Moral Hazard Pinnacle 

Doug Nolan


German 10-year bund yields dropped 10 bps this week to negative 0.62%, the low since March. French yields fell eight bps to negative 0.35%, only four bps from March panic lows. Italian and Greek yields ended the week at record lows 0.65% and 0.78%. Spanish yields closed Friday at a record low 0.12% and Portuguese yields at an all-time low 0.11%. European bond prices have an unmistakable correlation to European COVID infections.

European new daily COVID cases have spiked to 120,000, about triple the level from a month earlier. 

Infections in France have spiked to a daily record 30,000, with Paris and other cities now under restrictions. Cases have spiked in Spain, the Netherlands, Italy, Germany, Belgium, Greece, the UK and elsewhere. UK Prime Minister Boris Johnson has faced intense backlash for imposing regional “circuit breakers” with potential lockdowns. A Friday Bloomberg headline: “Europe is Losing Fight to Stay Open on Record Virus Surge.” From CNBC: “Europe’s ICU beds are nearing capacity in some areas, WHO says.”

Here in the U.S., the seven-day average for new daily cases is nearing 65,000, up 25% in just two weeks. 

In a troubling development, new infections are increasingly disbursed across the country with rural areas leading the rise. On Thursday, 39 states were reporting average new daily cases at least 5% above last week’s level. The Worldometer's 24-hour tally had Friday global infections at a record 412,000, with the U.S. surpassing 71,000.

From the NYT: “As the coronavirus caseload in the United States soars past eight million, epidemiologists warn that nearly half of the states are seeing surges unlike anything they experienced earlier in the pandemic… Uncontrolled outbreaks in the Midwest and Mountain West are driving the surge... Some of the states with the most extreme growth had relatively few cases until recently, and rural hospitals have been strained. Per capita, North Dakota and South Dakota are adding more new cases than any states have since the start of the pandemic. Wisconsin… has seven of the 10 metropolitan areas in the United States with the highest rates of recent cases. ‘What’s happening in the Upper Midwest is just a harbinger of things to come in the rest of the country,’ said Michael Osterholm, an infectious-diseases expert at the University of Minnesota.”

We’re all sick and tired of the pandemic. If the virus had awareness, it would surely be reveling in its success at wearing down opponents. Besides, we’re in the throes of an election ostensibly as historic as COVID-19. And, heck, with a manic marketplace - and stocks near all-time highs - how poor could prospects be? 

It all makes it so easy to forget about March. Governments have learned their lesson: There will be no more general lockdowns. And we are to believe central bankers have learned lessons as well.

The Fed’s Vice Chairman for Supervision – “The Federal Reserve’s point man on financial regulation” – raised some eyebrows Wednesday. At an event sponsored by the Institute of International Finance, Randal Quarles offered an admission: “It may be that there is a simple macro fact that the Treasury market, being so much larger than it was even a few years ago, much larger than it was a decade ago, and now really much larger than it was even a few years ago, that the sheer volume there may have outpaced the ability of the private-market infrastructure to kind of support stress of any sort there. …Will there be some indefinite need for the Fed to provide — not as a way of supporting the issuance of Treasuries, but as a way of supporting a functioning market in Treasuries — to participate as a purchaser for some period of time.”

Here are the numbers: 

The fiscal year ended in September with the federal deficit reaching $3.1 TN, or 15% of GDP. 

Outstanding Treasury Securities jumped $2.852 TN during the second quarter to $22.371 TN and were up $4.556 TN, or 25.6%, over the past year. 

After ending 2007 at about $6.0 TN, outstanding Treasury Securities increased $16.3 TN, or 270%. 

Treasuries ended June at 115% of GDP. This was up from 69% at the end of 2010 and 44% to conclude the nineties.

Mr. Quarles was simply stating what markets already knew. 

“You break it, you own it.” 

For too long, the Fed has accommodated unbridled Treasury issuance. And especially with the Powell Fed openly calling for additional massive fiscal stimulus, it’s difficult today to see the Treasury market ever operating adequately without resolute Fed support. 

Call it what it is: The ballooning Treasury market is “too big to fail” – right along with markets for equities and corporate debt. 

The ETF complex has become “too big to fail” – a fate money market funds and the “repo” market succumbed to years ago. 

First illuminated as “too big to fail” during the 1998 Russia/LTCM collapse, derivatives markets have become too big for even middling instability. 

March’s financial meltdown confirmed what I already knew. The Fed’s response to the “great financial crisis” has been an abject failure. An even somewhat reasonably sound system would not have required a $3 TN bailout – three times the size of 2008’s QE operation. 

