MNI INTERVIEW: US Bond Selloff A 'Stern Warning' To Fed -Stein

Bond market stress remains below levels which would require intervention by the Federal Reserve, but it is a “stern warning” to consider ways to help dealers when there is a plausible risk of a loss of confidence in U.S. Treasuries not only by global investors but by other central banks, former Fed Governor Jeremy Stein told MNI.       

"I strongly suspect some kind of hedge fund unwind is a piece of this," Stein said in an interview, after tariff announcements by President Donald Trump broke long-standing correlations by driving both a plunge in the dollar and a sharp sell-off in Treasuries.

The moves were amplified by a pull-back in the popular hedge fund arbitrage between cash Treasuries and futures known as the basis trade, prompting fears that banks' capacity to intermediate trades in the USD29 trillion U.S. government debt market would be eroded, as occurred in March 2020 when the Fed was forced to intervene.

"I don’t think we’ve gotten to that point. There’s no indication things are as serious as they were in March 2020," Stein said. "In March 2020 it was accompanied by a very sharp deterioration in liquidity in the Treasury market, a big spike in the cost of obtaining repo finance and a bunch of other things more core to market function. I don’t think we’ve seen that yet." 

POTENTIAL TOOLS

Nevertheless the Fed must now think about mechanisms to relieve stress on dealers, Stein said. 

The U.S. central bank established a standing repo facility, a backstop for the repo market, after March 2020, and could again temporarily exempt Treasuries and reserves from the supplementary leverage ratio requirement for banks, but "I don’t think those things are super potent if it’s a really big unwind," Stein said. 

SLR relief is good policy over the long run, but in a crisis, "it's like giving an aspirin," Stein said.  

A novel basis purchase facility as proposed by Anil Kashyap, Stein, Jonathan Wallen and Joshua Younger would specifically address the basis-trade unwind and allow the Fed to "take some of the stress out of the market function without absorbing interest rate risk and putting downward pressure on rates," Stein said. "It's a good thing for them to be thinking about." (See MNI INTERVIEW: Fed Uneasy Over Optics Of Intervention-Kashyap)

FOREIGN SELLING

But even a backstop for hedge funds would not solve problems for the bond market if fueled by massive foreign selling of Treasuries as investors lose confidence in the world's preeminent safe haven asset, Stein said. (See MNI INTERVIEW: Trump Accelerating Dollar Decline - Eichengreen)

"You can imagine a world where in a very orderly way over the next two months, foreign central banks decide to make a serious move out of Treasuries. They do it slowly and carefully, and there’s no problem with market function. But the term premium goes up by 100 basis points, which has the same effect as a tightening of monetary policy," he said. 

"There’s a question of whether the Fed would want to try to undo that," he said. "They can say they’re leaning against the tightening of financial conditions. But that’s purely a monetary policy judgement." 

So far QE has been a monetary policy tool reserved for after interest rates had hit the zero lower bound. Currently interest rates are in restrictive territory, with policymakers facing a difficult judgement as tariffs threaten both sides of their mandate. (See MNI INTERVIEW: Inflation Expectations Surge, Troubling For Fed) 

"They’re likely to be on hold until the data tell them we’ve got more of an inflation problem or more of a slowing of the economy problem," Stein said.