The Fed's worst nightmare looms: Other factors getting closer to a turnaround

W3.Hitchhiker

22-10-15 10:05

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Original author: David, W3.Hitchhiker

Since September, risks in geopolitics and financial markets have unfolded sequentially, and global markets are led by the Fed’s super-hawkish policies Descending into increasingly unknown territory. By analyzing the latest moves in three local markets, we may be getting closer to the Fed's turn.

1. U.S. bond liquidity The tension has reached the level of March 2020

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In early October, the liquidity problem in the U.S. Treasury market entered a new stage: Bloomberg's indicators measuring U.S. bond liquidity showed that the market Liquidity tightness has reached the level of March 2020.

In March 2020, when the US Treasury market collapsed due to panic selling, the Federal Reserve stepped in to buy bonds as a buyer of last resort. And the current level of liquidity may point to the possibility that the Fed is ready to step in to buy bonds at any time - even if the Fed is currently engaged in so-called quantitative tightening.

Duffy, Deputy Governor of the Federal Reserve Bank of New York, said: "The U.S. Treasury market is the most important securities market in the world and the lifeblood of our national economic security. You can't just say 'we want it to be better,' you have to act to make it better."

U.S. Treasury Secretary Oct. 11 No. issued a document saying that it did not see any need to worry about the financial market. A day later, he changed his tune, saying that "the lack of liquidity in the national bond market is worrying."

2. The Federal Reserve's income began to turn negative

After many hikes , the Fed's interest payments have exceeded the interest income generated by its bond portfolio held through QE.

In the past ten years, the revenue of the Federal Reserve has basically been around 100 billion US dollars, which has been directly transferred to the US Treasury Department. Some estimates say that the shortfall due to interest rate hikes this year may be as high as 300 billion U.S. dollars (the U.S. military expenditure last year was about 800 billion U.S. dollars). At the same time, due to QT, bond prices have plummeted, causing the Fed to sell bonds at a price that may have to be much lower than the purchase price, which becomes an unrealized loss (non-cash item).

The Federal Reserve will not go bankrupt. In the face of huge holes, either it can completely ignore it; or it can restart printing money.

In short, higher interest rates will only increase the cash burn everywhere within the Fed and Treasury. They will quickly realize that they are completely trapped. They cannot tame inflation without effectively bankrupting themselves. Of course central banks don't go bankrupt -- instead, they may turn in a storm of rate hikes and inflation.

3. "Lehman Moment 2.0" is getting closer

Recently, the market has been turbulent, and Credit Suisse and British pension funds have been in danger one after another.

In the 2008 financial crisis, the transmission of inter-agency risks is similar to the figure below: In the 2008 financial crisis, the transmission of inter-agency risks is similar to the figure below :

So after the 2008 financial crisis, is it possible for a new banking crisis to happen again?

Before National Day, several news outlets questioned whether Credit Suisse could herald another "Lehman moment". The "Lehman moment" refers to the collapse of Lehman Brothers, the 158-year-old former Wall Street investment bank, on September 15, 2008, during Wall Street's widening financial crisis. Lehman Brothers was the only major Wall Street bank the Federal Reserve allowed to fail.

according to financial At the time of Lehman's collapse, it had more than 900,000 derivatives contracts open and used Wall Street's largest banks as counterparties to many of those trades, according to Crisis Inquiry Commission documents. Lehman and JPMorgan have more than 53,000 derivatives contracts; Morgan Stanley more than 40,000; Citigroup more than 24,000; Bank of America more than 23,000; Goldman Sachs nearly 19,000, according to the data.

According to the conclusive report on crisis analysis issued by the agency, the financial crisis in 2008 was mainly due to the following reasons:

“Over-the-counter derivatives contributed to the crisis in three important ways. First, one derivative—credit default swaps (CDS)—propelled the growth of mortgage securitization .CDSs are sold to investors to protect against default or decline in value of mortgage-related securities backed by risky loans.”

“Secondly, CDSs are critical to synthetic CDOs. Creation was critical. These synthetic CDOs simply bet on the performance of real mortgage-related securities. By allowing multiple bets on the same security, they amplified losses from the housing bust and helped spread them across the financial system."

"Finally, when the housing bubble burst and crises ensued, derivatives were at the center of the storm. AIG was not asked to set aside capital Reserves served as a buffer for its sale protection, but were bailed out when it could not meet its obligations. Concerned that AIG's collapse would trigger cascading losses across the global financial system, the government eventually committed more than $180 billion. In addition, systemically important The existence of millions of derivatives contracts of various types between financial institutions - invisible and unknown in this unregulated market - increases uncertainty and fuels panic, helping In order to get the government to provide assistance to these institutions."

15 years after the crisis, do we have similar financial system risks?

On September 29, OFR (OFFICE OF FINANCIAL RESEARCH), a subsidiary of the Federal Reserve, analyzed who the bank chooses as the counterparty in the over-the-counter (OTC) derivatives market working paper, the authors found that banks are more likely to select non-bank counterparties that are already closely connected with and exposed to other banks' higher risk, which leads to connections to denser networks. Furthermore, instead of hedging these risks, banks increase their exposure by selling rather than buying CDS with these counterparties. Finally, the authors find that common counterparty exposures remain associated with systemic risk measures despite increased regulation following the 2008 financial crisis.

To put it simply, once a systemically important bank fails, the financial system will still have a systemic chain reaction like in 2008.

So, does the Fed need to turn like the Bank of Japan and the Bank of England?

We will wait and see.