QE and Cross Currency Basis Swaps

Today's BIS Quarterly Review includes an informative article titled, Covered interest parity lost: understanding the cross-currency basis, by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko (henceforth BMMS). In particular, the authors argue that the demand for borrowed dollars has increased while balance sheet restrictions have tightened, limiting the ability of firms to take advantage of the the widening in cross-currency basis swap spreads.

I've been making a similar point lately, though with a slightly different emphasis than the authors of this BIS article. So in this post, I'll highlight some of the more interesting aspects of their article, comment on a few areas in which my perspective differs slightly, and consider implications for the market.

Cross-sectional and time series data

BMMS approximate dollar funding gaps in the banking sectors of eight countries, by subtracting stated dollar liabilities from stated dollar assets on the consolidated, global balance sheets of banks headquartered in each country. They then plot these funding gaps against the basis swap spreads in each currency (against USD), for 3Y tenors. The results are shown in their Graph 3, reproduced here.

As predicted, the authors observe a correlation between the size of the funding gap in a market and the size of the 3Y cross currency basis swap spread in that market.

BMMS then compared their estimated funding gap for Japan against the 3Y JPY/USD basis swap spread over time. And, as expected, they observe the expected correlation between the funding gap and the cross currency basis swap over time.

BMMS explanations of these correlations

The authors cite a number of factors thought to be driving these spreads generally:

1. New regulations affecting money market funds in the US have caused a number of prime funds to convert to government funds, eliminating a key source of dollar funding for Japanese banks.
2. Large-scale asset purchases have compressed credit spreads, motivating US corporates to issue in affected currencies, swapping the proceeds into dollars.
3. Insurance companies and pension funds have increased their interest in "strategic hedging".

The QE Perspective

While I don't disagree with these explanations, I tend to emphasize somewhat different aspects -- particularly unintended consequences of quantitative easing.

My sense is that central bank purchases of government bonds in some markets are creating a need for asset replacement on the part of institutional investors and asset managers in these markets, consistent with the portfolio balance channel cited by Bernanke and others since the advent of QE. In some cases, asset managers have been replacing sovereign debt with corporate bonds and even with equities. But another option is for these managers to replace this missing sovereign debt in their domestic market with debt issued by another sovereign in another currency, combined with a cross-currency basis swap, in order to create synthetic sovereign debt denominated in their domestic currency.

In fact, this seems rather natural to me. For example, if I were running a pension fund that sold a 30Y Bund to the ECB, I'd view a 30Y Treasury, swapped into EUR, as a closer replacement for this bond than, say, an equity investment in BMW or Siemens.

The issuance of euro-denominated corporate debt works via a related mechanism. As the ECB creates somewhat of a vacuum in the EUR debt market, issuers like Apple help fill the void by issuing in euros and swapping the proceeds into dollars.

Note that this reverse Yankee issuance is functionally very similar to the mechanism described above for sovereigns. Rather than the asset manager buying a dollar-denominated issue and combining it with a cross-currency swap to create a synthetic euro issue, here the foreign corporate issues in euros and uses a cross-currency swap to bring the proceeds into dollars. In one case the issuer is the US government; in the other, Apple is the issuer. In one case, the asset manager arranges the cross-currency swap; in the other, the issuer does. But in both cases, the issuer receives dollar proceeds and the asset manager has a euro-denominated issue.

BMMS cite a role played by central banks too. But I tend to give greater emphasis to the direct effect of quantitative easing. For example, rather than ascribing the behavior of asset managers to "strategic hedging", I suggest their behavior is a predictable response to the vacuum created by large-scale central bank purchases.

Does the data support the key role I'm ascribing to QE? I believe it does.

The first chart below shows the percentage of JGBs held by the Bank of Japan, along with the 30Y JPY/USD cross-currency basis swap (shown on an inverted axis).

As expected, the 30Y JPY/USD basis swap spread has widened as the Bank of Japan has increased the share of outstanding JGBs on its balance sheet.

The next graph shows the PSPP holdings of the ESCB, along with the 30Y EUR/USD cross-currency basis swap spread, since the start of the PSPP in September of last year.

While these correlations don't constitute formal statistical tests, they are consistent with the notion that central bank purchases are creating shortages in domestic markets that are being filled synthetically via foreign sovereigns combined with cross-currency basis swaps.

Of course, the Fed also has purchased a considerable percentage of the Treasury market via its own large scale asset purchase program. Might these purchases be enough to create a similar phenomenon in the US and move the cross-currency basis swap spreads back toward zero?

