of stress can have a destabilizing effect and trigger a dash for cash by liquidity investors.
[T]he market can break down if trade involves dealers that are subject to balance sheet constraints. The risk of market break-down can be self-fulfilling, as it leads investors without pressing liquidity needs to sell preemptively in order to avoid the possibility of having to sell at lower prices in the future.
Somewhat ironically, the first-mover problem that we experienced in institutional MMF now is seen in Treasury markets too.
The NY Fed also wrote a post for Medium titled The “How and When” of the Fed’s Balance Sheet Runoff13
To understand how runoff will proceed across Treasury and agency MBS holdings, some additional details are useful as context. Indeed, due to some specifics of managing the Fed’s securities holdings, settled holdings data may not always track one-for-one with the runoff trajectory implied by the caps. The next two sections explain how the public can use available data to understand these details.
The following chart shows projections of future maturities of Treasury securities held by the Fed along with the monthly cap. The area below the line shows the types of Treasury securities that will be redeemed by the Fed. In most months, coupon securities will make up most of the redemptions (dark blue bars). Periodically, Treasury bills (dark red bars) will also be redeemed when aggregate coupon maturities are less than the cap.
The pace of the Fed’s agency MBS runoff going forward is subject to significant uncertainty.
[W]hen the Fed conducts its agency MBS reinvestment purchases, it uses proceeds from paydowns from the prior month, and the actual purchases occur beginning in the middle of the current month. … In addition, by market convention, agency MBS purchases do not settle until up to a month and a half in the future (settlement is the final exchange of the securities and payments). Combining these two features, there can be as much as a three-month lag from when principal is received to when the agency MBS will show up on the Fed’s balance sheet. Finally, to avoid negatively impacting agency MBS market functioning, the Fed may choose to delay settlement of some agency MBS purchases even further through dollar roll transactions (any such operations are reported on the same day).
Board research staff are also weighing in with Bank Deposit Flows to Money Market Funds and ON RRP Usage during Monetary Policy Tightening14 They estimate that relatively little will flow into the ON RRP facility. This is not what I have read that folks in the market had expected.
Using the historical experience from past monetary tightening cycles and the market-expected path of the federal funds rate for the current tightening cycle, we project that the flows from bank deposits to money market funds (MMFs) would be relatively small, at about $600 billion through the end of 2024, or about 3 percent of current bank deposits. Of these potential inflows to MMFs, about $100 billion are projected to flow into the overnight reverse repo (ON RRP) facility, or about 7 percent of MMFs’ recent take-up. Other factors such as the private demand for repo funding and the net supply of Treasury bills are expected to have more substantial effects on MMFs’ take-up at the ON RRP facility than the inflows from bank deposits.
They do a nice sensitivity analysis around their best estimate, and find:
Importantly, there is considerable uncertainty around our projections, given differences between the current tightening cycle and the past. To take this uncertainty into account, we show that under alternative scenarios, bank deposit flows could be larger or MMFs’ portfolio allocation at the ON RRP facility could be higher than our baseline projections. However, we find that the most substantial changes to our baseline estimates of ON RRP take-up would arise from lower-than-projected rates for private repo funding or a lower-than-projected net Treasury bill issuance, rather than from the factors shaping the flows from bank deposits to MMFs.
Liquidity Issues Hit European Electricity Providers
Talk about systemic risk, it’s not just for banks anymore!
Energy Trading Stressed by Margin Calls of $1.5 Trillion15 (Bloomberg)
European energy trading is being strained by margin calls of at least $1.5 trillion, putting pressure on governments to provide more liquidity buffers, according to Norway’s Equinor ASA.
Sweden, Finland Step in to Avert Lehman-Like Situation for Power Companies16 (US News)
Finland is aiming to offer 10 billion euros ($9.95 billion) and Sweden plans to offer 250 billion Swedish crowns ($23.2 billion) in liquidity guarantees.
Uniper may need more German bailout funds, CEO says (Seeking Alpha)
"We got the stabilization package from the government we have agreed with a €7B backstop to be reached the fourth quarter, and it will definitely be earlier. Most likely we will reach that ceiling in September," the CEO said at the Gastech conference in Milan.
