Fed Paid $29.3 Billion To Banks NOT To Lend In 2017 (Excess Reserves), Fed Earned $80.2 Billion For Treasury

Yesterday, The New York Federal Reserve announced that it actually increased their $4.2 trillion balance sheet by $1 million rather than shrinking it.

This comes on the heels of The Federal Reserve announcing that it provided $80.2 billion in payments to the US Treasury in 2017. This is the lowest remittance to Treasury since 2015, but still positive.

The Fed’s $4.45-trillion of assets – including $2.45 trillion of US Treasury securities and $1.76 trillion of mortgage-backed securities that it acquired during years of QE – produce a boatload of interest income. How much interest income? $113.6 billion.

Which brings us to excess reserves. Excess reserves—cash funds held by banks over and above the Federal Reserve’s requirements—have grown dramatically since the financial crisis. Holding excess reserves is now much more attractive to banks because the cost of doing so is lower now that the Federal Reserve pays interest on those reserves.  Excess reserves as of the end of 2017 are around $2 trillion and the interest rate paid on excess reserves is now 1.50%.

In 2017, the interest that the Fed paid the US banks and foreign banks doing business in the US jumped by $13.8 billion to $25.9 billion. The Fed also paid banks $3.4 billion in interest on securities sold under agreement to repurchase. That brings the amount that the Fed paid to banks of $29.3 billion.

The Fed will likely raise rates further this year, perhaps 4 times.

This would push the rate on excess reserves to 2.5% by the end of the year. Excess reserves will likely shrink as QE is being unwound, but I am doubtful. And the amount that the Fed pays the banks this year might surge to $40 billion or more (slow shrinking and rising interest paid on Excess Reserves).

So, Treasury is receiving a windfall every year from The Fed courtesy of QE. And Treasury receives another windfall from the notorious 2012 profit sweep from Fannie Mae and Freddie Mac. (Can you spot Treasury’s changing of the Fannie/Freddie bailout terms??)

Yes, Treasury makes good money from The Federal Reserve and having seized the profits from Fannie Mae and Freddie Mac. Will they relinquesh control?


In(som)nia: Fed Fails To Sell T-notes/T-bonds AGAIN! Balance Sheet Back To Trump Election Week (All Agency MBS Sales)

Yawn! Another week goes by in December another week without The Federal Reserve of New York selling any of its Treasury Notes and Treasury Bonds held in SOMA (System Open Market Account).

SOMA holdings (aka, the assets on The Fed’s balance sheet) fell -$10.5 billion from the previous week.


However, none of the sales were of Treasury Notes or Treasury Bonds. It was all agency MBS.


SOMA (balance sheet) holdings are back to election week 2016.


I am getting insomnia waiting for The Fed to seriously start shrinking their balance sheet.

Meanwhile, both the 30Y-2Y and 10Y-2Y Treasury curves are back to October 2007 levels.


It is almost as if The Fed was … paranoid.



Yield-Hungry Japanese Investors See End-of-Year Swap Price Hike

Yes, Japan has negative sovereign debt yields for maturies of less than 9 years.

And now this:

(Bloomberg) — The year-end cost for Japanese investors to borrow dollars with forward swaps is near the highest since the 2008 crisis.

The search for yield has driven Japanese investors to load up on U.S. bonds, exchanging yen for dollars using cross-currency forward swaps. Such activity can create a demand-supply imbalance, especially at financial reporting dates like year-end.

Merry Christmas from Nakatomi Plaza!

‘Twas The Week Before Christmas: US Dollar Swaptions Dive To Lowest Point Since 2005 As US Treasury 30Y-2Y Curve Lowest Since Sept 2007

‘Twas the night week before Christmas, when all through the (financial) house
Not a creature trader was stirring, not even a mouse;

With the exception being traders sending 2Y30Y Swaptions down to their lowest level since 2005. Not to mention sending the 2Y30Y Treasury curve down to 86 basis points, the lowest since September 2007.


Meanwhile the crypto currency Bitcoin remains above 18,000 the week before Christmas.


Merry Christmas, one and all! Except those renting housing.



Whalen: Banks and the Fed’s Duration Trap (The Perils Of Fed QE and Low Rate Policies For Ten Years)

As we approach final exams at George Mason University School of Business, I thought this summary of how The Fed is impacting both Treasury and Agency MBS risk (duration) would be appropriate. A great summary of the topics we have discussed in class are provided by my friend Chris Whalen.

Chris Whalen (Institutional Risk Analyst): Is a conundrum worse than a dilemma? 

One of the more important and least discussed factors affecting the financial markets is how the policies of the Federal Open Market Committee have affected the dynamic between interest rates and asset prices.  The Yellen Put, as we discussed in our last post for The Institutional Risk Analyst, has distorted asset prices in many different markets, but it has also changed how markets are behaving even as the FOMC attempts to normalize policy.

One of the largest asset classes impacted by “quantitative easing” is the world of housing finance.  Both the $10 trillion of residential mortgages and the “too be announced” or TBA market for hedging future interest rate risk rank among the largest asset classes in the world after US Treasury debt. Normally, when interest rates start to rise, investors and lenders hedge their rate exposure to mortgages and mortgage-backed securities (MBS) by selling Treasury paper and fixed rate swaps, thereby pushing bond yields higher.

An essay on this very subject was published by Malz, Schaumburg et al in a blog post for the Federal Reserve Bank of New York in March 2014 (“Convexity Event Risks in a Rising Interest Rate Environment”).  Since then, the size of the Fed’s portfolio has grown a bit, and volatility has dropped steadily. The key characteristic to note is that the Fed owns most of the recent vintage, lower coupon MBS that would normally be hedged by private investors and banks. For those of you who follow our work, this argument tracks that of our colleague Alan Boyce, who has long warned about the hidden duration risk in the bond market since the start of QE.  The FRBNY post summarizes the situation nicely:

“When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.”    

