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How the Fed Saved Structured Note Issuance
There’s an aspect of the higher interest rate structure we are now blessed/cursed with that hasn’t gotten as much airplay, but which is great news for dealer desks and also a good thing for institutional investors (and some high net worth individual investors). And that is the new energy that the higher rates will inject into private note structured product.
A classic structured note is typically designed so that the buyer is guaranteed to get his money back, plus the possibility of some more-attractive payout. So, for example: I might issue a note that will pay you 60% of the total gain in the S&P 500 over the next 5 years – but if the S&P is lower in 5 years, you still get your money back. That’s a pretty simple version, but the embedded bet can be as exotic as you like (and from the standpoint of the dealer, the more exotic the better because the harder it will be for you to price it and the more profit, therefore, they can book on it).
When I was tasked with issuing notes from the Natixis Securities (North America) shelf, for example, we offered a 10-year note that redeemed at either the total rise in the CPI over those 10 years, or the average return of the S&P, Nikkei, and EuroStoxx 50, or par (100%), if both of the other two possibilities were negative. I recall another dealer in 2007 or 2008 was selling a 1-year note that had a huge coupon as long as inflation was between, say, -1% and +3%, but zero otherwise. But you still got your money back. You could structure something with knock-out options, average-price or best-of or lookback options – on interest rates, equities, commodities…even an option on a hedge fund. I want 20% of the latest global macro fund’s upside, but with guaranteed downside…
The key ingredient to all of these things, though, is interest rates – and when interest rates are very low, it is difficult to make a structured note look attractive.
Once upon a time, like back at Bankers Trust in the mid 1990s, the way a structured note was created was to make a special purpose trust that held two securities: a zero-coupon Treasury bond with a maturity equal to the note’s maturity, and ‘something else’ – usually an option. The investor would invest $100. The dealer would spend $80 on the zero coupon bond…which, since it matures at par, guarantees the principal…and have $20 left over to spend on anything else that couldn’t decline below zero. Classically, this is an option, so the trust would look like this:
Since the option can’t be worth less than zero at maturity, and the STRIPS is guaranteed to be worth $100 at maturity, this bond is principal-guaranteed by construction and has no credit risk. Any value the option has at the end of the term is an add-on. If the option is worthless, then the bond matures at par. So simple.[1]
You can see why interest rates matter. This 5-year zero-coupon bond at $80 implies that it is priced at a compounded interest rate of 4.56% (because $80 * (1+4.56%)^5 = $100). But suppose that 5 year interest rates are 0.75%, as they were two years ago at this time? Then the 5-year coupon bond will be priced at 96.33, and instead of having $20 to spend on options the structurer will have less than $4. There aren’t a lot of options priced at $4 that will be exciting enough to an investor (or have enough spread to be exciting enough to a dealer). Never mind the fact that in all of this I have neglected that a dealer generally also gets paid to underwrite and distribute the bond, so that $1 or $2 will come off the top. In this last example, the dealer doesn’t have $3.67 to spend on options…it probably has only $2. Good luck.
I present the notion behind structured product that way because it’s easy to conceptualize and because that’s the way the concept started, but it has been a long time since dealers actually used zero-coupon Treasuries in such a structure. The way such a note is made today is driven by the credit of the issuer, so the structured note trust really holds an IOU from the borrower. In most cases, this is the dealer itself but there are other companies who will issue in their name in order to get bargain financing rates (once the dealer hedges away all of their risk). The mechanics are not worth going into here: if you are someone who would care, you probably already know how to do it, and most of you won’t care. The significance is that the structurer can get a little more spread to play with, since the interest rate will be a corporate credit rather than a government bond. But still not lots.
However, now interest rates are back up. Two-year Treasuries are at 4.90%, 3-years are at 4.50% and 5-years are at 4%. That’s back to the way it used to be. Even real rates are meaningfully positive. And implied volatilities are generally low as well. All in all, structuring desks doubtless have a lot more to do these days than just a few years ago. Not everyone hates higher rates!
[1] Since this column generally concerns itself with inflation and real variables I should point out that you can also guarantee par in real terms, by substituting a TIPS STRIP or the derivative equivalent, so that the investor will get at least the inflation-adjusted amount of his money back rather than the nominal amount; however, then the structurer will have less premium to play with.
Tight Spreads’ Cost: Orderly Markets
In this article I am taking a brief break from writing about inflation. There have been lots of great stories and anecdotes recently about inflation. I loved the Wall Street Journal article about how “Inflation and Other Woes Are Eating Your Girl Scout Cookies”, and we have seen several contributions from former Treasury Secretary Larry Summers that are worth reading. One was an opinion piece in the Washington Post (“Opinion: The stock market liked the Fed’s plan to raise interest rates. It’s wrong.”) and one was a very good NBER working paper on “The Coming Rise in Residential Inflation,” in which he confirms and extends the normal way inflation people forecast rents and comes up with even higher numbers than I’ve been working with for a while. Incidentally, if you haven’t seen these stories before now, consider installing the Inflation Guy mobile app. I don’t curate every single inflation story; just the ones worth curating.
