Central bank expansionism

A keynote talk at the FGV EPGE (Brazilian School of Economics and Finance) 60th anniversary conference, program here. Direct link to my talk here (YouTube).  (I start at about 4:00 if you're impatient). I plan to turn these thoughts in to an essay at some point. All the conference videos here 

The theme: Central banks, and especially the US Fed, are spinning out of control. I trace the history of this expansion, and how little steps taken here and there mushroomed. The decision in 2008 to regulate assets rather than pursue equity-financed banking, and buying huge amounts of assets, are small steps that mushroomed. They are the moment that central banks became the proverbial two year old with a hammer. The end, the natural meaning of "whole of government" approaches, must be the end of central bank independence and their complete politicization. 

Portfolio podcast

I did a Rational Reminder podcast and video, focusing on portfolio theory, but also a tour through asset pricing. My hosts Benjamin Felix and Cameron Passmore were unusually well prepared and asked great questions! Video below, or go here for video, podcast, and transcript for people (like me) who read more than listen.

FiveThirtyEight p-hacking

 A correspondent sends me the lovely FiveThirtyEight site,  on how to p-hack your way to scientific glory.  

Should I be proud or ashamed that it only took me 30 seconds to get a 1% p value? I fault it though for much too modest an effort, compared to many papers I have read. Include judges, mayors, state legislators. Measure  performance with levels, growth rates, unemployment, inequality, demographic breakdowns, house prices, health measures, investment, exports and more. Control for far more than recessions -- exchange rates, or all the other outcome measures. Let each variable take its turn on right and left hand sides. Instruments... 

Have fun

Interest rate survey

Torsten Slok passed on a lovely graph, created from the Philadelphia Fed survey of professional forecasters: 

It's not just the Fed, whose own forecasts and dot plots have the same characteristics. 

Some potential lessons

1) Just you wait. There is the story of the hypochondriac, who when he died at 92 had inscribed on his tombstone "See, I told you I was sick." More serious stories have been told of the 1980s high interest rates, worried for a decade about inflation that could have come but never did. Or the famous "Peso problem," persistently low forward rates that eventually proved to be right. 

2) A lot of fun is made in survey research about the "irrational" expectations revealed by surveys. Whether "professionals" are involved is often a used to select between "rational" and "noise" investors in asset pricing studies. Hello, the professionals are just as behavioral as the rest of us. As are the Fed economists whose forecasts look the same. The argument from irrational-looking surveys to let the "experts" run and nudge things never did hold water. 

3) Just what do survey forecasts mean? How many of these Wall Street economists, or their trading desks are heavily short 10 year bonds? How many of them lost money on that trade for 20 years running? It's a good bet the same economists work for firms that, to the contrary, have been riding this... well, call it a trend, call it a bubble, call it a golden two decades for long-term bonds. What is the risk premium story for believing long term bonds are about to take a bath, but buying a lot of them anyway? 

4) Just what do survey forecasts mean? We ask people "what do you expect," and scratch our heads that they do not reply with numbers that make sense as true-measure conditional means. The event of a sharp raise in rates might come with substantially higher marginal utility, i.e. a very bad event. Reporting risk-neutral measure, probability times marginal utility might make sense for many reasons. Reporting a 40% quantile, shaded to bad news, makes a lot of sense for many reasons. Clients who make money don't complain. Clients who lose money do.  

5) Just what do survey forecasts mean?  For most surveys, the interesting thing is not the average but the astounding variation around that average. In theory, asset trading should lead to common expectations. In fact it does not. I would love to see the variation around this mean forecast. 

Confessions. I've been ... well, not forecasting, but doom and glooming about a sharp interest rate rise for just as long. And, I have to report, the graph has not yet changed my mind. To some extent, one faces the problem of the value investor, who every time the stock goes down has to say, "now it's an even better deal!" I guess I have company.  See, I told you I was sick? 

ESG catch 22

The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment. It's a form of boycott. The cost of capital is the expected return. If it works, it raises expected returns of disfavored industries, and lowers the expected return of favored ones. 

