Yesterday was another boring day, with no Fed purchases. Some analysts suggested that the sell-off in Treasuries was driven by hedging of the latest State of California issue. In my letter of April 20th, I had proposed this thesis to explain the sell-off after 12pm on Friday. But I thought it had been related to GSE debt ($5.66BN, mostly in the 7+ years). The State of California issued a total of $6.855BN (A2/A/A, between 4 and 30 years, paying approx. T+365bps). I think this issuance offers a better explanation for the action on Friday.
Yesterday’s action was range-bound, without major announcements. Given the lack of major news in either Treasuries or Agency debt, I fear stocks (but surely not oil!) traded on fundamentals yesterday! The S&P500 managed to reach 860 intraday, after the announcement of the 0.7% rise in home prices in February (ignoring Morgan Stanley’s $578MM loss in Q109) but finished lower (843.55pts, -0.77%) on GM’s news that it will not make a scheduled $1BN debt payment in June. CDX IG12 tightened 4bp, to 185bps.

In previous letters, I made reference to recent unconventional central bank policies. Given the feedback and requests for more details on this subject, I thought it would merit further elaboration, given how slow and boring the markets were yesterday. As the inflationary process unfolds, this subject will gain more attention, which makes understanding it worthwhile.
On April 21st, markets sold off after Mr. Trichet said that a zero-rate policy was not appropriate for the Euro area. In yesterday’s letter, I wrote the Canadian dollar regained what it had lost after the 25bps overnight rate reduction, helped by a lending transaction (C$226MM in Govt. bonds and T-bills) by the Bank of Canada. I further said that the Bank of Canada had “…a balance sheet in shape to control its liabilities…”. What does this all mean? When a Central Bank (CB) engages in quantitative easing, essentially the following takes place (with nuances, which are particular to each bank):

• The CB buys private sector (distressed) securities from financial institutions. These securities become an asset of the CB.
• The CB credits the Reserve account of the institutions. Reserves are a liability of the CB and an asset of the institutions.

Financial institutions do NOT get “cash”. The obtained liquidity is deposited in their Reserves account. Financial institutions only see a change in the composition of their assets; if the transaction is done at the value they were carrying the securities in their books (i.e. case shown above, for simplicity). If the transaction is not done at that value, these institutions have a gain or a loss. It is critical to understand that financial institutions, COLLECTIVELY, do not manage their Reserves level. This level is managed by the CB. To profit from increased reserves, each financial institution in particular, can either issue loans or offer reserves to other institutions that may need them. But in this recession, lending is almost non-existent. Thus, without new loans, the excess of reserves brings the CB overnight rate to zero. What is the overnight rate? The rate at which financial institutions lend each other money for one day (overnight). This rate is pushed to zero under quantitative easing.

1. Why did Trichet say this may this not be appropriate? Firstly, because a zero-rate hurts the profitability of institutions. The level of liabilities remains unchanged and the institutions keep paying interest on them. Meanwhile, these institutions now receive a zero spread on what previously paid a positive spread. Secondly, this policy creates a huge distortion in the money markets (Not elaborated here, for simplicity). Conclusion 1: Trichet questioning a zero-rate = No quantitative easing = ECB may not buy distressed assets = Distressed assets will remain in banks’ balance sheets = Banks’ shares are sold off = Markets go down 4%.
2. Why do CBs that engage in quantitative easing lose freedom to manage their liabilities? As the resulting excess of reserves was not driven by market prices, but by direct policy, it is now difficult to reduce reserves with changes in the overnight rate! A solution would have the CBs sell assets (sterilization). But it would not make sense for CBs to sell the securities they just bought: They are worthless. What else can CBs sell? Government debt! But if CBs sell government debt, its price goes down (yields go up), hurting the governments’ financing plans for increasing deficits! (That’s why, the Fed stopped caring long ago!! It does not sterilize reserves growth.) Conclusion 2: Bank of Canada lending C$226MM in govt. debt = No deficit monetization expected in the short term = Strong Canadian dollar.