How the Fed just bailed out Treasury

The Fed’s new BTFP program could have some interesting consequences

One of my more popular articles argued that the US dollar is not going to die or be replaced anytime soon. My contention is that the dollar is more like Facebook than gold, in that its real value comes from a globe-spanning network effect.

You could have the world’s most splendid currency (Bitcoiners believe it’s already been found) but if you can’t use it to buy Chinese trinkets or Brazilian soy beans, what’s the point?

Treasuries go hat in hand with dollars, and if most of the world is using the dollar there’s going to be ongoing demand to save those dollars in Treasuries. That being said… America’s ill conceived confiscation of Russian reserves is making foreign nations and sovereign wealth funds think twice before they invest in an asset that can be confiscated without due process.

I don’t think foreign nations are going to start dumping their Treasuries tomorrow, far from it, but even if there is a modest 2 or 3% reduction in purchases that would represent hundreds of billions of dollars worth of Treasuries that must find a new home. If the Fed isn’t gobbling up all those tasty bills, notes and bonds with QE, someone else will need to buy them and that’s how we’ve arrived at the topic of today’s article.

Let’s sweeten the deal

There are several provisions in the recent bailout package but the one we’re most concerned with is the Fed’s fancy new Bank Term Funding Program (BTFP). The program will let banks borrow against their bonds at par, which in my opinion is a pretty sweet deal.

For those who slept through their econ 101 class, if you own a bond and interest rates rise the value of your bond goes down. Banks and other institutions are particularly at risk right now because they’ve spent the last ~decade accumulating low yielding bonds when interest rates were at or near zero.

That wouldn’t have been a problem if rates had stayed low forever (the Japanese playbook). However, about a year ago at the annual Fed retreat there was Jay Powell on his third Jäger bomb when a loose Greenspan double dog dared him to take rates to 5%, and then clucked like a chicken until an unconstrained Jay roared, “Oh you’re so on you little chunkmuffin, it’s Jay’s time to shine.”

As soon as he’d unwound his hangover Powell began to deliver onto us the fastest rate hiking cycle in modern history and one of the results is that banks have heaps of these devalued bonds on their books.

Holding devalued bonds is theoretically not a problem because one day they’ll be redeemed at par. However, problems arise if the bank wants to do anything with their portfolio in the interim.

If a bank bought a bond for $1,000 and it’s now worth $700, the bond’s value as collateral has gone down quite a bit. In a free market system this could have some ugly consequences but all concerns have now been alleviated since the Fed has stepped in.

With their BTFP lending program the Fed is saying; G’day mates, we don’t care that your bond is trading at seventy cents on the dollar. Chuck it over Jay’s way and we’ll let you borrow against it at face value.

The BTFP lending program is currently scheduled to go on for a year but you know what they say, there’s nothing more permanent than a temporary government program. I’m just a public university graduate but when I look at this program I’m inclined to believe it will last longer than anticipated.

Theoretically it was going to be “like watching paint dry” to do QT, yet it turns out that pulling liquidity out of the system is a hell of a lot harder than putting it there in the first place.

If banks no longer need to worry about their interest rate risk (or duration risk as you’ve probably heard it called) then all else being equal I would expect these institutions to increase their purchase of Treasuries. Remember that shortfall of foreign buyers for American debt? Well this program could be an excellent way to encourage domestic institutions to pick up the slack.

Here’s Joseph Wang summarizing the situation in a recent interview he did with George Gammon (from the 21:50 minute mark).

It could be a very clever way of creating more demand for Treasury securities. I don’t know if that’s how they think about this, but if you’re issuing tons of debt every year and you’re worried that say a big country in Asia doesn’t want to buy as many Treasuries, a common thing to do is to have your banks buy it.
And how do you encourage banks to buy it? Well you know, sweeten the deal. Hey I’m going to take away your interest rate risk. Buy it, hold it and you’ll be fine.

Joseph goes on to say that he’s not sure whether this program was intentionally designed to have this outcome, but does it even matter? Whatever the intention, the result will likely be good for the government.

Conclusions

When is the last time that you saw a major crisis that resulted in less government intervention? For me nothing much comes to mind. It seems like we’re at a cultural/societal moment where the default response is always more government.

What could potentially end this unfavorable (in my opinion) cycle? Well, the government not being able to fund itself would seriously slam the brakes on this whole trend. But hey, we’ve solved that for hiccup for now. Our glorious leaders have likely found yet another way to kick the can down the road. Get the banks to buy even more Treasuries and we’ll keep the wheels on this train for a little while longer…