Moreover, the Fed increasingly sounds like they want to be aggressive with rates. That’s half the battle, though on the more important half (the balance sheet reduction) they don’t yet have a plan. I should note that saying hawkish things on half the plan isn’t really all that hawkish, especially when your notion of “pushing rates above neutral” means 3%: a level well below inflation. But it’s progress that these folks have finally realized that inflation is a real phenomenon and not just due to port congestion. They still don’t seem to see the role of money growth in causing that phenomenon, but it’s nice we’re making baby steps.
As I said, though, in this article I’m going to talk about market structure, and the deal with the devil we have made to seek ever-tighter-spreads at a cost of orderly markets.
Since the 1970s, the cost of trading equities has moved from a bid/offer spread of a half point or a quarter point ($0.50 or $0.25 per share), on round lots, plus large brokerage fees, to sub-penny spreads on any size trade, often with zero brokerage costs. The cost of bond execution has similarly declined, as has the cost of futures and swaps brokerage. Volumes, across all markets, have responded to the decrease in costs. Some of this improvement in the median cost of trading has come from increased transparency, and a lot from increased competition.
Those improvements have not come without a cost, but at most times the cost is less apparent. The way the stock market used to be structured was around a number of market-making firms whose job it was to maintain orderly markets – including the distasteful task of being the buyer when everyone else is selling. What this means for the profit of a market-maker is that they generally made steady, small profits (a quarter of a point on every share, day in and day out) and occasionally lost huge amounts in market panics. It’s a classic “short gamma” position of picking up nickels before the bulldozer, and well-understood by the market-makers to be so. But that was the deal: you let the market-maker take his spread as an insurance premium, and collect on that premium when a calamity hits. Primary dealers in the government bond markets worked the same way: in exchange for the privilege of building an auction book (and being able to bid on the auction with that knowledge) and making spreads as a market-maker most of the time, it was understood that they were supposed to work to keep markets liquid in the bad times.
Then, we decided that we didn’t like paying all of these insurance premiums, which we called the “cost of trading” but could also be considered “the cost of providing continuous liquidity in bad times.” So stock prices were decimalized, which immediately started narrowing spreads. Electronic trading made the deal even worse because anyone could jump in front of the market-maker and be the bid or the offer, meaning that the market-maker wasn’t earning the spread. In many cases, there wasn’t any spread left to earn.
There is a parallel to something else I’ve written about recently, and that’s the trend over the years to lower and lower costs, and longer and longer supply chains, in manufacturing. Such a system is lower cost, but the price of that cost-savings is fragility. A long, international supply chain gets snarled much more easily and much worse than a short, domestic one. That cost/fragility tradeoff is the bargain that manufacturers made, although not thoughtfully.
Similarly, the price of the cost-savings from sub-penny equity spreads is fragility in the market-making system. It is difficult to find dealers who will accept the responsibilities of being the buyer or seller of last resort, and maintaining orderly markets, when that cost is not counterbalanced by an increase in profit opportunities during placid times.
As with international trade, we have begun to see the downside of this tradeoff when trading risks increase. Not that this is the first time, but it seems these days that liquidity conditions get sketchier more quickly now than they used to. Of course, we saw this as recently as March 2020, when trading in credit got so bad that the Fed had to step in and backstop corporate bond ETFs by buying corporate bonds and ETFs under the Secondary Market Corporate Credit Facility.[1] Recently, the Nickel market basically broke when prices went vertical and the resulting margin calls would have put some LME brokers out of business (conveniently, the LME decided to just cancel the trades that they didn’t like, which means those brokers are still in business but probably won’t have a market to broker). Prices went vertical partly because there are fewer highly-capitalized market-maker shops to stand in the middle and make orderly markets. Also recently, the European Federation of Energy Traders pleaded for “emergency funding mechanisms” so that they can continue to trade energy markets that have had greatly increased volatility recently.[2]
Now, the disturbing thing is that we are starting to see declines in liquidity even in fairly unremarkable periods. The last seven months’ worth of volatility in interest rate markets was higher than we’d seen in some years, but not exactly unprecedented. This month, 10-year Treasury yields are up 57bps. In 2002, 10-year yields fell 170 bps between May and October, in something close to a straight line driven by mortgage convexity. In about 6 weeks from May to June in 2003, yields dropped 81bps and then immediately reversed 129bps higher over the ensuing 6 weeks (same reason, different direction). I mention those two episodes because I was making markets in rates options and remember them not-very-fondly.
