The Ultimate Insiders' Take on QE2 and Basel 3

This morning, Treasury released the minutes of the Treasury Borrowing Advisory Committee (TBAC). Why these are important, I've written previously:

Each quarter, representatives from the banking elite primary dealers meet with top Treasury officials to advise an optimal debt issuance strategy. The Minutes of these Treasury Borrowing Advisory Committee meetings and formal Report to the Treasury are a window into their perceptions and insider knowledge, yet they seldom receive notice--even outside the mainstream financial news outlets.

The most recent minutes do not disappoint and are filled with insight on what we can expect from QE2 and the new Basel 3 bank regulations. The highlights:

• QE2 is expected to be $130 billion per month, or $1,560 over the next year
• QE2 will last at least six months and up to two years
• The total amount of QE2 will be data dependent
• Treasury is encouraged to increase coupon issuance (especially in the 30 year maturity) to address "liquidity" shortfalls as a result of Fed purchases
• The Treasury yield curve is expected to flatten in the 5-10 year sector, with the yield on the 30 increasing with inflation concerns and US Dollar debasement
• Implications for the mortage market are that mortgage spreads relative to Treasurys may initially widen, but will ultimately narrow. However, as the 30 year yield is expected to climb, so should mortgage rates (as if the housing market needed another blow)
• A comparison of the scope of QE2 to "the entire combined expected net issuance of Treasuries, Agencies, Agency MBS and Investment Grade Corporates" leads us to speculate the Fed may end up purchasing these very instruments
• The Fed's QE2 "exit strategy" may involve simply selling its holdings in small, predictable increments (no mention of term deposits, IOER or other Fed tools)
• As a result of QE2, investors will be edged out of the 2-10 year range and into very short term (T-Bills) and long term (T-Bonds), and into riskier assets in general
• Basel 3 is being implemented at a record pace (beware of unintended consequences)
• Basel 3 will lead to increased lending costs, causing lending to move outside of the regulated banking system into the non-bank financial system
• Basel 3 will force banks to buy sovereigns ($400 in US Treasurys alone by 2015)
• The Fed is the 800 lb gorilla in the room, and all the other central banks are scrambling to adjust

The full minutes are here, but the relevant excerpts follow (boldings, underlines and brackets are ours):

With regard to the average length, several members of the Committee noted that if Treasury continued with its current issuance pattern, the average length would gradually increase from current levels. One member suggested that Treasury should issue significantly more 30-year bonds, despite some metrics that suggest that long-term issuance is expensive (i.e. the spread between 10- and 30-year yields). This member underscored that 30-year rates were near historic lows. Overall, the committee was comfortable with continuing to extend the average maturity of the debt.

The discussion about lengthening the average maturity of the debt led to a discussion about the size of the Treasury bill market. One member noted that bills were near historically low levels as a percent of the portfolio and that further shrinkage would be problematic for the bill market. Another member stated that negative bill rates ultimately benefit Treasury, because reduced bill issuance would most likely result in making longer-dated coupons and bank deposits more attractive to investors. Members agreed that Treasury should monitor the bill market going forward.

At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting. The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities. The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.

It was pointed out by members of the Committee that the Fed and the Treasury are independent institutions, with two different mandates that might sometimes appear to be in conflict. Members agreed that Treasury should adhere to its mandate of assuring the lowest cost of borrowing over time, regardless of the Fed's monetary policy. A couple members noted that the Fed was essentially a "large investor" in Treasuries and that the Fed's behavior was probably transitory [right :)]. As a result, Treasury should not modify its regular and predictable issuance paradigm to accommodate a single large investor.

...

The Committee next turned to the second question in the charge concerning the outlook for non-bank financial institutions in the aftermath of the 2008 financial crisis and the more diminished role played by these entities in the allocation of credit.

The presenting member began with a theoretical discussion of similarities and differences between non-bank and traditional bank financial institutions, noting that both institutions engage in maturity transformation, liquidity transformation, and credit quality transformation. However, it was noted that traditional banks engaging in these activities are subject to regulatory oversight, have deposit insurance, and have access to a lender of last resort. This is not the case for the non-bank financial institutions.