In theory, I'd agree that this is a possibility. But in practice, I'd make two points. First, the Fed isn't adding to its holdings currently. And second, the Fed holds a smaller percentage of the Treasury market (16%) than the Bank of Japan holds of the JGB market (34%). But were the Fed to engage in further rounds of QE (perhaps in response to the next recession), the changes in relative holdings would be worth watching.

Implications

BMMS conclude:

"tighter limits on arbitrage make it harder to narrow the basis whenever it opens up as a result of pressures that reflect underlying order imbalances. In particular, even in the absence of bank funding strains like those seen during the GFC, a sufficiently high net demand for currency hedges could result in persistent deviations from CIP [covered interest parity]."

I agree that tighter balance sheet restrictions limit the ability of banks to facilitate the transactions that would narrow these basis swap spreads. In fact, I've argued that these restrictions affect a variety of markets in which banks play a key intermediating role, including the relation between sovereign yields and plan vanilla interest rate swaps.

As the BoJ and the ECB increase their holdings of JGBs and EGBs, I expect asset managers will continue to respond by replacing these holdings with debt issued by other sovereigns, in conjunction with cross-currency basis swaps. And I expect corporates will continue to issue in euros and in yen, swapping the proceeds into dollars.

But the specific parts of the curve involved will depend on relative pricing. For example, the graph below shows yields of Treasuries, Bunds, Gilts, and JGBs, all swapped into dollars. 

There is a modest gain from swapping 30Y Bunds into 30Y Treasuries -- and a more significant gain from swapping 30Y Bunds into 30Y Gilts. As a result, I suspect the EUR/USD 30Y cross currency basis swap will widen further, while the GBP/USD cross-currency basis swap will narrow further, continuing the trend shown in the graph below.

On the other hand, we see that swapping from JGBs to any of the other sovereigns in the 10Y sector is not advantageous. As a result, as seen in the graph below, the JPY/USD cross-currency basis swap in the 10Y sector has been narrowing relative to the EUR/USD cross-currency basis swap in the same sector, and I expect this trend too will continue while swapping from 10Y JGBs is disadvantageous.

Of course, the relative benefits from swapping from one currency to another don't depend solely on the cross-currency basis swaps. They also depend on the relative swap spreads in each of the markets. So predicting changes in cross-currency basis swaps isn't as simple as monitoring the relative yield advantages from swapping.

On the other hand, these cross-currency swapped yields are an important piece of the puzzle, and monitoring them is becoming increasing important as central banks continue bond purchases.

Williams v Summers: Half Full or Half Empty?

SF Federal Reserve President Williams last night delivered an interesting speech with the provocative title, Whither Inflation Targeting? A good portion of his speech echoed comments he made a few weeks ago, in Monetary Policy in a Low R-star World -- namely that the Fed could better fulfill its mandate under a modified monetary regime. But some of his comments pertained to the current policy decision and are worth considering further.

Williams starts by addressing employment, noting "a very strong labor market by any standard." Turning to inflation, he notes, "We’re not quite at our target yet, but the combination of fading transitory factors and a strong economy should help us get back to our 2 percent goal in the next year or two." In light of these views, Williams addresses the implication for rate policy, concluding, "...it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later."

Contrast this with the views Larry Summers included in his comments yesterday. On employment, Summers noted, "Private sector GDP growth for the last year has averaged 1.3 percent a level that has since the 1960s always presaged recession." He continued, "Total work hours have over the last 6 months grown at nearly their slowest rate since early 2010." (I addressed this point in Is the US Near Maximum Employment?) As for inflation, Summers observed, "both market and survey measures of inflation expectations continue to decline."

What accounts for the discrepancy between the views of Williams and Summers? Is this simply a case of the glass being half full or half empty depending on one's perspective?

I believe the divergence in views can be explained in part by the divergence in their motives. As a current FOMC member, Williams shares Yellen's concern that the FOMC may not have sufficient room to reduce the IOER in response to the next recession, in which case the Fed would be subject to political pressure to expand the policy toolkit to include less traditional tools, such as negative interest rates and an expansion of assets available for purchase as part of the Fed's large scale asset purchase program. As we've discussed, various FOMC members appear uncomfortable with such tools -- hence the debate over the existing policy toolkit.