But these recent 57bps have been a lot more stressful on the market with fewer strong hands responsible for maintaining order. The chart below shows the BofA MOVE index, which measures normalized implied volatility on 1-month Treasury options. Recently, that index reached its second-highest level since the Global Financial Crisis. The highest prior level was in the March 2020 shutdown crash…understandable… and during the GFC banks were undercapitalized and in risk of failure. What’s the reason now?
We also see it in various market ecosystems. For example, there are roughly two dozen “Lead Market Makers” in the ETF ecosystem. In order to launch an ETF, you need to find someone to be the LMM. The function of the LMM is to make markets in virtually all conditions. But it is exquisitely hard to get an LMM signed up nowadays because the math for them works out badly. If your fund is very small, they make a decent spread but on tiny volume so it’s not very lucrative. As soon as your fund gets large, everyone else jumps in front of your markets, because they can and there’s money there to be made, so the LMM either makes no spread at all or makes a very small spread. Of course, those other Johnny-come-latelies will scatter the first time there is volatility, leaving the LMM there all alone to make orderly markets. So the market-making itself is a bad deal for the LMM in almost all circumstances. Their models are only tenable if they are able to make money on the relationship with the ETF issuer in other ways – being a broker for fund rebalancing, etc. This means that fewer good ETFs come to market than otherwise would. I have lamented this elsewhere. And the root cause and ultimate result are the same: we’ve engineered a very low-cost, high fragility system for investors to deal in.
The bottom line is that as any insurance agent can tell you people really hate paying for insurance. But no one expects insurance companies to provide insurance without being paid at least a fair premium. What would happen if we did? Well, then we wouldn’t have any insurance. Financially speaking right now, we don’t have much insurance because it’s too costly to stand in the middle. That looks like a win, until something catches on fire.
[1] For the Fed to buy corporate bonds was long held to be impermissible, since the Federal Reserve Act listed the assets the Fed was authorized to buy and that list did not include corporates and equities. Clearly, this was meant to follow Bagehot’s dictum that a central bank, to avert panic, “should lend early and freely, to solvent firms, against good collateral, and at ‘high rates’”, but thanks to clever lawyers who note that the Act does not explicitly prohibit the Fed from buying these things the Fed has in recent years decided that since it wants to, what could go wrong?
[2] A sad aside is that the movement to remove “pricey, greedy market-makers” and replace them with bailouts provided by central bank or treasury is the opposite of what Dodd-Frank was supposedly trying to do in ensuring that systemically-important institutions were adequately capitalized. They’re adequately capitalized now, but they don’t provide the market-braking function they used to because that’s ‘speculative activity’ that penalizes capital severely.
Last Time Was Different
They say that the four most dangerous words in investing/finance/economics are “This time it’s different.”
And so why worry, the thinking goes, about massive quantitative easing and profound fiscal stimulus? “After all, we did it during the Global Financial Crisis and it didn’t stoke inflation. Why would you think that it is different this time? You shouldn’t: it didn’t cause inflation last time, and it won’t this time. This time is not different.”
That line of thinking, at some level, is right. This time is not different. There is not, indeed, any reason to think we will not get the same effects from massive stimulus and monetary accommodation that we have gotten every other time similar things have happened in history. Well, almost every time. You see, it isn’t this time that is different. It is last time that was different.
In 2008-10, many observers thought that the Fed’s unlimited QE would surely stoke massive inflation. The explosion in the monetary base was taken by many (including many in the tinfoil hat brigade) as a reason that we would shortly become Zimbabwe. I wasn’t one of those, because there were some really unique circumstances about that crisis.[1]
The Global Financial Crisis (GFC hereafter) was, as the name suggests, a financial crisis. The crisis began, ended, and ran through the banks and shadow banking system which was overlevered and undercapitalized. The housing crisis, and the garden-variety recession it may have brought in normal times, was the precipitating factor…but the fall of Bear Stearns and Lehman, IndyMac, and WaMu, and the near-misses by AIG, Fannie Mae, Freddie Mac, Merrill, Goldman, Morgan Stanley, RBS (and I am missing many) were all tied to high leverage, low capital, and a fragile financial infrastructure. All of which has been exhaustively examined elsewhere and I won’t re-hash the events. But the reaction of Congress, the Administration, and especially the Federal Reserve were targeted largely to shoring up the banks and fixing the plumbing.