Yet ESG advocates claim that you do not have to trade return for virtue, that you can even make alpha by ESG investing! 

If that is the case, it means ESG investing does not work! Take your pick. 

Why do ESG advocates care? It seems perfectly normal to say, "Look, this little boycott is going to cost you something but it's worth it to save the planet and other social goals." The problem is, most funds are handled by intermediaries who are not allowed to lose a little money on your behalf in return for their idea of virtue, for the simple reason that it may not be your idea of virtue. A mutual fund marketed this way cannot sell to a pension fund, even if the mutual fund and pension fund managers all agree completely on what environment, social, and governance criteria are valid, because neither knows that the recipients of pension fund money have the same preferences. Our laws and regulations occasionally do make some sense! 

But if you don't lose money on ESG investing, ESG investing doesn't work. Take your pick. 

(HT, thoughts resulting from Jonathan Berk and Jules van Binsbergen's paper on ESG returns.) 

A conversation with Tyler Cowen

Conversation with Tyler podcast interview. Perhaps predictably, the most challenging interview / podcast I've ever done. Video here  and embed below 

Update:

My comments on efficient markets and active management provoked a lot of email. 

I mentioned Jonathan Berk, and should have mentioned his coauthors Rick Green and Jules Van Binsbergen, on how active management can persist even though investors don't make any money on it. The basic idea is really clever:  A manager has 5% alpha skill on $10 milllion, i.e. he can earn $500k, but the skill does not scale. So he earns 5%, charges 1% fee, investors get 4%.  Investors see his great performance and rush in.  Now he has $50 million assets under management. He still earns $500k. He charges 1% fee, and investors get zero alpha. It’s equilibrium – if investors leave,  alpha to investors goes up again, and they return. Investors are earning the same zero alpha they get on the index so why not. And that’s about what we see. Fees persist in equilibrium, fees are equal to alpha on average, alpha post fees are about zero, flows follow performance. The seminal paper is "Mutual Fund Flows and Performance in Rational Markets" Jonathan B. Berk, Richard C. Green  Journal of Political Economy 2004  112 1269-1295 and a series following, here . It's not a perfect theory, but the glass is nearer full than empty, and it's a lovely supply and demand starting place to understand an industry that persists for decades. 

More generally, the average fund earns no alpha, almost guaranteed by free entry. The trouble is distinguishing the good ones from the bad ones, on ex-ante characteristics. The filters used by academics are pretty weak -- past returns, ratings, education of principals etc. On the other hand, now we just move it all up to the meta-game. Picking managers is no different than picking stocks. Skill on skill, alpha on alpha, fees on fees...

Trading halts and game over

David Battan writing in the WSJ brings come clarity to Robin Hood's trading stop.  It raises some questions for me, however. Much of the problem seems to stem from two-day clearing and settlement, and brokers lending people money to trade. Instant settlement and at least separating the lending activity from the trading activity ought to help. The institutions are really stuck with relics of a pre-computer world, it seems. 

OK, first the facts, then speculation, and an invitation for commenters to correct me as I am not a master of these important plumbing issues. 

When clients trade, especially on margin, they use the broker’s money to play. Imagine a client buys 100 shares of GameStop for $400 a share, using $20,000 of his own money and borrowing $20,000 from Robinhood. If the stock drops from $400 to $120 (as it did on Jan. 28), the client’s position may be sold for $12,000 due to the margin violation, leaving Robinhood trying to collect an unsecured $8,000 debt from “u/Thicc_Ladies_PM_Me.” Good luck. Multiply this by hundreds or thousands of similar clients. Option trading is worse because the leverage is much greater. 

"Margin violation" means basically this: 

Long and short of bubbles -- Grumpy podcast with Owen Lamont

The long and short of bubbles. A conversation with Owen Lamont on Gamestop and other matters. See my  last post for background and great papers by Owen. A direct link in case the above embed doesn't work. 