In contrast, I suspect Summers' best prospect for replacing Yellen as Fed Chair when her term expires in February 2018 is for the Fed to come under political pressure , without which there would be political pressure for Yellen's reappointment. More specifically, the Democratic party has moved considerably to the left since Summers was Treasury Secretary, and Summers needs to overcome critics such as Elizabeth Warren, who openly supported Yellen over Summers when the job was last available in 2013. By aggressively advocating a more dovish policy than Yellen, Summers may be positioning himself as an acceptable alternative to Yellen when the job is next available.

To be fair to both men, I suspect both genuinely believe in their respective positions. But people have a tendency to choose their beliefs to suit their interests, and I suspect Williams and Summers are as susceptible to this influence as are the rest of us.

Implications

The current incumbents on the FOMC have an interest in raising the policy rate ahead of the next recession to a level that would allow them to mount a sufficient response to the next recession with a combination of lower but positive IOER rates, forward guidance, and perhaps a modest increase in quantitative easing. As a result, I believe they'll make every effort to increase the IOER whenever the data permits -- and this includes financial market data (ie, asset prices). While I suspect the won't be able to hike as much as implied by the latest dot plot (or Yellens' fan chart), I imagine they will be able to hike more quickly than suggested by current market pricing -- particularly with the Oct16 Fed Funds futures contract currently at 99.565.

But in addition to the usual schism between hawks and doves, we're now seeing an increasingly active debate regarding the strategies and tactics with which the Fed pursues its mandate. On one side we have Yellen and David Reifschneider, deputy director of the division of research and statistics at the Board of Governors, who believe the Fed can continue targeting an inflation rate of 2% with its available tools. On the other hand, we have Williams, Olivier Blanchard, and others who believe the Fed should adopt a new strategy (such as a 4% inflation target or a switch to targeting nominal GDP) -- or at a minimum believe the Fed requires new tools, such as negative interest rates, in order to successfully pursue its objectives.

The problem for the market is the uncertainty that this open debate engenders. Williams argues that now is the the time to reconsider these strategies and tactics, given the current performance of the economy. But the market is facing considerable uncertainties already, including a change of administration in the US, Brexit, a constitutional referendum in Italy this November, elections in Germany and France next year, and a review of monetary policy In Japan.

As seen in the graph below, volatility in the rates and equity markets is already low by historical standards. It's difficult to see volatility remaining this low given the events on the calendar -- let alone a reappraisal and reimplementation of monetary policy strategies and tools at the Fed. My sense is that the growing debate over monetary policy at the Fed -- and elsewhere -- will only add to financial market volatility in coming quarters.

Summers on the Fed's Toolbox

Larry Summers posted an excellent blog entry today, titled The Fed’s complacency about its current toolbox is unwarranted. The central message is clear from this title, but it's well worth considering his arguments in some detail, as they help clarify some of the market implications of upcoming policy decisions.

The crux of Summers' argument is a refutation of the most influential paper at Jackson Hole that wasn't on the agenda -- David Reifschneider's aptly titled, Gauging the Ability of the FOMC to Respond to Future Recessions, upon which Yellen drew heavily in her Jackson Hole speech, The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future. In general, Summers takes strong issue with Reifschneider's conclusion (shared by Yellen) that the Fed has ample tools with which to address the next recession. More specifically, he offers five specific critiques worth considering.

Summers' five critiques of Reifschneider's analysis

Summers' first critique is a response to Reifschneider's reliance on the Fed's FRB/US model rather than on empirical observation of the actual economy. In particular Summers advises:

"distrust conclusions reached primarily on the basis of model results.  Models are estimated or parameterized on the basis of historical data.  They can be expected to go wrong whenever the world changes in important ways."

I've made this point repeatedly myself and believe Summers' concern is appropriate in this case.

Summers continues by questioning Reifschneider's assumption that the IOER will increase to 3% before the onset of the next recession. Again, I've made similar arguments, in particular that market-based measures of inflation expectations are unlikely to increase toward their recent averages before the start of the next recession.

Summers' third critique is that Reifschneider is too dismissive of his finding that Fed policy will not fare as well given the zero lower bound under the assumption that the Fed will adopt an optimal control policy rather than a Taylor-style rule. While this is an interesting point, it's quite technical, and the Fed hasn't made any clear announcements that it's following an optimal control policy.

I have considerable sympathy with Summers' fourth critique:

"I suspect that prevailing views at the Fed about the efficacy of QE and forward guidance substantially exaggerate their likely impact. I don’t think the Fed has taken on board the lesson of the three year period since QE ended.  If longer term rates had risen after QE and forward guidance ended, this would surely have been taken as further evidence of their potency.  It follows that the fact that term spreads have fallen substantially since the end of unconventional policy ... should lead to more skepticism about their efficacy."