So the Federal Reserve took an unusual step early on and started paying Interest on Excess Reserves (IOER; it now is called simply Interest on Reserves or IOR in lots of places but I can’t break the IOER habit) as they undertook QE. That always seemed like an incredibly weird step to me if the purpose of QE was to get money into the economy: the Fed was paying banks to not lend, essentially. Notionally, what they were doing was shipping big boxes of money to banks and saying “we will pay you to not open these boxes.” Banks at the time were not only liquidity-constrained, they were capital-constrained, and so it made much more sense for them to take the riskless return from IOER rather than lending on the back of those reserves for modest incremental interest but a lot more risk. And so, M2 money supply never grew much faster than 10% y/y despite a massive increase in the Fed’s balance sheet. A 10% rate of money growth would have produced inflation, except for the precipitous fall in money velocity. As I’ve written a bunch of times (e.g. here, but if you just search for “velocity” or “real cash balances” on my blog you’ll get a wide sample), velocity is driven in the medium-term by interest rates, not by some ephemeral fear against which people hold precautionary money balances – which is why velocity plunged with interest rates during the GFC and remained low well after the GFC was over. The purpose of the QE in the Global Financial Crisis, that is, was banking-system focused rather than economy-focused. In effect, it forcibly de-levered the banks.
That was different. We hadn’t seen a general banking run in this country since the Great Depression, and while there weren’t generally lines of people waiting to take money out of their savings accounts, thanks to the promise of the FDIC, there were lines of companies looking to move deposits to safer banks or to hold Treasury Bills instead (Tbills traded to negative interest rates as a result). We had seen many recessions, some of them severe; we had seen market crashes and near-market crashes and failures of brokerage houses[2]; we even had the Savings and Loan crisis in the 1980s (and indeed, the post-mortem of that episode may have informed the Fed’s reaction to the GFC). But we never, at least since the Great Depression, had the world’s biggest banks teetering on total collapse.
I would argue then that last time was different. Of course every crisis is different in some way, and the massive GDP holiday being taken around the world right now is of course unprecedented in its rapidity if not its severity. It will likely be much more severe than the GFC but much shorter – kind of like a kick in the groin that makes you bend over but goes away in a few minutes.
But there is no banking crisis evident. Consequently the Fed’s massive balance sheet expansion, coupled with a relaxing of capital rules (e.g. see here, here and here), has immediately produced a huge spike in transactional money growth. M2 has grown at a 64% annualized rate over the last month, 25% annualized over the last 13 weeks, and 12.6% annualized over the last 52 weeks. As the chart shows, y/y money growth rates are already higher than they ever got during the GFC, larger than they got in the exceptional (but very short-term) liquidity provision after 9/11, and near the sorts of numbers we had in the early 1980s. And they’re just getting started.
Moreover, interest rates at the beginning of the GFC were higher (5y rates around 3%, depending when you look) and so there was plenty of room for rates, and hence money velocity, to decline. Right now we are already at all-time lows for M2 velocity and it is hard to imagine interest rates and velocity falling appreciably further (in the short-term there may be precautionary cash hoarding but this won’t last as long as the M2 will). And instead of incentivizing banks to cling to their reserves, the Fed is actively using moral suasion to push banks to make loans (e.g. see here and here), and the federal government is putting money directly in the hands of consumers and small businesses. Here’s the thing: the banking system is working as intended. That’s the part that’s not at all different this time. It’s what was different last time.
As I said, there are lots of things that are unique about this crisis. But the fundamental plumbing is working, and that’s why I think that the provision of extraordinary liquidity and massive fiscal spending (essentially, the back-door Modern Monetary Theory that we all laughed about when it was mooted in the last couple of years, because it was absurd) seems to be causing the sorts of effects, and likely will cause the sort of effect on medium-term inflation, that will not be different this time.
[1] I thought that the real test would be when interest rates normalized after the crisis…which they never did. You can read about that thesis in my book, “What’s Wrong with Money,” whose predictions are now mostly moot.
[2] I especially liked “The Go-Go Years” by John Brooks, about the hard end to the 1960s. There’s a wonderful recounting in that book about how Ross Perot stepped in to save a cascading failure among stock brokerage houses.
The Fed’s Reserves Management Problem
There has been a lot written about the Fed’s recent decision to start purchasing T-bills to re-expand its balance sheet, in order to release some of the upward pressure on short-term interest rates in the repo market. Some people have called this a resumption of Quantitative Easing, while others point out that it is merely an adjustment to a technical condition of reserves shortage. The problem is that both perspectives may be right, under different circumstances, and that is the underlying problem.
The triggering issue here was that overnight repo rates had been trading tight, and in fact briefly spiked to around 10%. It isn’t surprising that the Federal Reserve responded to this problem by adding lots of short-term liquidity: that’s how they respond to every issue. Banks in trouble? Add liquidity. Economy slightly weak? Add liquidity. “Stranger Things” episode somewhat disappointing? Add liquidity.