The strategy of ensuring the banking system remains well capitalized – while letting market-based finance run wild – may have plausible theoretical underpinnings. Yet it wantonly disregards the core shortcomings of contemporary finance. The Fed’s post-2008 crisis assessment essentially came to a conclusion: had bank loan officers only lent responsibly, then risk intermediation, speculation and leverage would not have evolved into systemic issues. In reality, Bubbles in risk intermediation and leveraged speculation were the cart pulling the horse – the force spurring the increasingly reckless lending boom. 

I appreciate vice chair Quarles’ Wednesday speech, “What Happened? What Have We Learned From It? Lessons from COVID-19 Stress on the Financial System.” 

While his Treasury market comment garnered media interest, he provided insightful analysis outlining the systemic nature of March’s market dislocation. 

Moreover, it supports my thesis that the entire system (at home and abroad) has inflated into one colossal “too big to fail” quagmire. 

What the Fed today views as policies supporting financial stability are in truth measures sustaining historic Bubble excess. 

From Quarles: 

“Some of the most severe strains emerged in short-term funding markets and among institutions engaged in liquidity transformation… 

First, we saw a pullback from commercial paper, or CP, markets… At the same time, some prime and tax-exempt money market funds experienced large redemptions, forcing these funds to sell assets. 

In addition, we saw large outflows at corporate bond funds and exchange traded funds. 

Corporate bond funds promise daily liquidity, but the underlying assets often take a longer time to sell. 

This creates conditions that can lead to runs on these funds in times of stress. Indeed, each of these three developments - the pullback from CP and the elevated redemptions at prime money funds and at corporate bond funds-can be viewed as a kind of run by investors. A run occurs when investors concerned about potential losses clamber to withdraw funds or sell their positions before other investors do.”

“A fourth area of strain was in the Treasury market-one of the largest and deepest financial markets in the world. Treasury securities play a central role in short-term funding markets, such as the repo market… Significant amounts of Treasuries are held by institutions that use short-term funding, like broker-dealers and money market funds. 

And, the structure of the Treasury market has evolved substantially in recent years, with the growth of high-speed and algorithmic trading, and a growing share of liquidity provided by new entrants alongside established broker-dealers… Treasury market conditions deteriorated rapidly in the second week of March… Foreign official and private investors, certain hedge funds, and other levered investors were among the big sellers.”

“First, in March, many businesses-unable to satisfy their large cash demand through CP or corporate bond issuance… drew down on their existing credit lines with banks in order to raise cash. As a result, commercial and industrial (C&I) loans in the banking system increased by nearly $480 billion in March-by far the largest monthly increase ever.”

“While the continued ability of banks to lend to creditworthy borrowers has been good news, a lot of credit in the United States is provided by nonbank financial institutions and markets. Indeed, almost two-thirds of business and household debt in the United States is held by nonbanks…”

“In light of these unusual and exigent circumstances, the Federal Reserve took a series of emergency actions to support liquidity in markets and the flow of credit to households, businesses, and communities… Interestingly, in many cases our facilities had their effect less by actually providing liquidity or credit, than by providing a backstop. 

The ‘announcement effect’ of the Fed's willingness to step in returned confidence to market participants and function to markets, without the facilities themselves seeing large amounts of use.”

“Looking back at these events since the COVID event, what have we learned about the U.S. financial system? One lesson is that several short-term funding markets proved fragile and needed support -- the commercial paper market and prime and tax-exempt money market funds, as key examples. The runs on prime money funds and commercial paper were particularly disappointing, since in many ways they resembled runs that we saw in these markets during the GFC.”

“A second lesson we learned last spring is that the Treasury market is not immune to the problems of short-term and dollar funding markets… In addition, we have to ask: What can be done to improve Treasury market functioning over the longer term so that this market can withstand a large shock to demand or supply? I will simply raise that question, but not attempt to answer it here.”

“Almost all of these measures were targeted towards financial markets, nonbank financial institutions, and the real economy. Moreover, the unprecedented and in many ways unimaginable nature of the shock posed by the COVID event made it appropriate to take these steps when we did, to backstop the functioning of markets essential to the financial system. 

Their creation was an unmistakable signal to market participants of the capability and willingness of the Fed to restore market functioning, and the fact that this functioning was restored so quickly, with relatively little borrowing, shows this message was received, and believed. The system worked.”

“Vulnerabilities associated with short-term funding have always been at the heart of financial crises and central banks' efforts to promote financial stability. Such vulnerabilities led to Walter Bagehot's 19th century dictum that central banks need to stand ready to lend freely against good collateral during periods of financial strain.”

Noland: Let there be no doubt, Walter Bagehot would be absolutely aghast at the current state of central banking. From the New York Fed’s website (excerpted from a 2013 speech by Thomas C. Baxter): 

“Bagehot’s central theme was about liquidity, and how the central bank must inject it during times of financial panic… Bagehot urges the central bank to lend freely into a panic, and to do so ‘at a very high rate of interest.’ 

