This book isn’t about central banks, but just the Federal Reserve. I’m sure it’s common knowledge to those who work in finance, but I don’t work in the field so it’s still a great primer on everything you need to know about the Fed and the U.S monetary system.

Main Takeaways

• The types of money are:
  • Fiat currency – government-printed paper money
  • Bank deposits – created by commercial banks
  • Central bank reserves – a special type of money issued by the Federal Reserve that only commercial banks can hold
  • Treasuries – issued by the U.S. government and can be readily convertible to bank deposits by selling them in the market or by using them as collateral for a loan
  • Central bank digital currency – Allows everyone to have an account at the central bank and allow people to hold “central bank reserves”. This would replace both fiat and bank deposits
• The Fed has a dual mandate: full employment and stable prices
  • It thinks of the economy through the lens of interest rates, which is the primary tool through which the Fed achieves its mandate. In the eyes of the Fed, there is a thing called r* (pronounced “r star”), which is the neutral rate of interest at which the economy is neither expanding nor contracting
• Shadow banks are non-commercial bank businesses that engage in banking-like activity
  • Primary dealers – a group of dealers that have the privilege of trading directly with the Federal Reserve. They are the primary conduit for Federal Reserve open market operations when the Fed is conducting quantitative easing by buying Treasuries. In addition to making markets for financial products, dealers also act as financial intermediaries, borrowing from one client to lend to another.
  • Money-market funds – a special type of investment fund that invests only in short-term securities and allows investors to withdraw their money at any time with next-business-day availability
  • Exchange-traded funds – investment funds whose shares are traded on an exchange like a stock. An ETF takes an investor’s money and uses it to purchase assets such as stocks, bonds, or commodity futures
  • Mortgage REITs – investment funds that invest in mortgage-backed securities, usually Agency MBS securities guaranteed by Fannie Mae or Freddie Mac. They are classic shadow banks that take out very short-term loans to invest in very long-term assets.
  • Private investment funds – they take investor money and invest in a broad spectrum of financial assets (e.g. hedge funds, private equity funds)
• Eurodollars are U.S. dollars held outside of the United States. They are called Eurodollars because the first offshore dollars appeared in Europe in 1956
• The offshore dollar banking system is around $10 trillion, as of 2018, which is one-third of the global dollar banking system.
  • Dollars are widely accepted and even preferred to some home currencies. In effect, the Fed is wresting some control of monetary policy away from these other central banks
  • In times of crisis, the Fed has shown a willingness to lend to foreign banks and support the offshore dollar market. During both the 2008 Financial Crisis and the 2020 COVID-19 panic, the Fed became lender of last resort to foreign banks via the FX-swap lines, where the Fed lends dollars to a foreign central bank, who in turn lends to the foreign banks within their jurisdiction.
  • The Fed has in effect become the world’s central bank and ultimate backer of the dollar banking system.
• Interest rates are the building blocks of all asset prices, financial or real
  • The Fed controls short-term interest rates through its control over overnight interest rates.
    • While the Fed determines short-term rates, the market determines longer-term interest rates. When an investor is thinking about lending longer term, they take into account a number of things such as how the Fed will set short-term interest rates in the future, estimates for future inflation, how volatile those estimates are, and future supply and demand dynamics of Treasury debt issuance
• Money markets are markets for short-term loans with maturities that range from overnight to around a year. Money markets are the plumbing of the financial system; they keep the financial system working but are out of sight
  • In secured money markets, a borrower puts up a financial asset as collateral for a short-term loan.
  • In unsecured money markets, a borrower does not put up collateral and borrows on the basis of their creditworthiness
• Capital markets are where borrowers go to borrow from investors rather than from commercial banks.
  • Equity markets – most emotional and least reflective of economic conditions
  • Debt capital markets – where companies or governments borrow money by issuing bonds
  • Corporate bonds – divided into an investment-grade universe (bonds rated BBB-59 and above) and a high-yield universe (bonds rated below BBB-, also known as junk bonds).
  • Agency MBS – mortgage-backed securities guaranteed by the government. Mortgage-backed securities are bonds that receive the cash flow generated by a pool of mortgage loans
  • Treasury securities – issued by the U.S. government in regular auctions in a range of tenors, broadly divided into bills and coupons. Treasury bills are short-term debt that matures within 1 year and is issued on a discount basis, while coupons are issued in tenors that range from 2 years to 30 years and pay interest semi-annually
• Conventional monetary policy relies on the central bank to be the lender of last resort to commercial banks and to use short-term interest rates to influence economic activity. In 2008, the Fed reached the zero lower bound, where the overnight interest rate is 0%, which on its face seemed like a point where monetary policy would become powerless as the Fed could no longer lower interest rates. But the Fed was able to surprise everyone with the introduction of two new tools: forward guidance and quantitative easing.
  • Forward guidance is a way for the Fed to extend its control of interest rates from short-term rates to medium-term rates as well. The Fed would verbally commit to keep its policy rate low for an extended period of time. As long as the market believed in the Fed’s commitment, then even medium-term interest rates should move lower as the market would price out any rate hikes from the present to medium term
  • Quantitative easing is a way for the Fed to control longer-term interest rates by purchasing longer-dated Treasury bonds and thus driving the yields of those bonds lower
  • Yield curve control is when a central bank announces specific numeric targets for its interest rates
• Fed watching
  • FOMC statement – a statement released at the conclusion of each of its meeting. The statement briefly summarizes the FOMC’s view on the state of the economy and the actions the FOMC is taking to achieve its duel mandate
  • FOMC press conference – each FOMC meeting ends with a one-hour press conference starting at 2:30 p.m. EST where the Fed Chair takes questions from the press
  • FOMC minutes – the minutes for each FOMC meeting are released three weeks after the meeting takes place. The minutes offer a glimpse of what information was presented to the FOMC and what they discussed during the meeting
  • FOMC “dot plot” – a set of economic projections released every quarter
  • Fed official speeches – Federal Reserve Bank Presidents and Federal Reserve Board Governors routinely give speeches on how they are thinking about monetary policy
  • Desk operating statements – The Desk releases its operating policies and operating calendar on the Federal Reserve Bank of New York’s website. This information can tell you a bit about how the Fed is thinking about the financial markets
  • Fed balance sheet
  • Fed research – each Federal Reserve Bank has a large staff of PhD economists who regularly publish economic research either in the form of research papers or blog posts
  • Fed surveys – The Federal Reserve Banks and the Board of Governors conduct surveys.