Traditionally, the Fed’s response would have been correct. In the “old days,” the overnight interest rate was how the Open Markets Desk gauged liquidity in the interbank market. If fed funds were trading above the Fed’s desired target (which was not always announced, but which could always be inferred by the Desk’s actions in response to reserves tightness or looseness), the Fed would come in to do “system” repos and add short-term liquidity. If fed funds were trading below the target, then “matched sales” was the prescription. It was fairly straightforward, because the demand for reserves was relatively easy to monitor and the adjustments to the supply of reserves small and regular.
But the problem today goes back to something I wrote about back in March, and that’s that reserves no longer serve just one function. In those aforementioned “old days,” the function of reserves was to support a bank’s lending activities in a straightforward statutory formula that was easy for a bank to calculate: this amount of lending required that amount of reserves, calculated over a two-week period ending on a Wednesday. Under that sort of regime, spikes in funds and repo rates (other than occasionally over the turn of year-end) were very rare and the Desk could easily manage them.
This is no longer the case. Reserves now serve two functions, as both lending support and as “High Quality Liquid Assets” (HQLA) that systemically-important banks can use in calculating its Liquidity Coverage Ratio (LCR). This has two really critical implications that we will only gradually learn the importance of. The first implication is that, because the amount of reserves needed to support lending activities is unlikely to be exactly the amount of reserves needed for a bank to achieve its HQLA, at any given time one of these two effects will dictate the amount of reserves the system needs. For example if banks need more reserves for HQLA reasons, then it means they will have more reserves than needed for their existing loan books – and that means economic stability and inflation control will in those cases take a back seat to bank stability. So, as the Fed has struggled to keep up with HQLA demand, year-over-year M2 growth (which is partly driven by reserves scarcity or plenty) has risen fairly quickly to 2-year highs (see chart, source Bloomberg).
The second implication is that, because the demand for each of these two functions of reserves changes independently in response to changes in interest rates and other market forces, it is not entirely knowable or forecastable by the Desk how many reserves are actually needed…and that number could change a lot. For example, there are other assets that also serve as HQLA; so if, for example, T-bill yields were a bit higher than the interest paid on reserves a bank might choose to hold more Tbills and only as much reserves as needed to support its lending activities. But if Tbill rates then fall, or customers lift those bills away from the bank’s balance sheet, or the denominator of the LCR (the riskiness of the bank’s activities, essentially) changes due to market conditions, the bank may suddenly choose to hold lots more reserves. And so rates might suddenly spike or plummet for reasons that have to do with the demand and supply of reserves for the HQLA function, with the Fed struggling to add or subtract large amounts of reserves over short periods of time.
In such a case, targeting a short-term interest rate as a policy variable is going to be exquisitely more difficult than it used to be, and honestly it isn’t clear to me that this is a solvable problem under the current framework. Either you need to declare that reserves don’t qualify as HQLA (which seems odd), or you need to require that a bank hold a certain amount as HQLA and set that number high enough that reserves are essentially the only HQLA a bank has (which seems punitive), or you need to accept that the central bank is either going to have to surrender control of the money supply (which is scary) or of short-term interest rates (which is also scary).
But simply growing the balance sheet? That’s the right answer today, but it might be the wrong answer tomorrow. It does, though, betray that the central bank has a knee-jerk response to err on the side of too much liquidity…and those of us who remember that inflation is actually a real thing see that as a reason for concern. (To be fair, central banks have been erring on the side of too much liquidity for quite some time. But maybe they’ll keep being lucky!)
What if ‘Excess Reserves’ Aren’t Really Excess?
One intriguing recent suggestion I have heard recently is that the “Excess” reserves that currently populate the balance sheet of the Federal Reserve aren’t really excess after all. Historically, the quantity of reserves was managed so that banks had enough to support lending to the degree which the Fed wanted: when economic activity was too slow, the Fed would add reserves and banks would use these reserves to make loans; when economic activity was too fast, the Fed would pull back on the growth of reserves and so rein in the growth of bank lending. Thus, at least in theory the Open Markets Desk at the New York Fed could manage economic activity by regulating the supply of reserves in the system. Any given bank, if it discovered it had more reserves than it needed, could lend those reserves in the interbank market to a bank that was short. But there was no significant quantity of “excess” reserves, because holding excess reserves cost money (they didn’t pay interest) – if the system as a whole had “too many” reserves, banks tended to lend more and use them up. So, when the Fed wanted to stuff lots of reserves into the system in the aftermath of the financial crisis, and especially wanted the banks to hold the excess rather than lending it, they had to pay banks to do so and so they began to pay interest on reserves. Voila! Excess reserves appeared.
