MNI INTERVIEW: Fed Uneasy Over Optics Of Intervention-Kashyap

An intervention by the Federal Reserve in strained Treasury markets would give the appearance of policy easing, something that officials are keen to avoid at this point, Chicago Booth economist Anil Kashyap told MNI, as he urged the U.S. central bank to consider a special facility to undertake Treasury-futures basis trades instead.

Turbulent Treasury markets this week reminiscent of the March 2020 meltdown had traders pricing in the possibility of an emergency rate cut and analysts warning emergency bond purchases by the Fed may again be necessary, said Kashyap, who has advised an array of global central banks and is a consultant with the Chicago Fed's research department.      

"It’ll be very hard if they do outright purchases to convince people this isn’t the beginning of a cutting cycle," Kashyap said in an interview. "Given all the effort the chair has put in to say there’s optionality and there's time, coming out to cut right now feels like a little bit of a panic. And because of the risk of inflation, it may be something they really regret." 

Regulators don't have a clear view into how large a role the unwind of the basis trade has played in Treasury market stresses this week, and even hedge funds that can keep borrowing maybe just don’t want to, Kashyap said. 

FINANCIAL STABILITY

"What we do know is the interconnections in the system make it so much more complicated to monitor," he said. Data suggest basis trades are larger now than in 2020 with volumes in the hundreds of billions of dollars. "Here’s something that starts with tariffs and spreads to other markets, and you wind up in a situation where a key player in the system steps back and gets more cautious. That amplifies things and creates the possibility of a doom loop of more volatility, margin calls on futures that could then suck up more cash and create more problems." 

The Fed will want to see how elevated the basis is and how long it stays there before intervening, but "they should be prepared in principle for something like this," Kashyap said. 

He along with former Fed Governor Jeremy Stein and two other economists recently proposed ideas for an extraordinary facility where the Fed gets the Treasury to capitalize a special purpose vehicle, with the Fed lending to the SPV and buying the basis in some sort of auction facility. (See: MNI: Fed Should Create Backstop For Basis Trade Unwind - Paper)  

"If they took up our idea of buying the hedged position, it would be clear you’re not trying to influence the term premia or change monetary policy, you’re just trying to stabilize the market," he said. "This situation is an example where you can’t always be sure monetary policy and financial stability will go the same way. Right now is not a time you'd want to say we’re sure we want to go dovish." 

"If you do it at a haircut, let the basis blow out a bit, and only stabilize at a much higher spread than normal, then you also put some pain on people who are having to get out."