The presenter then discussed the primary changes in "shadow-bank" liabilities versus traditional bank liabilities. The main changes in shadow bank liabilities include a large decline in commercial paper, asset-backed securitizations, and repurchase transactions (repos). On the traditional banking side, the presenter noted that bank liabilities are continuing to grow, particularly small time deposits. [note: the subtle shift from demand for zero maturity to slightly longer is a predecessor of M2 growth] The presenter highlighted that, although shadow banking liabilities have declined, they still exceed traditional bank liabilities.

...

The member concluded by discussing the overall implication of the diminished role of the shadow bank credit allocation on the US Treasury market. The member forecast higher Treasury security holdings as the likely outcome of these changes. This is due to a combination of factors that include high investor demand for cash-like investments, lower supply of alternative products, and regulatory changes like 2a-7 liquidity requirements and the Basel 3 liquidity coverage ratio.

The Committee next turned to the question in the charge regarding the impact of the Basel 3 on financial markets and the Treasury debt market. The presenting member began by noting that Basel 3 is going to impose stricter capital, liquidity, and leverage requirements on regulated financial institutions over the next decade. The benefits of doing so will be a significant reduction in systemic risk to the global banking system [only in your dreams, as risk is shifted to the very central banks themselves].

The presenter stated that Basel 3 is still a work in progress and many details have yet to be decided. That said, Basel 3 is significantly broader in scope and a more complex regulatory undertaking relative to prior Basel accords. It is also being implemented at a faster pace than previous Basel accords and these changes are occurring at a time when global economic activity is slow. Isolating the potential macro-economic and financial market impacts of Basel 3 is made more difficult by the fact that there are a number of other regulatory reforms being considered around the globe [that is an understatement].

The presenter then began discussing the changes in the Basel capital requirements. Capital requirements for banks are expected to rise due to the proposed increases in risk weights for certain asset classes and an overall increase in capital ratios. By some estimates, risk weighted assets are expected to increase by 60 percent. Calibration of the capital requirements going forward is critical to maintaining support for certain credit activities such as securitization and hedging. The presenter suggested that without proper capital calibration, borrowing rates will likely increase under Basel 3, and the inability for banks to hedge credit risk will ultimately reduce the bank's ability to extend credit. Capital calibration may impact such performance metrics like return on equity and the cost of equity for large banks, which in turn, may impact the supply of lendable funds and potentially move some lending activity outside of the regulated banking system into the non-bank financial system [this is huge: there's going to be a shift in consumer and small business lending to non-banks (and yes, your local loan shark will play his part)].

The presenter next focused the discussion on the Basel 3 liquidity ratios. Liquidity ratios are intended to guard against runs on banks' wholesale liabilities. This requirement is expected to be implemented by December 31, 2011. The liquidity coverage ratio is defined as the "stock of high quality assets divided by the projected net cash outflows over a 30 day horizon." High quality assets are defined as cash, sovereign, investment grade corporate and public sector debt, [this is the institutionalization of forced lending to big corporations and sovereign states] while cash outflows include retail deposits, unsecured wholesale funding, secured funding, conduits and contingent liabilities. As proposed in Basel 3, the liquidity requirement may prove to be problematic, particularly with regard to the treatment of deposits and unfunded liabilities. Banks would be required to carry a higher percentage of liquid assets, which would reduce lending capacity and banks' return on assets.

Overall, it was noted that these proposed changes in liquidity requirements could result in higher lending costs, reduced interbank liquidity, diminished ability of banks to hedge credit risk and a reduced ability to provide back-stop facilities for commercial paper. It could also lead to an expansion of the non-bank financial system.

The presenter then discussed the proposed leverage ratios contained in Basel 3. As currently proposed, Basel 3 creates a more conservative leverage standard than currently exists for most US banks, due to a stricter definition of Tier 1 capital in combination with a broader definition of total assets (including off balance sheet derivatives and contingent liabilities). The leverage ratios are expected to be implemented by 2015 and imply further deleveraging by US banks in order to comply with the proposed rule. This requirement would also impact the ability of banks to provide credit lines.

