Bond Vigilantes, Liberty Street Fed Collateral Study, and Art Cashin

This article was first published by me on Talkmarkets:

Art Cashin clarified the limits of volatility, as his statement about the 3 percent barrier to 10 year bond yields caused yields to decline. I don't know if the barrier is permanent and an accurate measure, or if breaking it a little bit would not cause chaos. But clearly, owners of stocks and bonds took Cashin seriously, and the 49th tantrum which goes for higher yield, was stopped in its tracks.

Well, I exaggerate. It may just be a few efforts at tantrum attacks on bond yields since 2013. But it is so continually attempted that it seems like 49 tries at it! Here is my take with a little help from Liberty Fed analysts, who say that there is something at work regarding long bonds that does not reflect traditional market moves.

Bond Tantrums and Goldman Sachs

So then, what is going on with all these failed bond tantrums and unsettling volatility and upheaval? Well, the simple truth is that there is a fence around this behavior. A little volatility makes money for Goldman Sachs, for example. But Goldman has 40 plus trillion dollars of Derivatives, many requiring low interest rates. So, when Goldman pines for higher rates, it is not to create risk for those derivatives, so there is a limit. I don't know what that limit is. But there is a limit. Cashin says 3 percent. But he was just speaking to the stock market. Goldman knows what the interest rate limit is for derivatives. At least we hope they do.

That is what makes Goldman's efforts to establish volatility so interesting. Clearly Goldman and the alumni had their hands in the volatility that resulted from a very irresponsible tax cut and spending package. Mnuchin, and Cohn, and even Bannon, all Goldman alumi, were key architects of tax breaks and perhaps even of the reckless spending that resulted because of a compromise between the Republican tax cuts and the Democrat spenders in congress.

That package of cuts to government revenue caused people who leveraged against volatility to lose massive amounts of money.

Yet Goldman must be confident that while this volatility may hurt stocks, it won't be a serious problem for bonds. Volatility clearly is not the same as risk for Goldman Sachs. They may have a handle on volatility. But Goldman cannot tolerate bond yields running wild.

I can't imagine that Goldman Sachs or any TBTF bank or clearinghouse or counterparty does not know the thinking of the Fed. The system is highly monitored, and frisky behavior is carefully fenced. Even Cashin said that there are too many people looking at the problem of rising rates to get too worried about it!

Donald Trump may think that the Goldman alumni/Wilbur Ross effort to bust the New Normal of slow growth and low yields will likely work. But it won't. It can't, at least for too long. The Fed won't allow it. In my opinion, it will take down any wage boom and excess corporate credit that threatens bonds by heating the economy.

The Liberty Fed Boys 

The Liberty Fed boys are writing about something many including myself have observed for a long time. The conundrum of long bonds, even in the face of Fed hiking the Fed Funds Rate, is still with us. Yes, even the Liberty Fed boys think that conundrum is still with us. And they have done a very complex study to prove it. They basically compared long bonds with corporate bonds of similar maturity and have discovered that long bonds have declined in yields as corporate bonds have risen in yield.

From a February 5, 2018 News Flash on the Repo Watch blog, this was the Liberty Fed view of persistent low interest rates ever since the collapse of Long-Term Capital Management:

Persistent low interest rates on U.S. Treasuries, ever since the collapse of the Long-Term Capital Management hedge fund in the late 1990s, may be caused in part by strong demand for safe investments to use as collateral for transactions like repo, reported Liberty Street economists at the New York Fed.
Collateral is strictly monitored. It is marked to market daily, as we see in a Liberty author's comments to an article posted at the Liberty Street Economics blog:

In response to Yaw’s question about possibly changing collateral value, the program required that collateral be valued daily by the clearing bank. Adjustments to collateral levels might then need to be made to maintain the designated margin amounts. 

Cashin basically warned investors to stop shorting treasuries or else all hell will break loose!

And for people who don't think that Cashin is not aware of these collateral issues, we have an article from Zero Hedge refuting this idea. Cashin may a very senior citizen, but he doesn't miss much. He said in the Zero Hedge article in 2016 speaking to oil issues:

Several market participants have been asked to put up more collateral to prepare for bad loans. Also, on Wednesday there were both rumors and indications that there was a good deal of forced selling going on. There were rumors that it could have been either a hedge fund or a sovereign wealth fund, maybe investors who are exposed to the oil prices. It could have been Saudi  Arabia or Norway. Forced selling and margin calls are very hard to deal with because such an investor basically has no latitude. Positions must be sold at any price and that’s very difficult for the market.
Cashin went on to say he didn't want the Fed to hike rates back in 2016, that it was a mistake. I wonder what he thinks about rate hiking now. He showed he was fiercely protective of collateral markets back then, which showed weakness when short rates went up, and surely with a much bigger stock market and the attempts to short long treasury bonds, he is fiercely protective of collateral in the bond market.

That is why he spoke out in my view. Clearly, if the repo market fails due to collateral considerations or for any other reason, the entire financial system is then in jeopardy.

So, for Cashin, it may be that this time, the Fed cannot remain behind the curve, being slow to raise  rates, or bond vigilantes may attempt to push long rates up to get the Fed to act more strongly. Cashin was warning the Fed as much as he was warning the bond vigilantes, in my opinion.

But keep in mind, bond vigilantes, if they exist, can do way more damage now if they could succeed in pushing rates on long bonds up. This is because of the Liberty Fed revelations, showing the massive demand for interest rate based collateral. With the decline of asset backed collateral, like MBSs, interest rate collateral has taken over and is the largest derivative market. If that collateral fails on a massive scale, all hell really could break loose.

The Fed has no real power to raise long rates, hence the conundrum still exists. What is the point of vigilantes who can do nothing but destroy the financial system? I don't think they can make the Fed do something it can't do regarding long rates.

If the vigilantes do not exist, could we see some stagflation? That seems dangerous for all that collateral based on interest rates, too. But at least the economy would not dive into a crisis for awhile longer. The Fed will likely become more aggressive in pushing short rates up, risking a yield curve inversion and possible stress on markets, and Chairman Powell has signaled those intentions.

As Tyler Durden has said, the Fed has changed its language regarding inflation:

  • Nov 1, 2017: "the Committee is monitoring inflation developments closely"
  • Dec 13, 2017: "the Committee is monitoring inflation developments closely."
  • Jan 31, 2018: "The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal."

Ed Yardini, who coined the term "bond vigilantes", in the 1980's, thinks rates may go a little higher because inflation is the real threat to yields. But he thinks that there is a cap, a fence, on long rates still. From the CNBC article:

However, he doesn't think inflation is coming back.
He ultimately sees the 10-year Treasury hitting 3 percent or 3.5 percent. 
The idea that the Fed would allow inflation when demand for bonds is so high, according to Liberty, is absurd. A little inflation would help wages, but the Fed is in the business of selling bonds, not in helping workers.

And yet the workers, the people of the United States, guarantee bank solvency in a crash. This lopsided injustice will never be rectified without an infusion of helicopter money on rare occasions, to the populace.  It isn't like we can engage in nuclear war to bring us out of the next financial crisis which could be worse than the current crisis as labor is very weak in relation to total national GDP.

For Further Reading:

Art Cashin Market Commentary

Tri-Party Repo Infrastructure Reform


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