Owen views the current situation more as a classic short squeeze than a replay of 3com/Palm and similar affairs in 1999. These are established companies with short markets, and there is little technological news about them.  We talk a bit about bubbles in general, short sales, supply responses, the puzzling lack of liquidity -- people willing and able to take the other side of crazy stuff, and the state of the market today.  

The review of "Famous First Bubbles" that Owen mentioned is here.  

Gamestop. 1999 déjà vu all over again?

In case you haven't noticed, Gamestop and a few similar stocks are in a classic bubble. At least it was at 8 AM pacific when I read the print WSJ, possibly not at 9:30 AM as I write. What's going on?

It's not the only time. This sort of thing has happened over and over again through history, most recently in the late 1990s. It's too easy to just say "people are dumb," and move on. That can explain everything. Instead, we can and should as always look at a repeated phenomenon like this and try to understand how the rules of the game are producing a weird outcome, despite pretty smart players. 

The best and most prescient analysis I know are Owen Lamont's "Go Down Fighting: Short Sellers vs. Firms," (last working paper, ungated here) Owen's classic paper with Dick Thaler, Can the Market Add and Subtract? Mispricing in Tech Stock Carve‐outs and of course my "Stocks as money" which offered (I think) a different and more cohesive view of the Add and Subtract event, and extended it to other situations.

There are four essential characteristics of these events, along with a few corollaries spelled out in my paper:  

1. Securities are overpriced. 
2. Trading volume is enormous. There is a big demand for short-term trading. There is some fundamental news and a lot of talk about the stock.  
3. There are constraints on short sales, limiting the ability to take a long-term bet on the downside.
4. There are constraints on the supply of shares,  among them the same short sale constraints. 

The first is obvious. The second through fourth however sharply limit our view of what is going on. Simple irrationality, people get attached to a stock, can explain overpricing, but not mad turnover, why they would sell it a day later. 

Portfolios for long-term investors

Portfolios for long-term investors is an essay that extends a keynote talk I will give Thursday Jan 21 at the NBER "New Developments in Long-Term Asset Management" zoom conference. The link takes you to my webpage with pdf of the essay and the slides for the talk. I'll blog the next draft of the essay, as I want to do it once and I'm sure I'll get lots of comments. 

The conference program is here. You can listen to the conference on YouTube here.  I'm on Thursday 12:30 ET, but many of the other papers look a lot more interesting than mine! 

Abstract: 

How should long-term investors form portfolios in our time-varying, multifactor and friction-filled world? Two conceptual frameworks may help: looking directly at the stream of payments that a portfolio and payout policy can produce, and including a general equilibrium view of the markets’ economic purpose, and the nature of investors’ differences. These perspectives can rationalize some of investors’ behaviors, suggest substantial revisions to standard portfolio theory, and help us to apply portfolio theory in a way that is practically useful for investors. 

Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 

"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”

Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired, or decide (Wal-Mart) to sue you for prescriptions you are legally required to fill. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

CBDC in EU

I wrote an oped for Il Sole 24 Ore on central bank digital currency, as part of a series they are doing. It's here in their premium edition (gated) here on their blog, in Italian on top and English below. Thanks much to Luciano Somoza and Tammaro Terracciano for translation and inspiring the project.

THE DIGITAL EURO IS A THREAT TO BANKS AND GOVERNMENTS. AND THAT’S OK. 

A central bank digital currency (CBDC) is in principle a very good idea. It offers the possibility of very low-cost transactions to households and businesses, especially in securities and international transactions. More excitingly, CBDC offers us a foundation for an efficient and nimble financial system that is completely insulated from recurrent crises. 

But CBDC poses a puzzle, as it undercuts many of governments’ and central banks other questionable objectives. Central banks want to prop up conventional banks, who benefit from taking deposits. And governments are unlikely to want to allow the anonymity that is the great attribute of physical cash. 

One vision for CBDC basically gives everyone access to bank reserves. Reserves are interest-paying accounts that banks hold at the central bank. When bank A wishes to pay bank B, it notifies the central bank, which just changes the numbers in each account on the central bank’s computer. The transaction can be accomplished in milliseconds, and costs basically nothing. Why don’t we have that? We should.