UK Sets Up £40 Billion Fund for Energy Traders as Markets Strain17 (Bloomberg)
The UK Treasury and Bank of England launched a £40 billion ($46 billion) fund to provide energy traders liquidity to deal with massive margin calls, joining a list of European states taking dramatic action to prevent the energy crisis becoming a “Lehman” moment.
Increased collateral requirements have been an issue for traders for months but the situation stepped up a gear this week after Russia moved to cut off gas through its crucial Nord Stream pipeline on Friday.
Lagarde Says ECB Can’t Offer Liquidity to Energy Firms (Bloomberg)
European Central Bank President Christine Lagarde ruled out providing short-term financing lines to struggling energy firms -- saying that’s the job of European Union governments.
Glad European governments are more responsive than we were in the US.
Accounting Observations from the PCAOB
The PCAOB issued Observations From the Target Team’s 2021 Inspections18 . They share observations in four areas: Fraud, Interim Reviews of SPACs and De-SPACs, Going Concern, & Cash and Cash Equivalents. The targeted firms did not include financials, but the Fraud and Cash sections are worth quick review by the operational risk folks.
Existential Risks
As if climate change isn’t enough: Avoiding the Great Filter: A Simulation of Important Factors for Human Survival. As a Bayesian, I’ll need to update my priors.
Using a probabilistic mode, we observed the effects of nuclear war, climate change, asteroid impacts, artificial intelligence and pandemics, which are the most harmful disasters in terms of their extent of destruction on the length of human survival. We consider the starting point of the predicted average number of survival years as the present calendar year.
Nuclear war, when sampling from an artificial normal distribution, results in an average human survival time of 60 years into the future starting from the present, before a civilization-ending disaster. While climate change results in an average human survival time of 193 years, the simulation based on impact from asteroids results in an average of 1754 years.
Since the risks from asteroid impacts could be considered in the far future, it can be concluded that nuclear war, climate change, and pandemics are presently the most prominent threats to humanity. Additionally, the danger from superiority of artificial intelligence over humans, although abstract in its sense, is a factor of careful study and could also have wide ranging implications, impeding man's advancements towards becoming a more advanced civilization.
HOW TO SUMMON THE DEVIL, AND WHAT TO DO WHEN HE SHOWS UP19
Those who have only been exposed to looser cinematic depictions of summoning may be shocked to learn the depth, specificity, and deep reverence that goes into the process. Indeed, reading between the lines, The Grimorium Verum details a laborious circuit of craft production and ritual performance to conjure one of the demons.
Poszar, War and Interest Rates
Putin, June 17th speech
Putin, June 17th speech
Poszar, War and Industrial Policy
Putin, June 17th speech
Poszar, War and Industrial Policy
Poszar, War and Interest Rates
Putin, June 17th speech
Putin, June 17th speech
Zobel, The Ample Reserves Framework and Balance Sheet Reduction: Perspective from the Open Market Desk, Federal Reserve Bank of New York
Eisenbach, Phelan, How Can Safe Asset Markets Be Fragile?, Federal Reserve Bank of New York Liberty Street blog
Eisenbach, Phelan, Fragility of Safe Asset Markets
Shiryaevskaya, The “How and When” of the Fed’s Balance Sheet Runoff, Medium
Morgan, Sarver, Tase, and ZlateBank, Deposit Flows to Money Market Funds and ON RRP Usage during Monetary Policy Tightening, Board of Governors of the Federal Reserve System
Energy Trading Stressed by Margin Calls of $1.5 Trillion, Bloomberg
Mukherjee, Lehto, Sweden, Finland Step in to Avert Lehman-Like Situation for Power Companies, US News
Morison, UK Sets Up £40 Billion Fund for Energy Traders as Markets Strain, Bloomberg
Observations From the Target Team’s 2021 Inspections, Public Company Accounting Oversight Board
Halloran, HOW TO SUMMON THE DEVIL, AND WHAT TO DO WHEN HE SHOWS UP, Bloodknife.com
Poszar or Putin is inspired!