Notes

Types of money

• Bank deposits are a separate type of money that is created by commercial banks. In practice, bank deposits can be seamlessly converted into government-issued fiat currencies in real time at any bank or ATM machine. But the two are very different.
  • A common misconception is that a bank takes in deposits and then lends those deposits out to other people. Rather than lend out deposits, a bank simply creates bank deposits out of thin air when it makes a loan
  • Since commercial banks create deposits out of thin air, they will have many more deposits than central bank reserves
  • In practice, a commercial bank both receives and makes large volumes of payments each day. At the end of the day, the amount of reserves they have usually doesn’t change that much, so they only need to hold a small amount of reserves against the deposits they create. This is known as fractional reserve banking
• Central bank reserves are a special type of money issued by the Federal Reserve that only commercial banks can hold. From a commercial bank’s standpoint, currency and bank reserves are interchangeable.
  • Central bank reserves are created when the central bank buys financial assets or makes loans
  • The central bank is the only entity that can create central bank reserves, so the total amount of reserves in the financial system is completely determined by central bank actions
  • Prior to the 2008 Financial Crisis, the Fed conducted monetary policy under a reserve scarcity regime where the Fed controlled short-term interest rates by making slight adjustments to the level of reserves in the banking system
  • There were only around $30 billion in reserves in the entire banking system, compared to a few trillion today
  • The Fed now controls short-term interest rates by adjusting the interest it pays banks on excess reserves and the offering rate of the Overnight Reverse Repo Facility, a program where participants can loan money to the Fed
  • Foreign central banks have the option of depositing their dollars at the New York Fed, but the transaction is structured as a secured repo loan. The foreign central bank does not hold reserves (it holds a repo loan, where it is lending money to the Fed), but when it moves money out of commercial banks into the Foreign Repo pool, then reserves leave the banking system into a separate Foreign Repo Facility account
• The final type of money is Treasuries. Treasuries are issued by the U.S. government. They can be readily convertible to bank deposits by selling them in the market or by using them as collateral for a loan
  • Treasury securities are unsecured debt issued by the federal government and are the dominant form of money in the financial system because they are safe, liquid, and widely accepted

Central bank digital currency

• A CBDC essentially allows everyone to have an account at the central bank. Instead of holding bank deposits at a commercial bank, the public would also have the option of holding something like reserves at the central bank. A CBDC would potentially replace both physical currency and bank deposit money.
• The core benefits of a CBDC are being touted as security and efficiency. Instead of bearing the credit risk of commercial bank deposits, non-banks would be able to hold risk-free deposits at the central bank. Payments would be faster because everyone would have an account at the central bank so money would simply be shuffled between different CBDC accounts. There would be no need for inter-bank payments.
• In practice, the purported benefits of CBDC are illusory. Government deposit insurance already makes bank deposits safe, and electronic payments today are already instant and very low cost. The true purpose of a CDBC is as a policy tool to conduct fiscal and monetary policy.
• CBDCs would give the government virtually complete control over the monetary system. They would know exactly how much money everyone has and who they send it to. They could debit or credit money to anyone’s CBDC account at will. They could lower or raise the interest rates of anyone’s CBDC account at will. At the moment, all those powers belong to the private commercial banks.
• In a CBDC world tax evasion and money laundering would be impossible, and the government would be able to manipulate spending by giving money directly to people. They could also directly take money away from people as a punishment