Challenges for central banks.

On October 20, I was graciously invited to give a talk at the  ECB Conference on Monetary Policy: bridging science and practice. 

I survey six challenges facing central banks: 1. Interest rates and inflation; 2. Policy reviews; 3. Financial reform post 2008 4. New challenges to finance post covid; 5. The many risks ahead; 6. Central banks and climate.  

For the whole thing, go here for a pdf. A video of my presentation is here. (The conference website will have all videso soon.) Items 1-5 are mostly interesting for monetary economists, though general readers might find my summary and distillation of the Fed policy review of some interest. 

Here, I post the section on climate change and conclusion, which are the most novel. And if you like the general approach and want to see it applied to the rest of what central banks are up to, that's another advertisement to read the whole talk pdf. 

In the section leading up to this, I describe risks to the financial system from widespread defaults, sovereign defaults, a US debt and currency crisis, another bigger pandemic, war, political chaos, cyber disaster and a few other unpleasant possibilities. But covid has taught us to prepare for the unexpected.  

....Which brings me to a great puzzle. In this context why are the ECB, BoE, BIS, IMF consumed with one and only one “risk”… climate? 

Challenge 6. Climate, Mission creep, and Politicization risk. 

I think this adventure is a dangerous mistake. 

Disclaimer: I do not argue that climate change is fake or unimportant. None of my comments reflect any argument with scientific fact. (I favor a uniform carbon tax in return for essentially no regulation.) 

The question is whether the ECB, other central banks, and international institutions such as the IMF, BIS, and OECD should appoint themselves to take on climate policy, or other important social, environmental or political causes, without a clear mandate to do so from politically accountable leaders. 

Moreover, the ECB and others are not just embarking on climate policy in general. They are embarking on the enforcement of one particular set of climate policies — policies to force banks and private companies to de-fund fossil fuel industries, even while alternatives are not available at scale, and to provide subsidized funding to an ill-defined set of “green” projects. 

To be concrete, I quote from Executive Board Member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends

"First, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures…"

Let me speak out loud the unclothed emperor fact: Climate change does not pose any financial risk, at the 1, 5 or even 10 year horizon at which one can conceivably assess the risk to bank assets.

“Risk” means variance, unforeseen events. We know exactly where the climate is going in the next 5 to 10 years. Hurricanes and floods, though influenced by climate change, are well modeled for the next 5 to 10 years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation. 

That banks are risky because of exposure to carbon-emitting companies, that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture, that banks need to be regulated away from that exposure because of risk to the financial system is nonsense. (And if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financial problem.) 

Deflation

 

For another purpose, I had reason to look up TIPS yields. 

The current Treasury Inflation-Protected Security (TIPS) yields are -1.27% (5 years) -0.98% (10 years) and, amazingly, -0.35% (30 years). You pay them 0.35% per year for a stable real value. I did not realize it was this low. 

The context. I serve on the advisory board of a small nonprofit that has an endowment. The endowment is intended to be perpetual. We're discussing the equity vs. fixed income allocation. I wanted to lay out the options. If they want absolute safety of principal and payout, under a perpetual constraint, they can pay out... -0.35% of the principal every year! I advised they accept some risk in the payout stream. 

It is not common for foundations to link the payout rate to the portfolio beta or composition. On economic grounds it should be. If you want a perpetual investment, the payout rate has to relate to the average portfolio return. Fixed income should have a lower payout rate than equity. 

Of course, some payouts are set by IRS rules or by a conflict between managers and donors, and there apparent illogic can serve other purposes.

A little financial-econometric history

The issues that have cropped up in applying present value ideas to government finance, in my last post, caused me to write up a little financial-econometric history, which seems worth passing on to blog readers. The lessons of the 1980s and 1990s are fading with time, and we should avoid having to re-learn such hard-won lessons. (Warning: this post uses mathjax to display equations.)

