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Water doesn't flow uphill. It's a lesson in physics so basic that even schoolkids know it.
In fact, everyone knows it...
Everyone except - apparently - the world's central bankers.
In their rush to provide liquidity to banks through experimental stimulus programs like "quantitative easing," central banks have failed to create the usual cascade of liquidity normally associated with massive money-printing shenanigans.
Indeed, by attempting to force-flow money uphill, liquidity in the all-important bond markets essentially has been drying up. Central banks have been taking bonds out of circulation, warehousing them on their own balance sheets.
As a result of this attempt to defy the laws of financial physics, we're now frighteningly vulnerable to a bond-market crash. And the best potential remedy - opening the sluice gates - can't be employed because liquidity isn't in the reservoirs where it's needed.
Today I'm going to show you how this financial-market Disruptor came into being. I'm also going to explain how ruinous it could be to the economy, to the bond market, to the stock market, and to you.
I'm also going to show you how to turn this expected "Disruption" to your advantage - to make money from it...
The "Little" Activity That Makes the System Run
Quantitative easing (QE) is a special Disruptor. In fact, it's the biggest financial Disruptor ever.
In the past, when the U.S. Federal Reserve wanted to do its part to stimulate the economy, it might first announce its intention to lower interest rates - and might even announce a "target rate." The interest rate they targeted was the "repo" rate.
Repos, short for repurchase agreements, are very-short-term interbank loans where one bank offers up U.S. Treasury bills, notes, or bonds as collateral for an overnight loan from another bank - and repurchases (buys back) that collateral the next day, or a few days later, depending on the term of the repo agreement.
When that first bank buys back its collateral, it pays a little more than it borrowed - which is the "interest" the lending bank earns.
That interest, when expressed in percentage terms as a "rate," is the overnight rate, or the "repo rate" - and serves as the base rate for all banking loans.
If banks can borrow cheaply from each other because the repo rate is low, they will borrow a lot and use that money to make loans throughout the banking system.
The Fed doesn't directly control the repo rate by mandating what it is. The repo market is a free market where the repo rate is set by traders engaged in repurchase agreements every day. All big banks have repo desks.
If Fed central bankers want to lower the repo rate, they can announce what they want it to be. But that doesn't always cause repo traders to adjust the rates they charge for overnight loans.
So, the Fed has its New York Bank - which conducts all the U.S. central bank's "open-market operations" - actually go into the repo market and offer loans at cheaper rates than other banks are offering. In other words, it's effectively trading overnight money by making it more available in order to bring down the cost of overnight borrowing by big banks.
All Wheels and No Grease...
In theory, that cheaper base-borrowing rate for banks that I just described for you is supposed to work its way through the financial system. By that I mean it's supposed to get translated all down the line into cheaper loans for banks' commercial and retail customers.
During the financial crisis, big banks weren't lending to each other. They were actually afraid that their "counterparties" - the other big banks - would go out of business... meaning the money they loaned might not be repaid.
The repo market essentially seized up.
And that left America's central bankers with a big challenge.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
Hi,
Your article ends a little abruptly, but a couple of comments.
– The central bank does not just affect the short term interest rate because changes in short term interest rates spill over into medium and longer term interest rates.
– The purpose of QE is not just to get bank to provide liquidity in the form of loans (the creation of bank money) it serves a variety of purposes that you don't mention. It serves to increase asset prices, to affect exchange rates, it's allows banks to rebalance their balance sheets (increase their capital ratio). More importantly it seeks to manage expectations and assure the market of the policy of the central bank in relation to interest rates and inflation. It's easy to say that QE is not perfect, and QE asset purchases stopped many years ago now, but it's not difficult to speculate on what might have happened in the absence of QE and this needs to be considered in your analysis.
– You assert that QE is very different to a monetary policy that merely adjusts interest rates. But it's not. It has the very effect that a monetary policy maker seeks to have on a negative output gap when interest rates are already at the zero lower bound.
The problem I have with your analysis and many other who like you criticise the Fed, is that you provide no viable alternative. You just focus on the glass half-empty.
So it's 2009. You are the Chairman of the Fed. (congratulations on your appointment btw). The open market committee is having a meeting. The economy is settling in an undesirable equilibrium where growth is zero or negative, unemployment is high and getting higher, the increasing unemployment is hurting aggregate demand, confidence is low and getting worse, interest rates are already at the zero lower bound, deflation is a real possibility, you remember the crash of 1929 and the years that followed, but you don't like QE, so what do you do now?
(Feel free to formulate your answer in terms of accepted economic theory instead of something that you play well to the audience of an ACU meeting).
/Lasse
I hope that Mr. Gilani answers you. I'm not qualified to answer. I just have questions. So, as Fed Chairman, I can see how emergency liquidity is needed. But do we, and did we need, QE 2, QE 3 and Operation Twist? Did we need $4 trillion worth of asset purchases? How do we know what the Fed has bought since there is no transparency? Shouldn't the Fed have tried to sell some of the accumulated assets, especially Treasuries gradually so that there isn't such low liquidity?
Great article. The Fed has sopped up all the liquidity and they don't understand what they've done. But I don't understand why they could not just sell the assets over time.
The Fed is trapped. If they announce that they are going to start selling off the assets they have accumulated on their balance sheet, even IF they specify how gradual that selling will be, the markets will leap to the conclusion that the Fed is starting the liquidation of their balance sheet, and that is ALL the markets will hear.
Bond yields will jump so high that they will make the "taper tantrum" look like nothing. The bond market will tank, and the prospect of MUCH higher interest rates will take stocks down with bonds.
I agree with your responder who asked the rhetorical question, why were all these additional QE stages necessary, after the initial QE had arrested the hemorrhaging of them market.
The Fed is deathly afraind of instigating market instability. So they have placed themselves into uncharted waters that they have NO idea how to navigate out of…