Central Banking 101
The open markets desk has two important responsibilities: gathering market intelligence for policymakers and executing open market operations (printing money).
Numbers you see in a bank account are called deposits and are created by commercial banks, not the government.
The government provides $250,000 in FDIC deposit insurance for deposit holders. This makes bank deposits as safe as fiat currency for most people.
Bank reserves are a special kind of money issued by the federal reserve that only commercial banks can hold.
Commercial banks use bank reserves when they pay each other or anyone else with an account with the Fed.
Treasuries are a type of money that pays interest and can be readily turned into bank deposits by selling them in the market or by using them as collateral for a loan.
A balance sheet gives an overview of a bank’s assets and liabilities and every asset is counterbalanced by a liability.
At the end of the day, total assets must equal total liabilities plus equity.
When the Fed buys Treasuries or other assets, it pays for them by creating reserves.
When commercial banks need currency, they send bank reserves to the Fed, who then sends over an armored car with physical currency.
When payments are made to the US Treasury, such as tax payments, reserves leave the commercial banking system and enter into the Treasury General Account (TGA).
Bank deposits are created when a commercial bank creates a loan or when it buys a financial asset.
Rather than lending out deposits, a bank simply creates deposits out of thin air when it makes a loan.
A CBDC essentially allows everyone to have an account at the central bank (the Fed). While this would help streamline certain processes (like taxes), its true purpose is as a policy tool to swiftly conduct fiscal and monetary policy.
Treasury securities are essentially money for large investors.
Longer-dated Treasuries are more sensitive to expected changes in inflation and interest rates, so their market values fluctuate the most.
After Treasuries, the most liquid and safe assets are agency RMBS (residential mortgage-backed securities that are guaranteed by the government).
Wealthy people in developing countries often prefer to store part of their wealth in major currencies like the US dollar. Dollar currency is held internationally as a store of value like gold during the gold standard.
The level of central bank reserves held by banks is determined by the Fed’s actions and is unaffected by the amount of loans made by commercial banks.
The lending constraint for commercial banks is either regulatory or due to commercial conditions. Banks are only interested in lending if they can make a profit and widespread defaults make that difficult during recessions.
Bank deposits are created when a commercial bank purchases an asset or creates a loan, and they’re destroyed when a loan or asset is repaid. Thus, the level of bank deposits is largely indicative of the level of loans made by the banking system.
The Fed has a dual mandate of full employment and stable prices.
The Fed thinks of the economy through the lens of interest rates.
Longer-dated Treasuries are less sensitive to changes in the overnight interest rate, so the Fed tries to indirectly influence them through QE.
The Fed’s goals with QE is to lower longer-term interest rates, with an increase in reserves and bank deposits being a necessary byproduct.
QE forces commercial banks to hold more of their assets in bank reserves, which drives non-banks to trade their bank deposits for higher-yielding corporate debt or speculate in equities.
The basic business model of a commercial bank is earning the difference in interest rates between the assets it holds and the liabilities it owes.
Since banks are historically prone to banking crises, they are heavily regulated. One regulation is a leverage ratio and another is a capital ratio, which requires them to hold a level of capital in line with the riskiness of their investments.
The offshore dollar banking system can only be understood through the Bank of International Settlements (BIS) data.
The Treasury Department does not decide how much debt to issue, congress does. The Treasury Department does, however, decide how to go about the funding. They can issue more longer-dated debt to steepen the curve or issue shorter-dated debt to flatten the curve.
The basic business model of a shadow bank is to use shorter-term loans to invest in longer-dated assets, and rather than being creators of money, they are simply intermediaries.
Both the 2008 financial crisis and the Covid-19 panic were largely due to runs on the shadow banking system.
The Federal Reserve conducts its monetary policy exclusively through primary dealers.
Dealers will fund their inventory of financial products by borrowing money in the repo market using the financial products as collateral.
Primary dealers provide liquidity to financial institutions and set the price of that liquidity.
Assets of MMFs mature very quickly, so there is always plenty of cash from maturing investments to meet investor withdrawals.
The relationship between the price of an ETF share and risk underlying asset value is policed by institutional investors who make money by arbitraging any spread away.
The Treasury market cash-futures basis trade is one where investors earn money by arbitraging the difference between pricing on a Treasury futures contract and pricing on a Treasury security in the cash market.
Virtually any financial asset that provides a stable cash flow can be securitized.
The rise of securitization meant a commercial bank could earn fees by originating a loan and selling it to a securitization vehicle instead of earning interest (and bearing the risk) on loans.
Eurodollars are US dollars held outside the United States.
Around 60% of all foreign reserves are held in dollars, around 50% of global trade is invoiced in dollars, and around 40% of international payments are made in dollars.
Whenever there is distress in the world, investors rush to the US dollar. The US dollar is backed by the world’s strongest military, largest economy, a relatively impartial legal system, and a central bank that has kept inflation stable for decades.
Everyone accepts dollars, so everyone holds dollars.
When the Federal Reserve sets short-term interest rates in the US at a level that is low relative to other countries, then interest rates of bank loans in dollars also become relatively low and attractive to foreign borrowers.