The Federal Reserve

• The Fed has a duel mandate: full employment and stable prices.
• The Fed thinks of the economy through the lens of interest rates, which is the primary tool through which the Fed achieves its mandate. In the eyes of the Fed, there is a thing called r* (pronounced “r star”), which is the neutral rate of interest at which the economy is neither expanding nor contracting
• When interest rates are below r*, then the economy is expanding, inflation is rising, and unemployment is ticking lower. When interest rates are above r*, then the economy is slowing, inflation is declining, and unemployment is ticking higher. When the economy is in trouble and the Fed’s models show that r* is currently a very low or even negative number, then the Fed will do everything it can to get interest rates below r* to promote economic growth.
• The Fed’s goal with QE is to lower longer-term interest rates, with the increase in reserves and bank deposits being a necessary byproduct. Academic models suggest that QE is effective in lowering interest rates and does help boost inflation
• However, the experience of the Fed, the BOJ, and the ECB all show that massive QE, at least by itself, is not enough to sustainably move inflation higher. All three major central banks have had trouble reaching their inflation mandates for over a decade but continue to believe in the utility of QE.
• QE appears to lift financial asset prices but not necessarily economic activity

Commercial banks

• A commercial bank faces two fundamental problems: solvency and liquidity.
  • Solvency is making sure the bank deposits it creates are backed by sound loans, and liquidity is making sure those deposits are freely convertible to bank deposits created by other commercial banks and to fiat currency.
• Commercial banks have to make sure they have enough central bank reserves to settle payments with other commercial banks and that they have enough currency on hand to meet any depositor withdrawals.
• A bank that cannot meet payments or withdrawals will likely panic its depositors even if it is fundamentally sound.
• If a bank underestimated its liquidity, it can still go borrow from another commercial bank or an institutional investor. As a last resort, a commercial bank can borrow from the Fed’s discount window. There is a strong stigma associated with this last option because it suggests the bank is in such dire straits that no one in the private sector would lend to them

The Treasury

• The Treasury Department is the part of the U.S. government that collects taxes and issues Treasury securities. The Treasury does not decide how much debt to issue; that is determined by the federal government’s deficit, which is a result of decisions by Congress
• However, the Treasury does decide how it will go about funding the deficit. This gives Treasury influence over the shape of the interest-rate curve, where a decision to issue more longer-dated debt will lead to a steeper curve and a decision to issue more shorter-dated debt will lead to a flatter curve

Shadow banks

• Shadow banks are non-commercial-bank businesses that engage in banking-like activity.
• Shadow banks generally operate under less restrictions than commercial banks. This can lead to higher returns, but their investors do not have the same public sector protections. Instead, investors in shadow banks must rely on alternative private sector protections. These protections include insurance provided by private insurers, hedging derivatives like credit default swaps, or assurances provided by ratings agencies
• The basic business model of a shadow bank is to use shorter-term loans to invest in longer-dated assets. This mismatch creates an opportunity for profit as longer-term interest rates are usually higher than shorter-term interest rates

Primary dealers

• Primary dealers are a group of dealers that have the privilege of trading directly with the Federal Reserve. They are the heart of the financial system and the primary conduit for Federal Reserve open market operations when the Fed is conducting quantitative easing by buying Treasuries, it only buys from primary dealers
• In addition to making markets for financial products, dealers also act as financial intermediaries, borrowing from one client to lend to another
• The primary dealers buy securities or offer loans using funds they borrow from other clients, usually money market funds. But they can also borrow from the Fed. The terms of the financing offered by the Fed affect the terms they are willing to offer their shadow bank clients. For example, if primary dealers can borrow from the Fed at 1%, then the interest rates received by the broader market won’t be too much higher.

Money-market funds

• A money market fund (MMF) is a special type of investment fund that invests only in short-term securities and allows investors to withdraw their money at any time with next-business-day availability
• MMFs are subject to regulations that tightly control the credit quality and tenor of the investments they can make
• MMFs are broadly divided into two types: government MMFs and prime MMFs. Government MMFs can only invest in government securities, while prime MMFs can also invest in nongovernment securities. In practice, prime MMFs largely invest in government securities and securities issued by foreign commercial banks
• Investments made by MMFs tend to be very short term, mostly overnight but potentially up to a maximum of 397 days. This is in part due to SEC regulations, which include a number of rules that limit the maturity profile of a MMF’s portfolio. The rules are intended to reduce the risk of “bank runs.”
• MMFs are a key source of cash for the shadow banking world

Exchange-traded funds

• ETFs are investment funds whose shares are traded on an exchange like a stock. An ETF takes an investor’s money and uses it to purchase assets such as stocks, bonds, or commodity futures
• In theory, the price of a share of an ETF should reflect the value of the ETF’s assets
• The relationship between the price on an ETF share and its underlying asset value is policed by institutional investors who make money by arbitraging the ETF’s share price and underlying fund asset values