Faced with a present value relation, say \[ p_{t}=E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}, \] what could be more natural than to model dividends, say as an AR(1), \[ d_{t+1}=\rho_{d}d_{t}+\varepsilon_{t+1}, \] to calculate the model-implied price, \[ E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}=\frac{\beta\rho_{d}}{1-\beta\rho_{d} }d_{t}, \] and to compare the result to \(p_{t}\)? The result is a disaster -- prices do not move one for one with dividends, and they move all over the place with no discernible movement in expected dividends.

Rethinking production under uncertainty

Even at my age, I get a little tingle when a paper is finally published. "Rethinking production under uncertainty" is now out at RAPS (free access for a while) and on my website.

The basic idea is simple.

Our standard way of writing production technologies under uncertainty tacks a shock on to an intertemporal technology.  We might write \[ y(s) = \varepsilon (s) f(k) \] where  \(k\) is capital invested at time 0, \(s\) indexes the state of nature (rain or shine) \(y(s)\) is output in state \(s\). That production technology does not allow producers to transform output across states at time 1. No matter high the contingent claim pricer for rain vs. shine, the producer can't make more in the rain state at the expense of making less in the shine state.

This is the production set of a farmer, say, with initial wheat that can be eaten providing \(y(0)\) or planted to give \( \{y(h), y(l)\} \) in states \( h, l\).

As a result, marginal rates of transformation are not defined, and you can't write a true production-based asset pricing model, based on marginal rate of transformation = contingent claim price ratio.

So, why don't we write down technologies that do allow producers to transform output across states as well as dates? Our farmer could plant wheat in a field that does better in rainy weather than shiny weather, for example. (You can feel an aggregation theory coming.)  The result is a smooth production technology,

The fire in Treasurys

Just where was the fire that caused the Federal Reserve to buy $1.3 trillion of treasury debt in a month -- financing all treasury sales and then some? I've been puzzling about this question in a few posts, most recently here. Commenter "unknown" impolitely but usefully points me to a nice paper by Andreas Schrimpf, Hyun Song Shin and Vladyslav Sushko that explains some market mechanics. I am still not persuaded that these gyrations motivate or justify the Fed buying these or more trillions of debt, but there is an interesting story here.

Treasury yields

Their first graph shows stock prices and bond yields. As risk and risk aversion rose, as they always do in bad times, stock prices fell and bond prices rose, with yields falling.

Trouble starts on  9 March when "the market experienced a snapback in yields" Look hard at the graph. The blue line rises a bit while the red line continues to fall.

OK, but still -- is it a disaster that the US treasury, that had been borrowing happily at 1.8% in January, must borrow at 0.8-1.2% in March? Is it such a disaster that the Fed must buy all new issues of debt?

"Arbitrage" redux

What caused the "snapback?" here is where the paper gets interesting. Basically a bunch of hedge funds replayed an age-old strategy and got caught. Plus ça change. They bought treasury bonds and simultaneously sold them in futures markets. Since treasury bonds are great collateral they can lever up a small price difference to make a lot with little investment.

But even arbitrage opportunities are not risk free.** Prices that are slightly off can get further off before they eventually converge. And then the hedge funds need to post margin, which they don't have. So, they follow the mother of all financial fallacies -- risk management that consists of selling  positions on the way down, trying to synthesize a put option with a stop loss order. But selling to who? Everyone else is doing the same thing, markets get illiquid in times of stress (no, they've never done that before), so the price difference widens even more.

Treasury Liquidity

So just what was the "disruption" in the Treasury market that so spooked the Fed, that now the Fed is buying more than the Treasury is selling?

A commenter on my last post on corporate bonds points to Treasury Market Liquidity during the COVID-19 Crisis by Michael Fleming and Francisco Ruela at the NY Fed, April 17 .

Michael and Francisco nicely show us the facts. They make no editorial comment at all, except perhaps in the figure titles, so my questions about just how big a problem this is are not directed at them.