But there is some speculation that things are different now because in 2011, the Basel Committee on Banking Supervision recommended (and the Federal Reserve implemented, with time to comply but fully implemented as of 2015) a rule that all “Systematically Important Financial Institutions” (mainly, really big banks) be required to maintain a Liquidity Coverage Ratio (LCR) at a certain level. The LCR is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) by a number that represents its stress-tested 30-day net outflows. That is, the bank’s liquidity is expressed as a function of the riskiness of its business and the quantity of high-quality assets that it holds against these risks.
In calculating the HQLA, most assets the bank holds receive big discounts. For example, if a bank holds common equities, only half of the value of those equities can be considered in calculating this numerator. But a very few types of assets get full credit: Federal Reserve bank balances and Treasury securities chief among them.[1]
So, since big banks must maintain a certain LCR, and reserves are great HQLA assets, some observers have suggested that this means the Fed can’t really drain all of those excess reserves because they are, effectively, required. They’re not required because they need to be held against lending, but because they need to be held to satisfy the liquidity requirements.
If this is true, then against all my expectations the Fed has, effectively, done what I suggested in Chapter 10, “My Prescription” of What’s Wrong with Money? (Wiley, 2016). I quote an extended section from that book, since it turns out to be potentially spot-on with what might actually be happening (and, after all, it’s my book so I hereby give myself permission to quote a lengthy chunk):
“First, the Federal Reserve should change the reserve requirement for banks. If the mountain will not come to Mohammed, then Mohammed must go to the mountain. In this case, the Fed has the power (and the authority) to, at a stroke, redefine reserves so that all of the current “excess” reserves essentially become “required” reserves, by changing the amount of reserves banks are required to hold against loans. No longer would there be a risk of banks cracking open the “boxes of currency” in their vaults to extend more loans and create more money than is healthy for an economy that seeks noninflationary growth. There would be no chance of a reversion to the mean of the money multiplier, which would be devastating to the inflation picture. And the Open Markets Desk at the Fed would immediately regain power over short-term interest rates, because when they add or subtract reserves in open market operations, banks would care.
“To be sure, this would be awful news for the banks themselves and their stock prices would likely take a hit. It would amount to a forcible deleveraging, and impair potential profitability as a result. But we should recognize that such a deleveraging has already happened, and this policy would merely recognize de jure what has already happened de facto.
“Movements in reserve requirements have historically been very rare, and this is probably why such a solution is not being considered as far as I know. The reserve requirement is considered a “blunt instrument,” and you can imagine how a movement in the requirement could under normal circumstances lead to extreme volatility as the quantity of required reserves suddenly lurched from approximate balance into significant surplus or deficit. But that is not our current problem. Our current problem cries out for a blunt instrument!
“While the Fed is making this adjustment, and as it prepares to press money growth lower, they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise.
“Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. It is possible that, as this happens, reserve requirements could be edged incrementally back to normal as well. But those decisions are years away.”
If, in fact, the implementation of the LCR is serving as a second reserve requirement that is larger than the reserve requirement that is used to compute required and “excess” reserves, then the amount of excess reserves is less than we currently believe it to be. The Fed, in fact, has made some overtures to the market that they may not fully “normalize” the balance sheet specifically because the financial system needs it to continue to supply sufficient reserves. If, in fact, the LCR requirement uses all of the reserves currently considered “excess,” then the Fed is, despite my prior beliefs, actually operating at the margin and decisions to supply more or fewer reserves could directly affect the money supply after all, because the reserve requirement has in effect been raised.
This would be a huge development, and would help ameliorate the worst fears of those of us who wondered how QE could be left un-drained without eventually causing a move to a much higher price level. The problem is that we don’t really have a way to measure how close to the margin the Fed actually is; moreover, since Treasuries are a substitute for reserves in the LCR it isn’t clear that the margin the Fed wants to operate on is itself a bright line. It is more likely a fuzzy zone, which would complicate Fed policy considerably. It actually would make the Fed prone to mistakes in both directions, both over-easing and over-tightening, as opposed to the current situation where they are mostly just chasing inflation around (since when they raise interest rates, money velocity rises and that pushes inflation higher, but raising rates doesn’t also lower money growth since they’re not limiting bank activities by reining in reserves at the margin).
I think this explanation is at least partly correct, although we don’t think the condition is as binding as the more optimistic assessments would have it. The fact that M2 has recently begun to re-accelerate, despite the reduction in the Fed balance sheet, argues that we are not yet “at the margin” even if the margin is closer than we thought it was previously.
[1] The assumption in allowing Treasuries to be used at full value seems to be that in a crisis the value of those securities would go up, not down, so no haircut is required. Of course, that doesn’t always happen, especially if the crisis were to be caused, for example, by a failure of the government to pay interest on Treasuries due to a government shutdown. The more honest reason is that if the Fed were to haircut Treasuries, banks would hold drastically fewer Treasuries and this would be destabilizing – not to mention bad for business on Capitol Hill.