Mortgage REITs

• Mortgage REITs (mREITs) are investment funds that invest in mortgage-backed securities, usually Agency MBS securities guaranteed by Fannie Mae or Freddie Mac. They are classic shadow banks that take out very short-term loans to invest in very long-term assets. The typical mREIT will buy mortgage securities that mature in 15 to 30 years using one-month repo loans that are continually renewed

Private investment funds

• Private investment funds, such as hedge funds or private equity funds, take investor money and invest in a broad spectrum of financial assets

Securitisation

• Securitisation is a financing structure where a pool of illiquid financial assets is funded by issuing bonds to investors
• Generally speaking, a commercial bank originates a loan and then sells it to a securitisation vehicle, who buys the loan using the proceeds of bonds it issues. The securitisation vehicles can buy hundreds or thousands of loans and issue different bonds, each with distinct risk profiles. The principal and interest payments from the loans are used to pay off the bond investors
• Traditionally, a commercial bank held on to the loans it originated, so it was careful who it lent to
• But the rise of securitisation meant a commercial bank could earn fees by originating a loan and selling it to a securitisation vehicle. Many commercial banks began to transition their business model from earning interest on loans to earning fees on originating loans. Since they did not hold the loans themselves, commercial banks were less interested if a loan soured. That was a risk borne by the securitisation bond investors.
• In August 2007, there was a run in a relatively obscure part of the shadow banking sector—the Asset-Backed Commercial Paper (ABCP) market. ABCPs are investment vehicles that borrow short term in the money markets by issuing commercial paper (which is unsecured debt that usually matures within a few months) and then investing the proceeds in longer tenor and more illiquid financial assets

Eurodollars

• Eurodollars are U.S. dollars held outside of the United States. They are called Eurodollars because the first offshore dollars appeared in Europe in 1956

Offshore dollar banking

• Overall, the size of the offshore banking system is around $10 trillion as of 2018, accounting for roughly a third of the size of the global dollar banking system
• A smaller foreign bank can build a dollar loan business as well, but it will instead use dollar deposits at a U.S. bank to settle interbank payments. In effect, the smaller foreign bank is creating a fractional banking system built upon a fractional banking system

Basel III

• Basel III made banks safer by forcing banks to hold more high-quality liquid assets like Treasury securities and also encouraged them to have more reliable liabilities. The regulators classified bank liabilities according to how “flighty” the liability would be in a time of stress, with retail deposits being the stickiest and unsecured deposits from banks and shadow banks the most unreliable.
• The change in regulatory treatment forced many banks to fundamentally restructure their liabilities. Large domestic banks were subject to the heaviest regulatory burden, so they pushed out many of their shadow bank clients and attempted to increase their footprint in retail banking. The shadow banks in turn began to move their money to medium-sized U.S. banks or foreign banks, both of whom were under less stringent versions of Basel III regulation.
• This structural shift was further enhanced by reforms in the Dodd-Frank Act that led to a change in the way FDIC insurance fees were calculated. FDIC fees are assessed on U.S. banks to fund the FDIC insurance that banks offer their depositors. Previously, the FDIC assessed fees based on the amount of domestic deposits a U.S. bank held.
• The new assessment regime significantly broadened the assessment base to all assets minus tangible equity and made risk-based adjustments. The effect of these changes was to encourage U.S. banks to reduce their borrowings from institutional investors in money markets, and instead rely on stabler retail deposits. The U.S. banks followed that incentive and reduced their borrowing in the money markets. The institutional investors instead redeposited their money into foreign banks, which are not FDIC insured and thus not subject to FDIC assessment fees. In effect, regulation shifted large amounts of institutional money out of domestic banks and into foreign banks, sometimes into their offshore offices.

The Fed as the world’s central bank

• Dollars are widely accepted and even preferred to some home currencies. In effect, the Fed is wresting some control of monetary policy away from these other central banks
• In times of crisis, the Fed has shown a willingness to lend to foreign banks and support the offshore dollar market. During both the 2008 Financial Crisis and the 2020 COVID-19 panic, the Fed became lender of last resort to foreign banks via the FX-swap lines, where the Fed lends dollars to a foreign central bank, who in turn lends to the foreign banks within their jurisdiction.
• The Fed feels comfortable doing this because it is lending to a foreign central bank, who is presumably a good credit risk and offering foreign exchange as collateral. The Fed has in effect become the world’s central bank and ultimate backer of the dollar banking system.