A big part of the reason China owns trillions in Treasuries even though it’s not very friendly with the US is that they have no alternative; there is no other market deep enough to hold all that money.
Holding dollars offshore is a way for investors to separate currency risk from a country risk. Finally, offshore banks have historically offered higher interest rates on their deposits than banks in the US.
Offshore borrowers usually have a more limited source of dollars, so they are willing to pay higher interest rates for dollars than a US-resident borrower.
US Banks discovered that they could evade onshore banking regulations by moving their banking activity to offshore banking centers like the Cayman Islands or London.
The offshore dollar banking world primarily serves corporations and institutional investors, while the domestic banking sector primarily serves retail clients.
The Eurodollar system can use bank deposits as if they were central bank reserves, and thus expand virtually without limit.
The lower the ratio of reserves to deposits a bank holds, the more profitable it would be, but also the more likely it would experience trouble meeting withdrawals and possibly collapse under a bank run.
The profitability of a bank’s loan is largely dependent on its net interest margin, which is the difference between the interest it earns on the loan and its funding costs.
One way to estimate the general profitability of commercial banking is to look at the steepness of the yield curve, specifically the spread between the 3-month bills and the 10-year Treasury. A wider spread suggests a more profitable banking sector, which, in turn, is positive for economic growth.
Basel three made banks safer by forcing them to hold more high-quality liquid assets like treasury securities and also encouraged them to have more reliable liabilities.
In effect, regulation shifted large amounts of institutional money out of domestic banks and into foreign banks.
Offshore dollar bonds give US-based investors exposure to emerging market growth without being subject to currency risk.
Through its control of the US banking system, the US government has the power to shut anyone out of the dollar banking system.
Banks take US sanctions very seriously because if they are caught violating them, then they may also be shut out of the US banking system, which is essentially a death sentence.
The existence of a vast offshore dollar system has significantly strengthened the influence of US monetary policy on foreign economies and also significantly raised the risk of financial instability.
The Fed has in effect become the world Central Bank and ultimate backer of the dollar banking system.
Assets cost money, and interest rates determine how much money costs.
The Treasury issues debt in tenors that range from one month to 30 years, and the yields on the securities form the Treasury yield curve.
In the current world with very high levels of reserves, the Fed controls the federal funds rate by adjusting the interest rate it offers on the reverse repo facility in the interest it pays on reserves that banks hold in their Fed account.
In practice, the RRP offering rate is probably a much more influential rate than the federal funds rate. The RRP rate is available to a wider range of market participants, while the federal funds rate is available only to commercial banks.
The Eurodollar futures market is the deepest and most liquid derivatives market in the world. Of all the financial instruments, Eurodollar futures are the most reflective of economic fundamentals.
When the US Treasury issues more Treasury securities than the market expects, then yields offered by those Treasury securities must increase to attract additional investors.
The supply of Treasuries is determined by the federal government’s deficit.
Basel 3 mandates large commercial banks to hold sizable amounts of high-quality liquid assets such as Treasuries.
When longer-term interest rates are lower than short-term interest rates, then the market is expecting the Fed to lower short-term rates soon.
Even if affected by Fed action, interest rates are still regarded as the best market signal for the state of the underlying economy.
Money markets are markets for short-term loans with maturities that range from overnight to around a year.
Historically, breakdowns in money markets have led to fire sales that precipitate financial crises.
The two largest segments of secured money markets are the repo market and the FX-swap market.
The repo market is the essential link that allows Treasury securities to be money.
A borrower looking for leverage through repo loans could be engaged in a few common strategies: they could be hoping that the security purchased would appreciate, they could be earning interest on the security purchased that is in excess of the interest cost of the repo loan, or they could use the security as a hedge to another part of their portfolio or as part of an arbitrage strategy.
The primary cash lenders in the repo market are money market funds.
FX-swap transactions are like repo transactions, but instead of securities, the collateral used is foreign currency.
The FX swap allows investors to obtain foreign currency and hedge out exchange risk, which can easily wipe out any investment gains.
Changes in interest rates in one country automatically affect those in other countries via arbitrage.
While a secured lender would lend largely on the quality of the collateral backing the loan, unsecured lenders rely heavily on ratings agencies to determine the creditworthiness of a borrower.
The federal funds market is an interbank market where commercial banks borrow reserves from each other on an overnight unsecured basis.
Capital markets financing is different from a commercial bank loan in that it does not increase the amount of bank deposits in the system, but allows holders of bank deposits to lend them to other non-banks.
Equity markets are the most emotional market and least reflective of economic conditions.
Market participants generally try to value equities on either a fundamental or relative level.
Fundamental analysts will take a discounted cash flow approach and view a stock price as a series of future earnings discounted by a risk-adjusted discount rate.
An analyst valuing a stock on a relative basis would compare a valuation metric like P/E ratio to those of similar stocks.
Over the past two decades, flows from passive investors have grown to become the marginal investors in the equity market.