The presenter also noted that Basel 3 will have an impact on Treasury markets by its impact on economic growth and rules governing the ownership of securities and loans. There have been a number of studies on the potential macroeconomic impacts of Basel 3. These estimates indicated that Basel 3 will result in an increase in lending rates of between 20 to 100 basis points in the US, and real GDP growth impacts of -0.1 percent per year to -0.9 percent per year. In terms of Treasury securities, Basel 3 will probably result in banks holding more Treasury and agency securities in their portfolios and fewer loans. There are a range of estimates but one private forecast predicted that Basel 3 liquidity requirements would result in $400 billion of new Treasury security purchases by U.S. commercial banks by 2015.

The Committee finally addressed the fourth question in the charge regarding the implications of a second round of quantitative easing. The member provided a presentation that considered market expectations of QE2 and its impact over the medium- and long-term horizons.

[Back to QE...]

The presenting member stated that the market expects the Federal Reserve to purchase $100 billion per month, as well as $30 billion per month in MBS reinvestments. This will total $1,560 billion in Treasury purchases over the next year. The member stated, however, that market participants believe the Fed will leave the status of QE2 open ended, with purchases ultimately dependent on economic conditions [this is consistent with Brian Sack's remarks that we commented upon on October 4, 2010]. The presenter also noted that the program should last six months to two years.

The presenting member thought that over the medium term (one to two years), QE2 would force Treasury yields lower and would likely lead the curve to flatten in the five- to ten-year sector. Meanwhile, the risk premium in 30-year bonds would likely increase given concerns about inflation and the value of the U.S. dollar [watch for the 10-30 spread and especially the 5-30 spread to become completely unhinged].

The presenter stated that financial markets generally believe that QE2 will push swap spreads wider as the float of U.S. Treasury supply declines. It was also noted that there could be some tightness in the repo market. Credit spreads are also expected to tighten alongside other risk premiums. While mortgages will initially trade wider versus Treasuries, the presenter expected that mortgage spreads should narrow relative to both the Treasury and swap curves [but keep in mind 30 year Treasury yields are expected to climb, so mortgage rates will rise as well]. The presenter further noted that rate volatility will decline as market rates approach zero, with realized volatility in the long-end remaining higher as uncertainty and re-inflation fears increase.

According to the presenting member, liquidity issues could arise as the projected scope of QE2, along with MBS reinvestments, may exceed the entire combined expected net issuance of Treasuries, Agencies, Agency MBS, and Investment Grade Corporates [this could just be to establish a reference point, OR it could be a projection that the Fed will eventually extend QE2 to cover these other securities, including IG CORPORATE DEBT]. The member noted that potential illiquidity in the intermediate sector of the Treasury curve could push some investors into bills, 30-year Treasuries, and/or riskier assets [watch out, M2].

The member noted that the U.S. Treasury and Federal Reserve are two independent [:)], separate institutions with different mandates. As a result, it was noted that Treasury should not alter its issuance strategy [get ready for a complete 180, no sooner than the following sentence]. However, the presenting member suggested that Treasury could address potential illiquidity issues through additional issuance in sectors impacted by QE [as predicted, though there's still the issue of the pesky debt ceiling].

The presenting member then discussed the potential impact on financial markets of the Federal Reserve's exit strategy [presumably still years away] from QE2 [note: the only real exit strategy will come with the end of the Fed itself]. The member noted that there was the potential for an extreme market reaction associated with the Fed's exit from potential purchases. This risk, however, may be mitigated according to the presenter, if the Fed were to gradually and predictably sell the assets on its balance sheet [interestingly, there is no mention of the plethora of new Fed tools designed to soak up excess liquidity].

Finally, the presenting member also stated that the Fed's monetary policy actions had global ramifications. It was noted that the recent depreciation of the U.S. dollar has forced many central banks around the globe to re-calibrate their monetary policy stances [but China is the real currency manipulator].