The Neatest Idea Ever for Reducing the Fed’s Balance Sheet
I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.” First, some background.
It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index.” But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.
This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.
I just didn’t say five years from when.
We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.
A similar approach was used with CDOs (Collateralized Debt Obligations). A collection of corporate bonds was put into a trust[1], and certificates issued that entitled the buyer to the first X% of the cash flows, the next Y%, and so on until 100% of the cash flows were accounted for. Since the security at the top of the ‘waterfall’ got paid off first, it had a very good rating since even if some of the securities in the trust went bust, that wouldn’t affect the top tranche. The next tranche was lower-rated and higher-yielding, and so on. It turns out that with some (as it happens, somewhat heroic) assumptions about the lack of correlation of credit defaults, such a CDO would produce a very large AAA-rated piece, a somewhat smaller AA-rated piece, and only a small amount of sludge at the bottom.
So, in 2004 I thought “why don’t we do this for TIPS? Only the coupons would be tied to particular subcomponents. If I have 100% CPI, that’s really 42% housing, 3% Apparel, 9% Medical, and so on, adding up to 100%. We will call them ‘Barclays Real Accreting-Inflation Notes,’ or ‘BRAINs’, so that I can hear salespeople tell their clients that they need to get some BRAINs.” A chart of what that would look like appears below. Before reading onward, see if you can figure out why we never had BRAINs.
When I was discussing CDOs above, you may notice that the largest piece was the AAA piece, which was a really popular piece, and the sludge was a really small piece at the bottom. So the bank would find someone who would buy the sludge, and once they found someone who wanted that risk they could quickly put the rest of the structure together and sell the pieces that were in high-demand. But with BRAINs, the most valuable pieces were things like Education, and Medical Care…pretty small pieces, and the sludge was “Food and Beverages” or “Transportation” or, heaven forbid, “Other goods and services.” When you create this structure, you first need to find someone who wants to buy a bunch of big boring pieces so you can sell the small exciting pieces. That’s a lot harder. And if you don’t do that, the bank ends up holding Recreation inflation, and they don’t really enjoy eating BRAINs. Even the zombie banks.
Now we get to the really cool part.
So the Fed holds about $115.6 billion TIPS, along with trillions of other Treasury securities. And they really can’t sell these securities to reduce their balance sheet, because it would completely crater the market. Although the Fed makes brave noises about how they know they can sell these securities and it really wouldn’t hurt the market, they just have decided they don’t want to…we all know that’s baloney. The whole reason that no one really objected to QE2 and QE3 was that the Fed said it was only temporary, after all…
So here’s the idea. The Fed can’t sell $115bln of TIPS because it would crush the market. But they could easily sell $115bln of BRAINs (I guess Barclays wouldn’t be involved, which is sad, because the Fed as issuer makes this FRAINs, which makes no sense), and if they ended up holding “Other Goods and Services” would they really care? The basis risk that a bank hates is nothing to the Fed, and the Fed need hold no capital against the tracking error. But if they were able to distribute, say, 60% of these securities they would have shrunk the balance sheet by about $70 billion…and not only would this probably not affect the TIPS market – Apparel inflation isn’t really a good substitute for headline CPI – it would likely have the large positive effect of jump-starting a really important market: the market for inflation subcomponents.
And all I ask is a single basis point for the idea!
[1] This was eventually done through derivatives with no explicit trust needed…and I mean that in the totally ironic way that you could read it.
Sometimes I Just Sits
An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”[1]
The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.
That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)[2]
More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.
The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.
I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.
To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.
Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.
In 2016, if the Fed goes forward with tightening, we will see:
- Lower corporate earnings
- Rising corporate default rates
- Rising inflation
- Lower equity prices; higher commodity prices
- Banks vilified. I am not sure why, but it seems this always happens so there will be something.
All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.
To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.
The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.
[1] This story is attributed variously to A.A. Milne and to Punch magazine, among others.
[2] Cotton is +3% or so versus 1 year ago.
The New Fed Operating Framework Explained with Cheese
This will be a brief but hopefully helpful column. For some time, I have been explaining that the new Fed operating framework for monetary policy, in which the FOMC essentially steers interest rates higher by fiat rather than in the traditional method (by managing the supply of funds and therefore the resulting pressure on reserves), is a really bad idea. But in responding to a reader’s post I inadvertently hit on an explanation that may be clearer for some people than my analogy of a doctor manipulating his thermometer to give the right reading from the patient.
Right now, there is a tremendous surplus of reserves above what banks are required to hold or desire to hold. With free markets, this would result in a Fed funds interest rate of zero, or even lower under some circumstances, with a substantial remaining surplus.[1] In this case, the Fed funds effective rate has tended to be in the 10-20bps range since the Fed started paying interest on excess reserves (IOER).