As the price of a stock rises, it becomes a bigger part of an index and so more money needs to be allocated to it, reinforcing the upward momentum. In a market dominated by passive investors, companies with large market caps become even bigger.
Cheap companies, which tend to be smaller companies, are largely absent from the major stock indices that receive passive investor flows. These value companies thus continue to underperform.
The Fed does not have the legal right to purchase equities.
There are some benefits for a company to remain private, even if it can IPO. Often. Remaining private allows the company to be more long-term in its thinking because its shareholders have a longer time horizon. Public companies are under a quarterly reporting cycle and may be forced to behave in ways that maximize short-term gain at the expense of longer-term profitability.
To remain delta hedged, a dealer will reduce its short stock position by buying some of the stock. As dealers are structurally long call options, the higher the stock goes, the more shares the dealer shirts, and the lower the stock goes, the more the dealer buys.
When a dealer is short an option, whether it’s a put or call, the dealer is “short gamma.” That means that its losses on the put (call) it sold will increase in a non-linear fashion as the price of the underlying stock declines (rises).
Hedging a short gamma position reinforces the price trend, while hedging a long gamma position moderates the price trend.
Market participants usually evaluate bonds in terms of their yields as a spread to Treasury yields of the same tenor.
Credit risk takes into account how likely the company will default, and if it does, what percentage of the money lent could be recovered. Credit ratings are the single most important determinant of a bond’s perceived credit risk.
The higher a company is rated, the lower the interest rate it can borrow at. Once a company’s rating falls below investment grade, the interest rates it can borrow at shoot up significantly because many investment funds are not allowed to purchase so-called junk bonds.
In a bankruptcy, all debt holders are paid in full before equity holders receive anything, so a bankruptcy filing almost always implies that a company’s equity is worthless.
Broadly speaking, the market is divided into an investment-grade universe (bonds rated BBB- and above) and a high-yield universe (bonds rated below BBB-, also known as junk bonds).
Instead of relying on low rates to be transmitted to borrowers through the banking system, the central bank can now directly lower the borrowing costs of corporations by buying corporate bonds and pushing yields lower.
A more highly leveraged capital structure suggests greater volatility in stock prices on both the upside and downside.
Mortgage-back securities are bonds that receive the cash flow generated by a pool of mortgage loans.
When a mortgage rate is refinanced, a new mortgage loan is taken out to repay the old mortgage loan, so the mortgage investor gets paid back sooner.
By purchasing large quantities of Agency MBS, the Fed encourages mortgage lending by increasing the resale value of mortgage loans.
Today, when regulated entities are required to hold high-quality liquid assets, that exclusively means government assets.
The most recent issue of coupons is called “on-the-run,” while coupons issued from previous auctions are called “off-the-run.” On-the-run coupons at every liquid, but become progressively less liquid as time goes on.
The success of a bond auction can be judged by the auction award rate and degree of participation. A very successful auction would be one where the yield awarded is lower than the yield anticipated by the market and the amount of bids submitted far exceed the amount of Treasuries being auctioned (high bid to cover).
Market participants usually measure stress in short-term interest rate markets with the spread between the benchmark market rate of 3-Month LIBOR and the 3-Month Overnight Index Swap, which is roughly the expected average of the federal funds rate for the next 3 months.
Forward guidance is a way for the Fed to extend its control of interest rates from short-term rates to medium-term rates.
Quantitative easing is a way for the Fed to control longer-term interest rates by purchasing longer-dated Treasuries and thus driving their yields down.
Yield curve control (YCC) is when a central bank announces specific numeric targets for its interest rates.
The evidence suggests that interest rates and economic growth are not negatively correlated but positively correlated, so interest rates tend to increase along with economic growth.
In a sense, negative interest rates are a tax on cash that is designed to force spending.
Judging from a decade of experience, lower interest rates appear to boost financial assets, but not necessarily real economic growth.
The “dot plot” is a market-moving data release because it gives a glimpse of what the trajectory of future policy rates could be and how dispersed the views are of FOMC participants.
The voting body of the FOMC is composed of the Board Governors, the President of the New York Fed, and a set of four Presidents from the regional Federal Reserve Banks that rotates annually.
The Phillips curve is a concept in economics that links the unemployment rate with inflation, where a lower unemployment rate would generate higher inflation.
The Fed’s second mandate is to maintain stable prices, which has been interpreted as an inflation target of 2% on the Personal Consumption Expenditure (PCE) index.
The Fed has officially adopted an average inflation target framework where past undershoots of its inflation target would be met with future overshoots.
Inflation is largely a political choice. Any government can create inflation with massive fiscal spending and create deflation by massively raising taxes.
Modern Monetary Theory (MMT) postulates that a government issuer of fiat currency is not constrained by taxation or debt but by inflation. Taxation and debt issuance are merely tools through which the government manages inflation.
The prevailing g belief is a country with a high debt load would have to increase taxes on future generations to repay the debt. Too much debt may also lead investors to demand higher interest rates, further dampening growth.
A monetary system is only as strong as the confidence placed in it, and removing long-held safeguards built into it opens up the potential for great disaster.