Short-term interest rates

• The Fed controls short-term interest rates through its control over overnight interest rates.
• In theory, this is through its control of the federal funds rate, which is the rate commercial banks pay to take out an overnight loan for reserves on an unsecured basis.
• By setting a target range for the federal funds rate, the Fed is able to exert influence throughout the short-term interest curve as market participants use the overnight rate as a reference for what the rate for slightly longer tenors, such as 3 or 6 months, should be
• However, this method of controlling the federal funds rate became obsolete when the Fed started conducting quantitative easing. Quantitative easing increased the level of bank reserves in the banking system from around $20 billion to a few trillion. It became no longer possible to control the funds rate by adjusting the quantity of reserves.
• In the current world with very high levels of reserves, the Fed controls the federal funds rate by adjusting the interest rate it offers on the Reverse Repo Facility (RRP) and the interest it pays on reserves that banks hold in their Fed account
• The option to lend risk-free to the Fed at the RRP offering rate puts a floor on the returns they are willing to accept from the private sector. For example, if an investor can lend risk-free overnight to the Fed at 1%, then it would never be willing to lend at a rate below 1%. The RRP offering rate effectively sets the minimum overnight interest rate in the market
• In practice, the RRP offering rate is probably a much more influential rate than the federal funds rate. The RRP rate is available to a wide range of market participants, while the federal funds rate is available only to commercial banks

Longer-term interest rates

• While the Fed determines short-term rates, the market determines longer-term interest rates. When an investor is thinking about lending longer term, they take into account a number of things such as how the Fed will set short-term interest rates in the future, estimates for future inflation, how volatile those estimates are, and future supply and demand dynamics of Treasury debt issuance
• A common framework for thinking about longer-term yields is to decompose them into two components: the expectations for the path of short-term interest rates and a term premium
• The short-term interest-rate futures market offers a glimpse of what the market thinks short-term interest rates will be in the future. The most popular short-term interest-rate future is the market for Eurodollar futures. The Eurodollar futures market is the deepest and most liquid derivatives market in the world
• For example, regulatory tweaks that allow more risk-taking would dampen demand for Treasuries, which are safe but very low yielding. A looming pension crisis where pensions cannot afford their obligations could conceivably lead to such regulatory tweaks

The yield curve

• The yield curve can be used to infer the market’s perception of the state of the economy. Market participants often focus on an inverted yield curve—one where longer-term yields (usually the 10-year Treasury) are lower than short-term yields (usually the 2-year Treasury or 3-month Bill)—as a sign that the economy will soon be in recession
• The shape of the yield curve is also in part determined by Fed action. The Fed purchases longer-dated securities through quantitative easing, which effectively lowers longer-term yields and thus flattens the yield curve by putting downward pressure on longer-dated yields.
• In the past, the Fed has also engaged in operations which flattened the yield curve by selling short-term Treasuries and buying longer-term ones. This flattens the yield curve by raising short-term interest rates in addition to putting downward pressure on longer-term rates.

Secured money markets

• In secured money markets, a borrower puts up a financial asset as collateral for a short-term loan.
• The two largest segments of secured money markets are the repo market and the FX-swap market.
  • Repo loans are secured by securities such as Treasuries, corporate bonds, MBS, or equities.
  • FX-swap loans are loans in one currency secured by another currency, such as a loan for 1000 euros secured by collateral of 1000 U.S. dollars.
• In a repo transaction, which is short for repurchase transaction, a borrower “sells” a security to a lender while at the same time entering into an agreement to buy back the same security at a future date at a slightly higher price.
• The prices for these transactions will be lower than the market value of the security to provide the lender with an extra margin of safety. Economically, this is equivalent to borrowing money using the security as collateral. The slightly higher price paid to repurchase the security is equivalent to the interest on the loan
• In practice, most repo transactions are overnight loans collateralized by safe assets including U.S. Treasuries and Agency MBS.
• The repo market is the essential link that allows Treasury securities to be “money.” The Treasury market is already the world’s deepest and most liquid market, but a $1 trillion overnight repo market goes one step further and allows Treasuries owned outright to be converted to bank deposits any time for virtually no cost, and then returns the same Treasury security the next day
• The repo market is the largest and most important market that most people have never heard of. It’s about $3.4 trillion in size and comprised of three major segments: Tri-party, uncleared bilateral, and cleared FICC
  • The tri-party repo market refers to trades conducted on the repo platform of a clearing bank, who performs the operational back office work of the transaction such as collateral valuation, securities custody, and payment settlement. In the U.S., the only tri-party platform is operated by Bank of New York Mellon
  • Cleared FICC repo refers to repo transactions that are centrally cleared through the Fixed Income Clearing Corporation, a clearing house. The FICC repo market is an interdealer market, so all transactions are between dealers
  • Uncleared bilateral refers to repo trades done without the assistance of the tri-party platform and are not novated to FICC. These trades are generally between dealers and either cash lenders that are too small for the tri-party platform or so large that they are able to demand terms more flexible than those possible on the tri-party platform
• The other major secured money market is the FX-swap market, which is a market for foreign currency loans. FX-swap transactions are like repo transactions, but instead of securities the collateral used is foreign currency

