Treasury is reducing issuance of T bills. At the same time they are starting issuance of 2 – 3 year FRNs. Why?

There is a strong consensus among investors that rates will rise and therefore they should reduce duration. As a result they are buying shorter and shorter maturities.

This trend is hurting Treasury’s ability to issue notes and bonds. The only way Treasury can issue outside of a year is to offer a short duration, long maturity instrument. Enter the FRN.

Now, in order for Treasury to control debt service the Fed Funds Rate will have to be kept at 0.25% for much longer since the FRN’s coupons are benchmarked to short rates.

This only confirms what I’ve already expected, that regardless of QE tapering or not tapering, the FFR will be kept low for multiple years. 

Strategy:

Don’t expect floating rate credit to profit from rising rates, the short end will not move. Be that as it may, USD duration will still get punished, just not as soon as we thought. We still need USD floating rate funds.

European duration will likely be unaffected. That means you could even buy the EUR or GBP debt of a US issuer. This is interesting. The need for a Euro floating rate fund is perhaps not that urgent as in EUR, you want duration.

EM duration remains bad news. Outside of price controlled goods, inflation is actually a problem. I expect BRIC term structures to underperform. If ever floaters worked, they would work in EM, unfortunately, EM bank debt doesn’t trade.

With consistent central bank asset purchases, the term structure of interest rates cannot find its natural market clearing level. It is difficult to know if asset bubbles are being inflated or not, and it is hard to tell if the economy is yet on a self sustaining growth path. The only way to tell, to discover the price of things, is to wind down the asset purchase programs. 

The constant feeding of liquidity into the financial system has failed to revive labour markets even if it has revived markets for equities, bonds and real estate. GDP growth while positive has fallen short of expectations.

Asset purchases may be stifling credit market liquidity. As more market liquidity has migrated to secured lending markets, the availability of eligible collateral becomes more important. As the Fed does not lend out its assets for collateral, it is possible that the Fed is in fact starving the credit markets of suitable collateral with which to lubricate the flow of short term credit. This mode of liquidity injection definitively precludes any sort of multiplier effect since it creates no bank capital to be multiplied. For this reason, the velocity of money falls almost in perfect reaction and in inverse proportion to the magnitude of balance sheet expansion.

By suppressing interest rates, central banks are making it more attractive for companies to finance themselves with debt instead of equity. In the US, share buybacks have reduced the free float of equity markets even as high yield issuance remains robust. Equity market capitalization growth has lagged the S&P index level growth by almost 3% per annum since 2005 for a -30% lag. The economy seems preoccupied with equity returns rather than growth of income and employment. The Modigliani Miller theorem’s assumptions are certainly violated by the convoluted US tax code which generally favors equity finance, for the businesses, and equity investment, for investors.

The benefit of lower interest rates favors large companies with access to debt capital markets. Small and medium businesses which rely on bank loans for financing continue to be starved of capital as Basel III and a lack of bank capital impedes bank lending. As employment tends to be created in small and medium enterprises compared with large businesses, which on balance tend to consolidate, the impact of low interest rates do not encourage job creation.

What then does QE do? It does inflate asset and house prices and supports consumption through the wealth effect. It supports equity and debt valuations by suppressing rates across the term structure. It monetizes debt which may not obtain sufficiently robust bid to cover ratios thereby maintaining confidence in the treasury and agency MBS markets. It supports co-investors in treasury and MBS assets.

It would be unfair to say that QE wasn’t working, employment has improved, manufacturing has rebounded and growth has stabilized, but the improvements have been small and slow to gain traction, and the side effects are potentially serious. Given that the economy has stabilized, there are grounds for the withdrawal of QE simply to understand the distortionary effects of having QE in force.

Our system of politics and economics is very much a product of history, so much so that some basic questions about fairness and efficiency remain unresolved.

Why is income taxed more vigorously than capital gains? Why are the gains from gambling not taxed more aggressively?

In a meritocracy, what is to be done with under performers? More importantly, in a meritocracy, how should underperformance which is due to bad luck, or indeed outperformance which is due to good luck to be considered? Is the outcome more important than the route?

Does a sovereign country expect to repay its debts within a finite time period, by which is meant, achieve a net cash financial position?

A prudent way to run a business is to increase its equity over time. How should a business plan its capital structure? Should a business plan to achieve a net cash position within a finite time period?

A prudent householder should plan to accumulate equity over time while it is productive and to build an asset base to provide for retirement. Is it prudent to draw down equity during the retirement phase and if so how should it plan to do so? If a generation within a household is deceased with a positive equity, how much discretion should the deceased have (through their wills), over the distribution of the excess equity?

Markets are generally efficient in aggregate and over time. Markets can be inefficient in parts or for periods of time. Do I really believe this? Yes, provided they are proper markets by which I mean that there are sufficiently numerous independent participants, neither of which has sufficient individual influence over pricing.

Most of the familiar asset types exhibit these properties. Equity markets are a good example. So are corporate credit markets. The persistent performance of a small group of hedge fund managers, and the disappointing performance of the significant majority of their competitors is instructive. Successful equity hedge fund managers are rare. Credit managers tend to display more persistent out performance. The liquidity, symmetry of information, completeness of markets in equity markets tends to level the playing field. They also make inefficiencies small, relative to background noise, complicating the job of the equity investor. Here is another point. Every market has a level of background noise. Inefficiencies have to be larger and more persistent if they are to be captured by an investor. If the inefficiencies are too small or last too short a time, then by definition these markets are too efficient. This could be one measure of the efficiency of a market. That some investors are able to repeatedly beat the market implies that there are inefficiencies but that they may not be obvious enough for the majority to identify or capitalize on.

