2 Questions

[Wonkish1]

These are some questions that I don't feel that I have definitively answered with a large degree of confidence, but have developed some well thought out theories on what I think may happen.

1) What happens when the Fed increases the FFR?
2) What happens when people no longer perceive the need to hold safe haven assets?


1) I feel the likely answer is nothing. Most people operate under the assumption that the FFR sets base interest rates, and that is a false assumption. Instead the FFR only determines the cap for base interest rates. The reason is because if I as a bank can borrow cheaper from the Fed than I can from depositors than I'll choose to set my deposit rate at the same amount as the FFR and borrow from the Fed for any additional need for liquidity. If instead I can borrow cheaper from my depositors than from the Fed than I will just rely upon my depositors and not touch Fed money.

The reason why I think interest rates wont really budge is because as a bank I'm already awash in liquidity and so are all of my competitors. I have more liquidity than I could want and would actually prefer not to pay interest on liquidity I don't need because I have limited capital to engage in operations. So it's my contention that the Fed could raise the FFR to 10% tomorrow and besides the shock of the announcement its likely going to have zero material impact on my ability as a bank to get cheap liquidity. The only thing a higher FFR will do is allow  base interest rates to rise eventually, but that will only happen when the large cash reserves of banks are deployed into the system and all of sudden banks actually need more liquidity.

What is interesting is that after those cash reserves are deployed this can produce an 'anti Volcker' moment where the FFR is 5%, 10%, 15%, etc. and inflation is running high yet deposit rates are very, very low. Now of course this will result in a lot of cash being yanked out of deposit institutions because of the very high negative real interest rate, but they will find limited places to put it and much of those deposits will end up coming back on deposit again. It will create a situation where the greenback becomes 'hot' and the velocity of money explodes because no one wants to hold money in an institution for long. Scary situation.


But in order for those cash reserves to exit the Fed and enter into the system bank capital has to rise or capital ratios have to fall. But that creates another tough question that I can't seem to answer. In a near rock bottom interest rate environment in the future where are banks going to get the growth on capital necessary to allow those reserves to flow out? Banks really only get huge increases in capital when they find another treasure trove of debt capacity somewhere they can lend out to. Where in the world are banks going to find a treasure trove of debt capacity? I really have no idea how to answer this one and for this reason I find this event unlikely to happen for a while.

2) This one I also think is pretty interesting and actually quite scary. Where are the safe haven assets in the world? Well you have US treasuries, the yen and indirectly the JGB, German Bunds, Swiss Government Bonds, Canadian deposit accounts and the Canadian treasuries, and potentially to a lesser extent(mostly because of the Euro) OATs(France). Now if people stop demanding safe haven assets and start demanding risk assets then what happens here?

The Swiss will be fine. Germany will be fine. But what about a country like Japan? If the demand at all for the JGB falls causing an increase in yield, large losses occur very quickly on holders of the JGB which can produce more selling. Rather quickly the Japanese have a sovereign debt crisis on their hands which in turn will harm world markets which in turn drives money right back into safe haven assets. See it's interesting we may find ourselves in a catch 22. As soon as we experience any movement out of safe haven assets it's likely that one of these safe havens will have a problem causing money to move back into safe haven assets minus them.

[opebo]

Which is another way of saying there is only one safest haven, Wonk = US Treasuries.