He explains that the reason to charge a penalty rate is to use price as a self-limiting mechanism. In Bagehot’s words, a penalty rate mitigates moral hazard and ‘will prevent the greatest number of applications by persons who do not require [a loan from the central bank].’ 

Bagehot also urged another core principle for central bank liquidity. He believed that central bank lending should be secured by good collateral.”

The “penalty rate” issue is key to mitigating moral hazard. 

Yet markets knew funding rates would be slashed to zero, while the Fed would bypass “lending” and simply inject massive liquidity directly into faltering markets. And from the March experience, markets now fully comprehend that “whatever it takes” includes Trillions of free “money.” Instead of lending against good collateral, the Fed will now aggressively purchase Treasuries, MBS, corporate bonds and corporate ETFs – backstopping market liquidity and prices. 

And from the Fed’s September 2019 policy pivot, markets appreciate any incipient risk of funding crisis would see the Fed administer aggressive monetary stimulus. Bagehot would have never imagined – let alone condoned - such a policy course. Fed policy has reached the Pinnacle for Promoting Moral Hazard. 

One of Quarles’ “lessons” is so fundamental that it’s deserving of further discussion:

 “Several short-term funding markets proved fragile and needed support.” 

“Vulnerabilities associated with short-term funding have always been at the heart of financial crises and central banks' efforts to promote financial stability.” 

My retort: 

Markets in perceived “money” and money-like instruments are invariably at the heart of financial panics. 

That’s where risk intermediation tends to be the most impactful. Indeed, markets operating under a prevailing perception of liquidity and safety (store of nominal value) are inherently susceptible to an abrupt change of perceptions and resulting “run.”

 “This secure ‘repo’ money market instrument backed by Treasury collateral is absolutely safe and liquid.’ “Holy crap, my ‘repo’ with Lehman Brothers is in major jeopardy and I gotta get out of it (and others similar)!”

Pondering the momentous ramifications of the Bernanke doctrine, over a decade ago I warned of an unfolding “global government finance Bubble.” I introduced the concept “moneyness of risk assets.” 

On the one hand, this Bubble has gone to the very foundation of “money” with the egregious expansion of central bank credit and sovereign debt. 

Moreover, central bank stimulus, market backstops, and massive fiscal spending have worked to confer “money-like” attributes upon an ever-broadening array of risk assets. In particular, Wall Street alchemy (risk intermediation) has come to include the transformation of risky stocks and corporate debt into perceived safe and liquid ETF shares. 

Moreover, Fed measures continue to promote the ever-enlarging derivatives universe that operates on the specious premise of liquid and continuous markets.

It's as if policymakers go out of their way not to learn lessons. 

Mr. Quarles outlines key factors in a crisis that nearly spun out of control. He pinpoints areas of fragility, yet his speech is bereft of prescriptions or solutions. This financial system is what it is. “The system worked,” he said. Three Trillion worked to further inflate history’s greatest Bubble. 

September Chinese Credit was out this week. Aggregate Financing, China’s metric for system Credit growth, expanded $517 billion (3,480 renminbi) during the month to a record $41.6 TN. This was about 10% ahead of forecasts, and the strongest growth since March’s $770 billion. 

August and September combined for a snappy $1.05 TN two-month expansion. The $4.402 TN y-t-d growth was 44% and 64% ahead of comparable 2019 and 2018. At 13.5%, year-over-year growth in Aggregate Financing was the strongest since 2017 – a notable feat in the face of economic stagnation.

Total Bank Loans rose $281 billion in September, up from August’s $189 billion and about 10% ahead of forecasts. Year-to-date growth of $2.409 TN (13% annualized) is running 19.3% ahead of comparable 2019 growth. 

Consumer Loans jumped $143 billion in September. Year-to-date growth of $909 billion is 7.7% ahead of comparable 2019. Consumer Loans were up 14.7% y-o-y, 33% over two years, 57% over three, and 135% over five years. 

Corporate Loans rose $140 billion, up from August’s $86 billion and the strongest expansion since April. 

At $1.569 TN, year-to-date growth in Corporate Loans is running 29% ahead of comparable 2019 and 49% ahead of comparable 2018. 

Government Bonds increased $150 billion during September, down from August $205 billion but up significantly from the year ago $56 billion. Year-to-date growth of $1.0 TN was 69% ahead of comparable 2019. Government Bonds expanded 20% over the past year to $6.6 TN. 

China M2 “money” supply surged $405 billion during September, the strongest expansion since June. 

This put year-to-date growth at $2.639 TN, or 18% annualized, to a record $32.156 TN. 

M2 inflated $3.148 TN over the past year (10.9%). 


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