Unsecured money markets

• Unsecured money markets are markets for short-term loans where the promise to repay is backed by nothing other than confidence in the borrower. These loans tend to offer higher interest rates than secured loans because of the higher risk involved
• Before the 2008 Financial Crisis, commercial banks were major participants in the unsecured money markets. The well-known benchmark rate, 3-month LIBOR, is in fact a benchmark rate for the interest rate a commercial bank would have to pay to borrow dollars on an unsecured basis for 3 months
• The most well-known unsecured money market is the federal funds market, which is where the Fed sets its policy rate. The federal funds market is an interbank market where commercial banks borrow reserves from each other on an overnight unsecured basis.
• Historically, commercial banks borrowed in the funds market to have enough reserves to meet reserve requirements at the end of the day or to meet daily payment needs
• Regulars have also put forth rules that make it unattractive for a bank to borrow in the unsecured money markets. As a result, the interbank unsecured money markets have virtually disappeared. What remains of the unsecured money markets is primarily a nonbank to bank market, and that has also shrunk significantly due to Money Market Reform

Equity markets

• Equity markets are actually the most emotional market and least reflective of economic conditions
• Over the past two decades flows from passive investors have grown to become the marginal investors in the equity market.

Debt capital markets

• These are where companies or governments borrow money by issuing bonds. A bond is just a promise to repay issued by a borrower in exchange for an investor’s bank deposits
• Credit risk takes into account how likely the company will default, and if it does, what percentage of the money lent could be recovered. Credit ratings are the single most important determinant of a bond’s perceived credit risk
• Liquidity risk takes into account how difficult it would be to sell the bond in case the investor needed money before it matured

Corporate bonds

• Broadly speaking, the market is divided into an investment-grade universe (bonds rated BBB-59 and above) and a high-yield universe (bonds rated below BBB-, also known as junk bonds). According to S&P, around 85% of corporate bonds are investment grade and the rest are high yield
• Instead of relying on low rates to be transmitted to borrowers through the banking system, the central bank can now directly lower the borrowing costs of corporations by buying corporate bonds and thus pushing yields lower
• Corporate bond purchases by central banks do appear to lower corporate borrowing costs, but also appear to make corporate bonds less sensitive to economic fundamentals. Many market participants now are less concerned with their risk exposure to corporate debt as they believe the central banks will just keep bond prices high even when fundamentals deteriorate.
• In practice, the amount of corporate bonds purchased by central banks has been relatively small. The Fed’s purchases have been a particularly small 0.1% of the U.S. corporate bond universe

Agency MBS

• Agency MBS are mortgage-backed securities guaranteed by the government. Mortgage-backed securities are bonds that receive the cash flow generated by a pool of mortgage loans
• Agency MBS are the second largest market for bonds in the U.S., with over $8.5 trillion outstanding. The vast majority of Agency MBS are backed by single family home mortgages, with around a $1 trillion backed by commercial real estate mortgages that are predominately multifamily homes
• Historically, mortgages were originated by commercial banks who held on to the mortgage loans for interest income. Fannie and Freddie offer commercial banks the additional option of selling the mortgage loan, provided the loan meets certain minimal credit standards. This additional flexibility was designed to encourage commercial banks to make more mortgage loans since they always had the option of selling them to Fannie or Freddie in case they needed to raise money
• Today, most mortgage loans are originated by nonbank mortgage lenders who specialize in the “originate to distribute” business model. These mortgage lenders take out a loan from a commercial bank, lend the money to a home buyer, sell the mortgage to Fannie or Freddie, and then repeat the process by taking the proceeds from the sale and lending to another mortgage borrower
• Fannie and Freddie take the mortgage loans, add a guarantee onto them, package them into securities, and return them to the mortgage seller to be sold to investors. A guarantee from Fannie and Freddie make the mortgage securities virtually risk-free. Should a mortgage loan default, Fannie or Freddie will buy it back so the investors would not face any losses. These securities, called Agency MBS, are in significant demand worldwide because they offer slightly higher yields than comparable Treasuries with minimal credit risk
• This demand for Agency MBS creates more demand for mortgage loans, which in turn encourages more mortgage origination, which makes more mortgage loans more widely available to the public.

Treasury securities

• Treasuries are issued by the U.S. government in regular auctions in a range of tenors, broadly divided into bills and coupons. Treasury bills are short-term debt that matures within 1 year and is issued on a discount basis, while coupons are issued in tenors that range from 2 years to 30 years and pay interest semi-annually
• In practice, this means that the Treasury will issue coupons in predictable sizes and make up funding shortfalls with bill issuance. For example, if the Treasury announced $100 billion in coupon issuance for the quarter but then realized it needed $20 billion more, then it would just issue $20 billion more in bills
• If Treasury needed to further customize its cash flow needs, it could issue Cash Management Bills, which are essentially bills that are issued in a nonstandard tenor
• Treasury debt is auctioned by the New York Fed to primary dealers, who then resell the debt to their clients. Technically, investors can place bids through the primary dealers (indirect bid), or investors can go through the process of becoming eligible to bid directly themselves (direct bid). Notwithstanding that, primary dealers play a key role in the auction process because they are obligated to bid on every auction. This means an auction can never fail due to lack of demand because it is backstopped by the primary dealers.