Bid-ask spreads widened, to financial crisis levels (when the Fed did not, by the way, intervene.) The plot is hard to read in the far right end in order to compare to 2008. (Suggestion to the authors: focus on the last three months so we can see what was happening, not on the comparison to 2008.) As far as I can make it out, the 5 year spread widened form 0.25 /32 to about 0.4 /32; the 10 year from 0.5 to 1.0 and the 30-year from 1 to 5.

If I read the caption correctly, each of these numbers is 1/32 of one percent of par, 0.03%, so the 5 year spread went from 0.008% to 0.012% and even the 30 year went from 0.03% to 0.16%.

The "order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices" (my emphasis) declined. There is usually a lot more for sale if you're willing to pay more.

The difficulty of trading includes not just the bid ask spread, but a guesstimate of how much you will depress prices if you sell $100 million in a huge hurry. This price impact went up. But, it is measured as "slope coefficients from ...regressions of one-minute price changes on one-minute net order flow." How bad is it to wait a whole minute to sell $100 million? Also, most traders use fairly complex strategies to minimize price impact. And there is lots to complain about in this measure of price impact. (I prefer autocorrelation measures -- how much did the price bounce back.)

And the absolute value looks to a layperson remarkably small. 7/32 = 0.22%, two tenths of a percent, on the 5 year bond. OK, 0.75% on a 30 year bond which is almost real money. But 30 year bonds are pretty volatile anyway as we'll see in a moment.

Price volatility jumped, especially (actually almost entirely)  for the 30 year bond. The 30 year bond was experiencing 70% annualized volatility, which is 4.4% per day. That puts some of these spread and price impact measures into context. They are orders of magnitude smaller than the daily price volatility.

This is not unique to the Treasury market.  Stock price volatility went through the roof too by the way. Here's the VIX, peaking at 80. The Fed has not yet seen fit to buy stocks, and let us hope it does not do so.

Throughout all these numbers, the steady march from 1, 5, 10, to 30 year bonds is instructive. Longer bonds are more volatile always. "Liquidity" is usually confined to the shorter maturities.

Trading volume was high too. Again you have to squint to see it.

... daily trading volume in the market overall reached a record high for the week ending March 4, averaging over $1 trillion, roughly twice its post-crisis average

What does it all add up to? 

A trillion dollars a week is a lot of buying and selling. What's "disruptive" or dysfunctional about that? This isn't Costco, whose trading volume in toilet paper went to zero after it sold out.

To me, there is a sense of utterly normal in all of this. Supply curves slope up, of everything, including "liquidity."

Obviously, we hit a period of huge uncertainty, divergence of opinion, and liquidity needs. The fundamental, rational, normal, functional, whatever you want to call it, price will be quite volatile, as was the stock price. The fundamental, rational, normal, whatever you want to call it desire to trade will rise as well.

So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price.

Dealers who buy and have to hold securities in inventory for a day or two are more exposed to risk when prices are more volatile, so they buy less other things constant. Bid ask spreads and price impact rise to give them a higher profit, commensurate with that risk. In a time of volatility, there is more asymmetric information, so dealers charge a higher bid-ask spread. This may sound like less of a problem for Treasuries, but there is short term information about future order flows and future Federal reserve actions and even interest rates given the huge macro uncertainty. And the price volatility may be both a sign of trading demand and an inducement to it. If you can spot the direction, there is a lot more money to be made.

Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers. (I wrote a paper a long time ago called "stocks as money," documenting a similar case of demand for trading)

Where is the evidence that something is wrong with supply, that there is also a shift in the supply curve?

Michael and Francisco wryly note the same point:

High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market turmoil around the near-failure of Long-Term Capital Management (see this paper) and during the 2007-09 financial crisis (see this paper). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand. 

also

Not surprisingly, volatility caused market makers to widen their bid-ask spreads and post less depth at any given price, and the price impact of trades to increase, illustrating the well-known relationship between volatility and liquidity. 