Again, I've made this point repeatedly, including in a recent blog post, Yellen at Jackson Hole. But Summers makes an additional, insightful observation about the net effects of QE, increased issuance by the Treasury, and the skewing of issuance toward longer maturities. In particular, Summers refers to work he published as a Brookings paper with Robin Greenwood, George Gund, Samuel Hanson, and Joshua Rudolph: Government Debt Management at the Zero Lower Bound, in which the authors report, "when measured in 10-year equivalents, the combined effect of maturity extension and the increased debt stock far outpace QE." Panel A of Figure 1 in that paper illustrates the point clearly.

In his blog post, Summers explains the implications succinctly.

"On the issue of QE Greenwood, Hanson, Rudolph and I show that the contrary to much of the discussion during the QE period the stock of longer term public debt that the market has to absorb went up not down.  The amount of longer term Federal debt that markets have to absorb is now as high as it has been in the last 50 years and long rates are extraordinarily low, as are term spreads.  This calls into question the idea that price pressures caused by changing relative supplies are likely to have large impacts at times like the present when markets are functioning."

Fifth, Summers questions Reifschneider's assumption regarding the potential decline in long-term rates with the onset of the next recession. In fact, it's worth quoting Summers at some length to appreciate the strength of his concern on this point.

"Reifschneider in his very careful paper shows that with a big recession rates would likely approach -6 percent, or even -9 percent, but for the zero lower bound.  I find the idea that forward guidance and QE could do the anything like the work of 600, let alone 900, basis points of rate cutting close to absurd.  Both QE and forward guidance are said to work by bringing down longer term rates.  The 10 year Treasury is now in the 1.6 percent range.  If the Fed returned Fed Funds to its lower bound level in the context of a recession, I would expect to see 10 year rates fall substantially perhaps to 1 percent without any QE or forward guidance.   How much room is there for unconventional policy to bring them down further?  Reifschneider ‘s assumption that there will be room for unconventional policy to bring down 10 year rates by hundreds of basis points seems to me very doubtful."

Again, I find Summers' argument persuasive on this count.

Market implications

So what are the market implications of Summers' critique?

First, I suspect there's quite a reasonable chance that Hillary Clinton will win the upcoming election and that she'll appoint Summers to one of the open seats on the Federal Reserve Board of Governors. I also believe there's a good chance she subsequently would appoint Summers as Chairman when Yellen's term expires in February, 2018. And based on his writings in recent years, I believe he would be more creative and provide a greater degree of effective stimulus than his predecessor. In fact, I suspect the Fed's toolbox would be expanded even further under Summers -- but we can look forward to hearing more about his thoughts on that subject in Summers' next blog post. In any case, I believe market-based measures of inflation compensation would be at least 50 bp higher under Summers than they are currently. In fact, this may be a conservative estimate, as these measures are currently well below the averages seen in previous years.

Second, as I mentioned in my Yellen at Jackson Hole post, "if the Fed is willing only to use relatively conservative policy tools during the next downturn, we might expect the dollar to strengthen, ceteris paribus, at least relative to central banks that are willing to take relatively more activist policy measures." Summers' critique appears entirely consistent with that view.

Third, I believe many FOMC members are sympathetic to Summers' general concern, even if they don't agree with all his specific points. In particular, I've argued in Is the US Near Maximum Employment? that the FOMC is aware of the importance of raising the policy rate sufficiently ahead of the next recession. More specifically, speaking of FOMC members, I concluded:

"...for now, I suspect they'll increase the policy rate at a moderate pace, but with sufficient deliberation to avoid getting caught by the next recession with the rate still close to zero. More specifically, they may not manage to raise the IOER quickly enough to fulfill the expectations in the last dot plot -- or in Yellen's Jackson Hole fan chart. But I wouldn't be surprised if they managed to raise the policy rate somewhat more than is currently priced into the market."

Of course, this prediction runs counter to the advice of Summers, who would prefer a more stimulative monetary policy in conjunction with renewed fiscal stimulus. But while Summers' perspective is normative, mine is positive -- and it would appear we have a few more years yet before Summers assumes the Chair of the FOMC.

A stealth helicopter drop?

As growth in developed markets has remained lackluster, increasing attention has focused on monetary financing, with high-profile proponents including Willem Buiter and Aidar Turner.