Democratising the Fed

• The growth of shadow banks and offshore banking meant that a significant amount of financial activity now takes place outside of the Fed’s purview. In 2008, panics emerged in the shadow banking and offshore banking world. To save the financial system, the Fed was forced to use its emergency Section 13(3) lending powers, which essentially allow the Fed to lend to anyone.
• Market participants usually measure stress in short-term interest-rate markets with the spread between the benchmark market rate of 3-Month LIBOR and the 3-Month Overnight Index Swap, which is roughly the expected average federal funds rate for the next 3 months. When the spread is wide, that means that market rates are much higher than the Fed’s policy rate, which suggests financial distress
• in the depths of the financial crisis, it reached all-time highs of around 4%. Investors were afraid to lend to foreign banks, forcing the foreign banks to offer extremely high interest rates for even 3-month loans.
• The Fed ultimately decided to lend to foreign banks by establishing central bank swap lines with a roster of friendly foreign central banks. The Fed would lend dollars to a foreign central bank, who in turn would lend to the banks within their jurisdiction. The swap lines solved the global dollar bank run, but they also essentially made the Fed the backer of the global dollar system, both within and outside of the U.S

Crisis management

• Forward guidance is a way for the Fed to extend its control of interest rates from short-term rates to medium-term rates as well. The Fed would verbally commit to keep its policy rate low for an extended period of time. As long as the market believed in the Fed’s commitment, then even medium-term interest rates should move lower as the market would price out any rate hikes from the present to medium term
  • There are different ways that the Fed can implement forward guidance. It can do so by committing to keeping rates low until specific economic performance targets are met or for specific lengths of time. For example, the Fed can commit to keeping interest rates at zero until inflation rises sustainably above 2%, until the unemployment rate drops below 4%, or for a minimum of 2 years, etc
• Quantitative easing is a way for the Fed to control longer-term interest rates by purchasing longer-dated Treasury bonds and thus driving the yields of those bonds lower
  • Purchasing Treasury securities by printing central bank reserves was like printing a $100 bill and using it to buy another $100 bill. The amount of money in the system didn’t change, just the composition of it. There were now fewer Treasury securities and more central bank reserves
• Yield curve control is when a central bank announces specific numeric targets for its interest rates
  • The Bank of Japan was the first major central bank to implement YCC when it announced in 2016 that it would anchor the yield of the 10-year Japanese Government Bond (JGB) to around 0%
  • Modern central banking dogma dictates that lower interest rates can spur economic growth, which is why central banks are so eager to lower rates during a recession. However, the evidence suggests that interest rates and economic growth are not negatively correlated but positively correlated, so interest rates tend to increase along with economic growth
  • Judging from a decade of experience, lower interest rates appear to boost financial assets, but not necessarily real economic growth.