So just where is the fire here? Where is the screaming hole in financial markets that justifies the Fed buying $1.3 trillion treasury securities in a month?

Even if "intermediation" were the problem, why is buying up the whole supply the answer, not both buying and selling, to reduce bid-ask spreads?

The Fed announced:

To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion.

How does buying it all up promote the "smooth functioning" of markets?  Is there anything more than
"because of (big financial gobbledygook which you wouldn't understand anyway so it doesn't matter if it makes any sense) we're going to buy a trillion dollars of treasurys?"

Finally, if absolute liquidity in Treasury markets is so important, if the ability to transact at 0.01% or less loss, in minutes, is a crucial social problem, then why not talk about some fundamental reforms to those markets?

As described in this post, roughly half of Treasury securities trading occurs through interdealer brokers (IDBs), in which dealers and other professional traders transact with one another, and roughly half between dealers and clients. Our focus is on the IDB market, and on the electronic IDB market in particular, which accounts for about 87 percent of IDB trading. 

Wider trading would make a lot of sense. Federal debt is carved up into 250 different securities or more. As I argued here, if you want them liquid, rearranging federal debt to only a few securities would make each one more liquid. If "balance sheet space," i.e. inadequate equity financing and regulatory risk-taking constraints, are stopping those with expertise in market making from making more markets, why in heaven's name after 12 years of Dodd-Frank act, capital requirements, essays on equity-financed banking, Volker rule and the rest, don't broker dealers have enough equity capital to let them trade through the covid-19 virus on top of a new cholera pandemic and a war? "Constrained balance sheets" are not a fact of nature, they are the product of 12 years of regulatory failure.

 There is a tendency throughout economics to write, "here is my policy," then "here are the problems that motivate my policy." But if you look at the problems, a lot of other policies would solve them better. Economics is too often answers in search of questions.

So, bottom line, I'm still looking for evidence. I'm willing to give the Fed the benefit of the doubt. All the people I know at the Fed are smart and well-intentioned looking at a lot more data than I am. Just what is it that motivates buying a trillion dollars of treasury debt, and more trillions to come?

Bond liquidity

When the Fed stepped in, were corporate bonds "illiquid," the market "dysfunctional," or were the prices just low, as they should be in advance of a Great Recession with larger bankruptcy risk? Did the Fed "liquefy" the market, "intermediate," grease the wheels, or is it just buying, and propping up prices so that bondholders can dump bonds on the Fed before things get really bad?

I asked for evidence on bond market liquidity in my last post on the topic, "Bailout redux," and Pierre-Olivier Weill passed on a paper he has recently written with Mahyar Kargar, Benjamin Lester, David Lindsay, Shuo Liu, and Diego Zúñiga, Corporate Bond Liquidity During the COVID-19 Crisis.

Here is their estimate of roundtrip trading costs -- if you buy and then sell, how much do you lose in bid ask spread. Feb 19 is the stock market peak.  March 18 is the day after the Fed announced it would lend money to broker-dealers and take bonds such as these as collateral. March 23 the Fed announced it would buy corporate bonds on the secondary market, and buy directly from companies issuing new corporate bonds.

Forbearance

Peter Wallison has a worthy OpEd in the WSJ, "Forbearance." Continuing my earlier thoughts on the financial response here and here, I don't think he goes far enough.

Let me tell a little story. Andy runs a restaurant. To run the restaurant, and live, he has a mortgage, he rents the restaurant space, and he borrowed money to buy to buy the equipment. Bob is retired. While he was working he lent Andy the money to buy the house and the restaurant equipment, and he owns the building. He lives off the income from these investments.

The virus comes and Andy has no income. He has enough savings to buy food for a while, and other current expenses. But he can't pay rent, mortgage, and debt payments. This is the central problem our government faces right now.

One answer: The federal government prints money and lends it to Andy so he can keep paying Bob. You can see a major problem here. Andy has no income. Eventually the restaurant may reopen, but then from the same profit stream Andy has to keep paying Bob and also pay back the loan that kept things going in the lockdown. Hmm.