Apart from the economic effectiveness of a helicopter drop, an important issue is whether the means for accomplishing the monetary financing are permissible in various jurisdictions. For example, writing in his Brookings blog, Bernanke offers that a People's QE "would certainly be illegal in most or all jurisdictions." And it's well-established that monetary financing is prohibited by EMU members states by Article 123 of the Treaty for the Functioning of the European Union. (See my earlier blog entry of 13-Nov-11 for more on this point.)

But in this respect, it's useful to consider the effect of a permanent increase in the money supply used to finance purchases of sovereign debt. From a 2013 interview, Michael Woodford addresses the relation between the helicopter drop and permanent QE:

It is possible for exactly the same equilibrium to be supported by a policy of either sort. On the one hand (traditional quantitative easing), one might increase the monetary base through a purchase of government bonds by the central bank, and commit to maintain the monetary base permanently at the higher level. On the other (‘helicopter money’), one might print new base money to finance a transfer to the public, and commit never to retire the newly issued money. Suppose that in either case, the path of government purchases is the same, and taxes are raised to the extent necessary to finance those purchases and to service the outstanding government debt, after transfers of the central bank’s seignorage income to the Treasury. Assuming the same size of permanent increase in the monetary base, the perfect foresight equilibrium is the same in both cases. Note that the fiscal consequences of the two policies are actually the same. Under the quantitative easing policy, the central bank acquires assets, but it rebates the interest paid on the government bonds back to the Treasury, so that the budgets of all parties are the same as if no government bonds were actually acquired, as is explicitly the case with helicopter money.

Woodford goes on to explain the critical role of public expectations:

The effects could be different if, in practice, the consequences for future policy were not perceived the same way by the public. Under quantitative easing, people might not expect the increase in the monetary base to be permanent – after all, it was not in the case of Japan’s quantitative easing policy in the period 2001-2006, and US and UK policymakers insist that the expansions of those central banks’ balance sheets won’t be permanent, either – and in that case, there is no reason for demand to increase. Perhaps in the case of helicopter money, it would be more likely that the intention to maintain a permanently higher monetary base would be believed. Also, in this case, the fact people get an immediate transfer should lead them to believe that they can afford to spend more, even if they don’t think about or understand the consequences of the change for future conditions, which is not true in the case of quantitative easing.

If the key criterion determining observational equivalence between helicopter money and quantitative easing is the perceived permanence of the latter, then the stage appears set for monetary financing to become a fait accompli merely by affecting public perceptions. And this could happen in one of two ways.

First, in permitted jurisdictions, central bankers could simply announce that principal and interest payments on sovereign holdings will be rolled over continually. In that case, taxpayers would perceive no budget constraint associated with the additional spending financed with printed money, and the proposition of Ricardian equivalence under rational expectations would no longer hold.

But there is a second way in which these public perceptions might change -- namely, taxpayers might simply adapt their expectations as central bankers reinforce the precedent of rolling over these bond purchases year after year. Already, the eventual reduction of the central bank balance sheet appears no longer to be on the agenda in many jurisdictions. Fiscal authorities, market participants, and financial journalists appear to have become inured to the prospect of elevated central bank balance sheets persisting indefinitely. And now that the Fed pays interest on reserves, it has severed the link between the supply of money market funds, the demand for such funds, and the price of these funds. The FOMC now can run a balance sheet policy independent of its rate policy, as has been the case with other central banks, such as the Bank of England and the ECB.

My sense is that it's rather unlikely that western central bankers will announce that their purchases of sovereign debt should be considered permanent, given the sensitivities involved. For example, in a speech earlier today before the German Institute for Economic Research in Berlin, French Central Bank Governor François Villeroy de Galhau noted [emphasis his]:

I think that so-called “helicopter money” would bring more harm than good: we do not need it and it is not on the table.

However, it wouldn't surprise me if current large-scale, sovereign debt purchases remained on the balance sheets of the Federal Reserve, the Bank of England, the ECB, the Bank of Japan, the Riksbank, etc for a sufficiently long period for taxpayer expectations to adjust so as to consider the status quo as the new norm. In fact, it wouldn't surprise me if central bankers responded to the next downturn in the economic cycle by purchasing still more sovereign debt, in the name of fulfilling existing mandates.

The growing interest in helicopter money may become moot at some point, if central bank watchers come to view continual reinvestment of principal and interest as a permanent feature, In that case, there will be no need to fire up the metaphorical helicopters; central bankers would have achieved via stealth the monetary financing that otherwise would have involved a fractious debate -- and very likely a violation of legal protections in various jurisdictions.