Since the Fed and other sovereign holders of MBS do not hedge their positions against duration risk, the selling pressure that would normally push up yields on mortgage paper and longer-dated Treasury bonds has been muted.  Thus the Treasury yield curve is flattening as the FOMC pushes short-term rates higher because longer-dated Treasury paper, interest rate swaps or TBA contracts are not being sold, either in terms of cash sales by the FOMC or hedging activity.  Chart 1 shows 2s to 10s in the Treasury bond market from FRED.

Source: FRED 

More, the volatility normally associated with a rising interest rate environment has also been constrained because the Fed’s $4 trillion plus portfolio of Treasuries and MBS is entirely passive.  As the FOMC ends purchases of Treasuries and MBS, and indeed begin to sell down the portfolio, presumably the need to hedge by private investors and financial institutions will push long-term rates up and with it volatility.  As Malz notes, “the biggest change [between 2005 and 2013] is the increase in Federal Reserve holdings, partly offset by a large reduction in the actively hedged GSE portfolio.”  Yet since the modest selloff in 2013, volatility in the Treasury market has continued to fall.

While it is clear that some smart people at the FRBNY understand the duration dilemma, it is not clear that the Fed staff in Washington and particularly the members of the Board of Governors get the joke.  Unless you believe that the FOMC is intentionally pursuing a flat yield curve as a matter of policy, it seems reasonable to assume that the folks in Washington do not understand that reducing the size of the System portfolio is a necessary condition for normalizing the price of credit.

George Selgin at Cato Institute wrote an important post this week talking about Chair Janet Yellen’s defense of paying interest on excess reserves (IOER) held by banks at the Fed (“Yellen’s Defense of Interest on Reserves”). Selgin’s analysis raises a couple of important issues.

The fact that Yellen and the FOMC will not manage IOER at or below the market rate for Fed Funds is quite telling, particularly since doing so would address many of the key criticisms of the policy. This suggests two things, first that there really is no “free” trading in Fed Funds anyway and the Fed is the market. Second that the FOMC somehow thinks that it must push higher the bottom of the band — this despite the huge net short duration position of the street and the $4 trillion passive Fed portfolio.

The more urgent question is Yellen’s view of a trade off between QE/open market operations and IOER that Selgin illustrates very nicely. The FOMC seems to think that merely not growing the portfolio or slowly selling is an option while they raise benchmark rates like IOER and Fed Funds. In fact, reducing the portfolio always was the first task, before changing benchmark rates. Especially if one is cognizant of current market conditions.

Unless the FOMC changes its approach to managing its $4 trillion securities portfolio, either through outright sales or active hedging, it seems likely that the Treasury yield curve will invert by Q1 ’18.  The Fed could sell the entire system portfolio and the street would probably still be short duration due to low rates and continued QE purchases by ECB, BOJ, etc. And to repeat once again, the agency mortgage securities market is down 30% on issuance YOY. Again, the FOMC does not seem to appreciate that the yield curve must invert, unless the bond trading desk at the FRBNY is actively selling and/or hedging all of the MBS and even longer dated Treasury paper.   

Some analysts such as Ed Hyman (Barron’s, “A Smooth Exit Seen for Mortgage Securities,” 11/20/17) believe that banks will increase purchases of agency paper as the Fed unwinds QE. We beg to differ.  Bank holdings of MBS as a percentage of total assets has barely moved in years.  But more to the point, one has to wonder if Yellen and other members of the FOMC appreciate the trap that has been created for holders of late vintage MBS.

 The Fed has suppressed both interest rates and volatility via QE, as shown in Chart 2 below:

Source: Bloomberg

As and when the balance between buyers and sellers in the MBS market slips into net supply, volatility will explode on the upside and the considerable duration extension risk hidden inside current coupon Fannie, Freddie and Ginnie Mae MBS could prove problematic for the banking industry. 

“The duration extension risk goes turbo if we see rates up, volatility up and a curve steepening,” notes Boyce.  Or as Malz noted succinctly in 2014:

“When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.”

Let me add color to Whalen’s interesting article.

First, here is a chart of Fannie Mae 3.0% 30 year TBA OAS duration compared to the 10-year Treasury yield and Freddie’s 30-year mortgage survey rate. You get the general idea of what will happen to Agency MBS duration when rates really begin rising.


Second, The Fed has suppressed Treasury volatility with its massive QE program along with the 10-year low Fed Funds policy.


Third, The Fed’s super low interest rate policy has left investors in the perilous left-hand side of the bond/MBS price-to-yield curve.


Fourth, The Fed finally began their long-anticipated balance sheet unwind this week, although it was barely noticeable (only 0.27). 


Here is a video of The Fed trying to unwinds its $4.4 TRILLION balance sheet.

Let’s see what happens when The Fed starts unwinding for real instead of just raising the target rate.


Good luck GMU finance students on your final exam! Just play Ten Years After “I’m Going Home” to calm your jangled nerves. 

Coincidentally, Fed Chair Janet Yellen is going home as soon as Powell is sworn in as Federal Reserve Chair.

Janet Yellen

VIX Flash Crash & Rebound, TYVIX 10Y T-Vol Hits All-time Low

‘Twas the day after Thanksgiving …

The stock market volatiity index VIX had a flash crash and a prompt rebound.


And the US Treasury 10-year note volatility index just hit its all-time low.


I think I am going to have a turkey leg wrapped in bacon (aka, A Swanson) for dinner tonight.