Cross asset inefficiencies are an example of how apparently efficient markets can be inefficient because they are in fact incomplete. Capital structure arbitrage is evidence of such inefficiencies. Because efficiency in equities and bonds are policed by different constituents whose pricing models do not look across asset classes, the valuation between different parts of a company’s capital structure may be mispriced and provide the suitably equipped investor arbitrage or relative value opportunities. This strategy is especially topical under the current cosh of increased regulation in the form of Basel 3, Solvency 2, Dodd-Frank and the Volcker rule. The best policing of capital structures used to be the proprietary trading desks of the investment banks. With increased regulation, prop desks are being shrunk or closed, reducing the amount of capital policing cross asset no-arbitrage conditions in the markets. The opportunities for arbitrage and relative value are greater now than ever before. In other words, markets are a lot less efficient these days.

There are other reasons why a market may be persistently inefficient. The existence of one or a group of participants with disproportionate influence can distort pricing. A simple example is a regulator or central bank. Under what was apparently regarded as normal conditions, central banks may unilaterally determine or influence the level of short term interest rates. While this is already a deviation from the assumption of market determined prices an even greater departure is if the said central bank additionally influences other maturities along the yield curve, for example through the open market purchases of government bonds we have come to call Quantitative Easing or QE. Under these conditions the market is far from perfect and no-arbitrage pricing should not be expected to hold. Investors trading on the assumption of efficient pricing are likely to be confounded.

Extending the complete markets argument for inefficient markets, one could argue that price distortion in one market can affect prices in other markets. A current example is equity markets. Investors consider equity valuations reasonable on an equity yield gap basis, that is relative to US treasuries. If, however, the yield curve is being artificially suppressed by the actions of the central bank, such as under the unconventional monetary policy we call QE, then equities are vulnerable if the central bank were to reduce or stop their purchases of US treasuries and the yield curve was to find its natural level.

Another instance where markets are temporarily inefficient are times or high uncertainty and turbulence where information is insufficient for the market to digest and interpret. Times of crisis and near crisis often lead to the inversion of credit default term structures, for example, making it more expensive to insure against default over a shorter period than over a longer period. US treasury bills may at times trade at higher yields than the unsecured LIBOR market in a recent example, when default by the US treasury seemed possible, albeit highly improbable.

In some markets, imperfections are more prevalent or persistent. Securitized markets such as mortgages, auto loans, student loans, and credit cards are a good example. Complexity of products, market conventions, market culture and regulation make the securitized products market a highly peculiar one. The highly contrived nature of the products being traded are the root of the overall complexity of the market, if it can even be called a market. The highly politicized nature of the underlying assets in which the derivative products are based also invite complex and confusing regulation driven by the confluence of politics, socio-economics and commercialism. One of the results is one of the largest, most liquid asset markets in the world: agency mortgage backed securities. Yet size does not an efficient market make. The best traders in mortgage markets are those who have been involve in the regulation or the industry, the production of the securities, the distribution of product and the origination and management of the underlying assets being securitized. They are bonds indeed, but not as we conventionally know it. Fixed income investors uninitiated to the peculiarities of the MBS market but lured by the high yield, high ratings, often struggle to trade an entrenched club of insiders.

Treasury will want to ensure no default regardless of the actions of the politicians. There are a couple of ways out.

1. They could do a voluntary exchange with the Fed, where by US T bills are exchanged for bonds. The old issue is retired at par. The new issue is a par instrument issued at 500 dollars, say.

a. The debt ceiling is respected since the face value of the debt is constant.

b. The transaction generates cash for the treasury.

c. The Fed gets shafted but then its just more QE anyway.

d. We have to worry about the legality of the transaction to see if any CDS will be triggered. My best guess is no. Even if there was a technical trigger, which I doubt, since the voluntary exchange actually disadvantages the participant (the Fed), under cram down rules, the other bond holders not involved in the exchange are actually better off than the Fed and therefore will have no legal recourse or cause for complaint under bankruptcy law.

2. Treasury could create an asset and sell it. I am slightly uncertain about the legality but I think it works.

a. A predetermined proportion of tax receipts is paid into a newly created, wholly owned subsidiary of treasury.

b. Equity in this subsidiary is sold for cash.

c. It could be argued that

i. A pledge of future cash flows constitutes a debt obligation. However, since the obligation is to a wholly owned subsidiary, I think this argument may fall.

ii. The pledge of current and future cash flows to the subsidiary may constitute fraudulent conveyancing under bankruptcy law. However, I would argue that US treasuries are senior unsecured claims that carry no covenants controlling the creation of senior or other liabilities in the capital structure of the treasury, and, that the solvency of the treasury is indeterminate anyway, since its largest asset is the capitalized cash flow from tax receipts.

iii. In effect, what treasury is doing is selling assets to fund current liabilities. It, however, has to structure the asset into saleable form. In this case, capitalizing its tax revenues.

With the above 2 devices. Jack Lew would not have to worry that the strategies employed by the Republicans and Democrats may accidentally trigger a default. I cannot help but suspect that such contingencies are already in place. While nobody wants a default, the strategies employed by the players may not be ‘trembling hand’ robust. Accidents can happen and we can’t very well have a silly mistake taking us back
to barter.