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No one is indestructible

As a result of the unprecedented global pandemic, the US government bond market, traditionally perceived as a bastion of stability, has undergone a fundamental change. On March 12, 2020, the world of US government bonds was suddenly thrown into chaos. Primary dealers, the mainstays of the US government bond market, were overwhelmed by the huge volume of selling. As a result, the spread between the supply and demand for government bonds widened, making it increasingly difficult to determine their fair price. The Fed responded to this crisis by taking extraordinary measures and offered massive financing to dealers and initiated a nearly trillion-dollar Treasury bond purchase in just three weeks. That was the action that triggered the chaos we are living today.

In order to avoid the turmoil of March 2020 and September 2022 in the future, when there were fluctuations and liquidity problems in the British government bond market, the US Treasury has prepared a buyback program for 2024. The so-called Bloomberg's US Government Securities Liquidity Index, which measures market liquidity, remained elevated and its level is reminiscent of the crisis situations of March 2020 and the turn of September and October 2022.

US Government Bond Index

Another indicator of the risk of an unexpected reduction in market depth is the average daily turnover in the US Treasury market as a percentage of total outstanding US Treasury securities. This gradually decreased from more than 12% to the current roughly 3%.

Average daily turnover as a % of outstanding government bonds

The Federal Reserve System routinely talks about its dual mandate of achieving maximum employment and maintaining stable prices, but it also plays a key, if less publicized, role defined in Section 2A of the Federal Reserve Act: The Fed is tasked with fulfilling three objectives using one policy tool – maintaining monetary and credit growth in line with the economy's potential.

In the past, this mainly meant purchases of government bonds in order to strengthen bank reserves in times of withdrawal. However, after 2008 quantitative easing came and the focus shifted to sufficient reserves and interest payments on reserves, culminating in the abolition of minimum reserve requirements in 2020. See this Saxo article for more detailed analysis. This leads to a substantive question: Can the Federal Reserve continue to act without constraints while primary dealers are bound by these capital constraints? In the first half of 2023, the Fed reported interest income of $88.4 billion, but also incurred interest expense of $141.8 billion. After accounting for $4.4 billion in operating costs, the Fed posted a staggering $57.4 billion loss. Interest-bearing assets consisted mainly of $5.5 trillion in government bonds, yielding 1.96%, and $2.7 trillion in mortgage-backed securities, yielding 2.20%. At the same time, the Fed paid out about 4.9% of the $3 trillion in bank reserve balances and 4.8% of the $2.4 trillion in repurchase agreements. The Fed's capital balance was just $42.4 billion. The above six-month losses could easily deprive the Fed of all its capital. However, the Fed accounted for the cumulative losses differently, labeling them as deferred receivables under the heading "revenue transfer for the Treasury." At the same time, there was a remarkable increase in this deferred receivable. As of December 31, 2022, it was USD 16.6 billion, by June 30, 2023 it was already USD 74.7 billion, and on September 13, 2023, it was an amazing USD 100.1 billion. Under this transfer policy, the Federal Reserve System remits to the U.S. Treasury all net income after deduction of expenses and 6% dividends to commercial banks that are members of one of the 12 district Federal Reserve Banks. If his income is insufficient to cover these costs, no transfer will take place until the income exceeds this deficit. Accumulated losses are recorded as assets because they represent a reduction in future liabilities to the Treasury.

Commercial banks that are members of district Federal Reserve banks are required by law to contribute funds equal to 6% of their capital plus surplus, of which 3% is paid in advance and the remaining 3% as required by the appropriate Federal Reserve Bank. In the event that a district Federal Reserve Bank faces a capital shortfall, it is authorized to require its member banks to repay 3% outstanding and an additional 6% of their capital and surplus to remedy the situation. Investors in the banking sector often overlook this risk. As of June 30, 2023, the Federal Reserve's System Open Market Account (SOMA) portfolio contained unrealized losses with a market value of $1.1 trillion. These losses occurred at yields of 4.15% on five-year and 3.84% on ten-year government bonds. These yields subsequently increased to 4.46% and 4.3%. Meanwhile, roughly 47% of the Federal Reserve's SOMA portfolio has maturities greater than five years, so market valuation losses may well exceed the initial estimate of $1.1 trillion. If yields on long-term bonds continue to rise, as the Fed continues to raise rates or more government bonds are issued, the market valuation of the Fed's unrealized losses may increase further.

One such significant incentive concerns the Fed's role in ensuring the proper functioning of the government bond market. The extent of this role is debatable, but it is clear that when a crisis strikes, such as in March 2020, the Fed will intervene. They must also take into account the need to prevent further accumulation of losses. Addressing unrealized losses at market valuation and restoring the soundness of SOMA's portfolio are critical. This has a clear incentive to lower short-term interest rates, so short-term yields can fall faster than long-term yields, which can have a major impact on markets.

In such a dynamic environment, there is a significant likelihood that short-term interest rates will be cut in the US. Be prepared for short-term yields to fall faster than long-term yields, and consider going long at the front end of the Treasury curve. It is also possible that the Federal Reserve will stop paying interest on reserves. This would save billions in interest costs. In such a case, however, it is necessary to take into account the possible re-introduction of mandatory minimum reserves. Their restoration would be necessary to regain control over the base interest rate. However, this would represent a significant departure from the current approach and a return to the pre-2008 regime where the Fed managed interbank liquidity by influencing the availability of excess reserves through open market operations in the form of repos and reverse repos.

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