Fed watching

• FOMC statement
  • The Federal Open Market Committee (FOMC) releases a statement at the conclusion of each its meeting. The statement briefly summarizes the FOMC’s view on the state of the economy and the actions the FOMC is taking to achieve its duel mandate
  • At each meeting, the FOMC will review the current briefing, discuss their view of the economy, and then vote on which courses of action to undertake.
• FOMC Press Conference
  • Each FOMC meeting ends with a one-hour press conference starting at 2:30 p.m. EST where the Fed Chair takes questions from the press
  • More importantly, this is on-the-fly speech that is not heavily edited and reviewed like other FOMC communications. The market watches the Chair’s reactions and parses their words to guess future Fed actions. The Fed Chair also knows this is an opportunity to guide the markets, so may purposefully choose their words.
• FOMC Minutes
  • The minutes for each FOMC meeting are released three weeks after the meeting takes place. The minutes offer a glimpse of what information was presented to the FOMC and what they discussed during the meeting
  • The first part of the minutes reviews the economic and financial conditions of the intermeeting period, then there is a forecast of economic conditions, and finally, there is a segment where FOMC participants discuss their views
  • Despite receiving a briefing on economic conditions at the meeting, each FOMC participant also has their own staff of economists and may have a different viewpoint based on the data they see in their respective district. The minutes will reveal some of the discussions that took place during the meeting but in an anonymized fashion
  • The minutes often foreshadow policy moves in coming months
• FOMC “Dot Plot”
  • Starting in late 2007, the Fed began releasing a set of economic projections (“Summary of Economic Projections”) every quarter at the March, June, September, and December FOMC meetings. The summary included projections on real economic growth, inflation, and the unemployment rate. Later in 2012, the Fed added projections for where the federal funds rate would be.
  • The “dot plot” is a market-moving data release because it gives a glimpse of what the trajectory of future policy rates could be and how dispersed the views are of FOMC participants. This is more concrete than the economic forecasts because it translates the forecasts into interest-rate adjustments. The more consensus there is in the dot plot, the more strongly the market will price in upcoming Fed action. But the dot plot is not always a good forecast of what will happen
• Federal Reserve Speeches
  • Federal Reserve Bank Presidents and Federal Reserve Board Governors routinely give speeches on how they are thinking about monetary policy. They don’t always agree, and some of them are much more important than others
  • The voting body of the FOMC is composed of the Board Governors, the President of the New York Fed, and a set of four Presidents from the regional Federal Reserve Banks that rotates annually. Within the FOMC, the most influential people are the Chair, the Vice Chair, and the President of the New York Fed (who is also a Vice Chair). These three are called the “troika” and have the most power on the FOMC, so their thoughts must be given the most weight
  • FOMC members are generally labeled as either “doves” or “hawks” based on the views that they reveal. Doves prefer more accommodative monetary policy, while hawks prefer less accommodative monetary policy
  • Fed Watchers take particular note when a dove turns hawkish or when a hawk turns dovish. These shifts can foreshadow a shift in the FOMC’s actions
• Fed Interviews and Congressional Testimonies
  • Fed officials generally have a preset schedule as to when they will communicate with the market. There are prescheduled FOMC meetings, industry group conferences, or other events
  • But they always have the option of just calling up the press and giving an unscheduled interview. Sometimes this occurs when the Fed thinks the market has misunderstood them and they want to correct the misunderstanding before it gets out of hand
• Desk Operating Statements
  • The Desk releases its operating policies and operating calendar on the Federal Reserve Bank of New York’s website. This information can tell you a bit about how the Fed is thinking about the financial markets
    • The Desk also posts the results of their daily operations immediately after they have concluded. Throughout the day they will post the results of their repo and reverse repo operations, MBS purchases, Treasury purchases, and securities lending. Fed Watchers notice changes in these operations and infer from them changes in the markets
• Fed Balance Sheet
  • Fed Watchers have become increasingly interested in the Fed’s balance sheet as that has become a bigger part of the Fed’s tool kit. They want to know whether it is growing, and if so, what assets are driving the growth. They use this information to predict what may happen to the financial markets
  • Generally, they assume that if the Fed is expanding its balance sheet, then interest rates will move lower and the stock market will move higher
• Desk Surveys
  • The Desk regularly surveys market participants to try to figure out what the market is thinking. The surveys go out to the primary dealers, as well as a select group of market participants that include many of the world’s largest investment funds
  • The surveys are used to try to figure out what is priced into the market so the FOMC can properly calibrate their actions. While some form of market expectations is readily observable in market pricing, the distribution of the outcomes is not
  • The Desk survey questionnaires are publicly available on the New York Fed’s website around two weeks before an upcoming FOMC meeting, and the results of the survey are publicly available about 3 weeks after the FOMC meeting
• Federal Reserve Research
  • Each Federal Reserve Bank has a large staff of PhD economists who regularly publish economic research either in the form of research papers or blog posts
  • The research published does not necessarily reflect the views of Fed officials but is rather an outlet for staff economists to share their personal views and findings
• Federal Reserve Surveys
  • The Federal Reserve Banks and the Board of Governors conduct surveys A couple of the more notable surveys are the Beige Book and the Senior Loan Officer Survey
  • The Beige Book, published eight times a year, is a compilation of anecdotes from business leaders in each Federal Reserve district. Federal Reserve staff conduct outreach to business contacts in their district and record their findings, particularly regarding information that pertains to employment and price changes
  • The Senior Loan Officer Survey, published quarterly, goes out to executives at commercial banks and is aimed at helping the Fed understand changes in credit conditions. The Fed wants to know if lending standards are tightening or loosening, since the availability of credit is a key economic indicator

Modern Monetary Theory

• MMT postulates that a government issuer of fiat currency is not constrained by taxation or debt, but only by inflation. Taxation and debt issuance are merely tools through which the government manages inflation
• This is in stark contrast to economic orthodoxy, which tends to negatively view deficit spending and high government debt levels
• Conventional economic thinking views a country like a household, where living beyond one’s means and going into debt means leaner times ahead. A country with a high debt load would have to increase taxes on future generations to repay the debt. Too much debt may also lead investors to demand higher interest rates, further dampening economic growth
• Proponents of MMT note that the government can simply print more money to fund its spending. The government does not need to borrow or to tax, but it should use those tools to combat inflation
• When the government engages in deficit spending it is actually boosting economic growth by creating money and spending it on goods and services. Deficit spending and high debt loads are not a source of concern and can be good for the economy, provided inflation is under control