Currency of Mordor

More than a year ago the Fed had its first rate hike in more than a decade. The event will definitely be remembered as a milestone, however, it is yet hard to tell if it will mark the start of a firm recovery or something worse. Just remember the example of ’36; it was premature then, and given the still negative output gap, underemployment, and demographic changes this might be proved to be wrong too.

The monetary tightening started a bit before December of 2015 though. Prior to the historical hike, the Securities Exchange Commission (SEC) announced its planned reform regarding the operation of money market mutual funds, the USD 2.7 trillion sector, which is responsible for both internal and external interbank lending. According to the new regulations, money market mutual funds investing in non-government issued securities must change to floating NAV accounting (making it a bit more volatile to investors), and can use liquidity fees and redemption gates to prevent fund-runs.

The legal changes came into effect last October, however, markets always price in advance. Exactly a year before the implementation of the reform, preparing for tightening and for the reform, investors headed to the exit, and started to stockpile funds with T-bills. This raised borrowing costs on the interbank market (USD Libor), made currency swaps (Eurodollar, yen) costly, and widened the TED spread, sending small, but significant shockwaves through the markets. If you were preparing for the rate hike with floating instruments linked to Libor you could beat the market for 14 month now.

But why did Libor rates rise? If I buy the T-bill from an other investor know he will have to hold the liquidity, or buy something else, in which case his new partner will hold the money. It cannot disappear from the system this way.

Similarly to the One Ring in Tolkein’s epic tale, modern currencies can only be destroyed were they were born. In the depth of Mount Doom, in this case also known as the Fed’s vaults (or accounts, to be more precise). Given the role of dollar in international finance, I believe it is not inappropriate to say that this little change made many markets’ life harder, especially when the dollar was already increasing financing costs due to its appreciation.

One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them…

As this little story foreshadowed it, if you are interested in the where the money went you have to dig up the Fed’s balance sheet. In this period, when Libor started rising, and money flew from prime money funds, you will find two factors behind the tightening of liquidity. Firstly, banks entered into reverse repo agreements, obtaining government bonds from the Fed’s stock. Secondly, the government account drained bank liquidity (high powered money). Although, the latter doesn’t necessarily imply that the banks were given bonds in exchange, the effect is nonetheless the same. Interbank liquidity dries up.

Liquidity quicksand

First of all lets make something clear about zero lower bounds and costs of holding liquidity, and money in general. Money, whatever form it might take, is a nominal financial asset, just as a bond, perpetuity, or T-bill. It just happens to be a zero coupon consol.

Hence, the zero-lower-bound  allpies for nominal interest rates, where at negative rates the non-financial sector can still choose the instrument with zero coupon. Actually in today’s financial world it’s not true either, since you can not use cash for all your transactions. Also there is a risk of losing the money, or the cost of keeping it safe, the “zero-lower-bound” is rather somewhere in the negative territory, I have seen various estimates, going from -2 to -6 percent.

According to classical economic theory, as real interests rates drop you hold more liquid money, as the opportunity cost is lower. Case closed.

I would disagree. The real cost of holding liquidity also depends on its return compared to alternative investments, nominal or real, inflation affects both in the same way. Liquidity traps doesn’t occur, cause real returns are near zero. They occur, cause the real return of holding money is a.) close to its alternatives b.) relatively high. By the latter I mean, that during normal times when inflation is positive you have a negative real return with this zero coupon, while at zero inflation holding money has no cost in real terms. That said lets consider the ways we can get out of such economic malaise.

Why can it be a quicksand?

In my view the best proxies as alternatives to holding cash (considering liquidity, affordability, and default risk) are safe bonds/consols. Theoretically one could consider any type of asset, but that would rule out a possibilty of negative real rates, since something (by definition) has to appreciate against everything else. It would be like saying, that you can earn double your money each year, you just have to be always at the right time and place. That would be just nonsensicle and extremly naive.

So realistically speaking safe bonds are good proxies, and even though they do not default you can earn a nice negative real return on it. That happened quite often during the last bear markets. The problem is that you have no haven option. You can stockpile into real assets (gold, REITs, stock ETFs), but that requires higher risk tolarence, and on a macro level also risks bubbles.

The problem with our current situation that IF inlfation picks up on the longer horizon, and IF central banks raise too soon they risk the offsetting of the recovery. If they are too slow noone would hold money/bonds, and an excessive amount of money would flow into commodities, raising inflation even higher. Precision will be required… for me it looks that we are in an eternal trap, where normalization is not viable in the short run.