So what happens when there is a floor price established above the market-clearing price? Economics 101 tells us that this results in surplus, with less exchange and higher prices than at equilibrium. Consider a farm-price support program where the government establishes a minimum price for cheese (as it has, actually, in the past). If that price is below the natural market-clearing price, then the floor has no effect. But if the price is above the natural market-clearing price, as in the chart below where the minimum cheese price is set at a, then in the market we will see a quantity of cheese traded equal to b, at a price of a.
But what also happens is that producers respond to the higher price by producing more cheese, which is why the supply curve has the shape it does. In order to keep this excess cheese from pushing market prices lower, the government ends up buying c-b cheese at some expense that ends up being a transfer from government to farmers. It can amount to a lot of cheese.[2] This is the legacy of farm price supports: vast warehouses of products that the government owns but cannot distribute, because to distribute them would push prices lower. So the government ends up distributing them to people who wouldn’t otherwise buy cheese, at a zero price. And eventually, we get the Wikipedia entry “government cheese.” https://en.wikipedia.org/wiki/Government_cheese
Now, this is precisely what has happened with the artificial price support for overnight interest rates. Whatever the clearing interest rate is with the current level of reserves, it is lower than the 0.25% IOER (and we know this, among other ways, because there are excess reserves. If the price floating to the actual clearing price, then there would be no excess reserves, although the mechanism for this result is admittedly more confusing than it is for cheese). So the Federal Reserve is forced to “buy up the surplus reserves” by paying interest on these reserves; this amounts to a transfer from the government to banks, rather than to farmers in the cheese example.
You should realize too that setting the floor rate higher than the market-clearing rate artificially reduces the volume of trade in reserves. The chart below, which comes from this article on the New York Fed’s blog, illustrates this nicely.
Creating such a floor also causes the supply of excess reserves themselves to increase beyond what it would otherwise be. This confusing result derives because while the Fed supplies the total reserves number to the market, banks can choose to create more “excess” reserves by doing less lending, or can create fewer excess reserves by doing more lending. Of course, banks aren’t deciding to create excess reserves per se; they are deciding whether it is more advantageous to make a loan or to earn risk-free money on the excess reserves. A higher floor rate implies less lending, all else equal – and, as I have said in the past, this means the Fed could cause a huge increase in bank lending by setting IOER at a penalty rate. This would create the conditions necessary for these lines to cross in negative nominal interest rate territory, with much higher volumes of credit and much lower levels of excess reserves being the result.
In this environment, and as recognized by the Sack-Gagnon framework that is now the presumed operating framework for Fed policy, raising IOER is the only way to change the overnight interest rates unless the Desk undertakes to shift the entire supply curve heavily to the left, by draining trillions in reserves. But raising IOER, just like raising the floor price of cheese, will create more imbalances: bigger excess reserves, less lending, and a bigger transfer from government to banks.
(Note: this is subtly different from what I have said before, which is that raising IOER will have no effect on the growth rate of the transactional money supply. Depending on the shape of the supply curve, it will reduce lending which in turn may reduce the growth rate of the monetary aggregates that we care about, such as M2. My suspicion is that the supply curve is in fact pretty steep, meaning that banks are relatively insensitive to small changes in rates, and thus loans and hence the monetary aggregates won’t see much change in the rate of growth – or, more likely, any change will be the result of other effects beyond this one such as the effect of general economic prospects on the quality of credits and the demand for loans).
Price supports, as any economist can tell you, are an inefficient way to subsidize an industry. And in fact, I don’t think the Fed is really interested in subsidizing banks at this stage in the cycle: they seem to be doing just fine. But they are taking on all of these imbalances, creating all of this government cheese, because they believe the effects I talk about parenthetically above are quite large, rather than vanishingly small as I believe. And the ancillary effect, by raising interest rates, is to spur money velocity – an unmitigated negative in this environment, as it will push inflation higher.
Now, all of this discussion may be moot since the current betting is that the Fed won’t raise interest rates any time soon. But it is good to understand this mechanism as clearly as we can, so that we can prepare ourselves for those effects when they occur.
[1] It is really hard to say how low interest rates would go, and/or how much surplus would remain, because we have no idea at all what the supply and demand curves for funds look like at sub-zero rates. Most likely there is a discontinuity at a zero rate, but how much of one and the elasticities of supply and demand below zero are likely to be “weird.”
[2] In fact, in high school I won an economics prize for my paper “That’s a Lotta Cheese.” No joke.
They Came to Play
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
Tempest in a Microsecond
News flash! High-frequency trading (HFT) is happening!
The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”
Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”
So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?
To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.
High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.
So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.
But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.
Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.
Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.
And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.
The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.
