November 17th, 2013
by Shah Gilani, Money Morning
A couple of weeks ago I told you I was going to break maybe the biggest investing story of the year.
I told you global capital markets are facing structural changes on a scale that's so huge, virtually every big bank, and in fact almost all banks, and every major trading institution will be affected.
You aren't hearing about this anywhere else, because it's not obvious - yet.
Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced, we will face unforeseen capital markets dislocations, economic uncertainties, global volatility... and, of course, tremendous trading opportunities.
I'm excited. I love disruptions like this, because there's always money to be made when the capital waves start rolling.
You heard it here first...
In the next 12 to 24 months, capital markets are going to struggle on account of... are you ready?... not enough government debt.
It sounds crazy, but it's not.
The problem of not having enough government bonds, notes, and bills might seem like a good problem because it assumes the government is balancing budgets and reducing deficits.
But any significant reduction in the issuance of Treasury securities would directly impact lending in the U.S.
Interest rates would rise, and capital markets would become distorted.
Don't get all hung up on the fact that our deficits are huge and unlikely to be tamed any time soon. That's probably true.
But then again, we thought massive deficits were incontrovertible and the budget impossible to balance. Then it happened under Clinton. Treasury issuance was greatly reduced as a result.
Something happened in the capital markets because there weren't enough Treasuries, something that fuelled the credit crisis. I'll get to that.
Long before budgets are balanced and deficits reduced, the soon-to-be vastly ratcheted-up demand for Treasury securities will be felt in the U.S. and globally.
The demand will come from banks, trading houses, and financial institutions of all stripes.
What's happening now - and will accelerate over the next few quarters and couple of years - is that regulatory changes are going to force banks and financial institutions to hold more Treasuries, a lot more Treasuries.
New Basel rules will eventually be implemented. New Dodd-Frank rules, those already written and the hundreds more that may get written, will eventually be implemented. And other regulators are imposing their own rules and requirements. The net result is that financial institutions are going to have to hold more and better capital and make themselves more liquid. They'll do that by owning more "risk-free" Treasuries.
Typical of the new proposed rules, Ben Bernanke, chairman of the Federal Reserve, came out last Thursday with new liquidity requirements for banks and systemically important financial institutions. The "liquidity reserve ratio" he proposed isn't his idea. It's already written into delayed-again Basel III rules. Institutions will have to hold high-quality liquid assets to cover (anticipated) total net cash outflows over a 30-day period.
As with virtually all the new proposed rules, the question "What constitutes high quality assets?" is answered in a word: Treasuries.
If you have to have liquid assets that aren't going to fall off a cliff in a financial crisis that you can liquidate, meaning there have to be buyers, U.S. Treasuries are it.
On top of filling liquidity requirements, Treasuries will be in huge demand as marginable collateral for credit default swaps, once the final language in Dodd-Frank is written and swaps are exchange-traded and trades are settled through clearinghouses that guarantee counterparty obligations.
To do trades through a clearinghouse that's taking on counterparty risk, margin has to be posted by traders. Collateral used for margin is only good if it can be quickly sold, especially in a multi-trillion dollar market where collapsing prices could implode global markets.
Again, "Who are you gonna call?" Treasuries are the answer.
The next best thing to Treasuries are agencies. Agency paper refers to debt instruments not issued by the U.S., but guaranteed either explicitly or implicitly by the U.S. Like debt issued by Fannie Mae and Freddie Mac. Those two giant Government Sponsored Enterprises (GSE) are the best example of issuers of agency paper.
But wait, what will happen if these two monsters are dismembered?
They are in Congress' crosshairs right now. There are at least four proposed bills floating between the Senate and the House that all envision the disintegration of Fannie and Freddie. When that happens, assuming it will, there will be a lot less agency paper to be used as liquid collateral. The two GSEs, along with the Federal Home Loan Banks, have almost $7 trillion in debt outstanding that are considered safe assets.
A dramatic reduction in agency paper will further increase the demand for Treasuries.
Money market rule changes are coming, which will additionally increase the demand for Treasuries
What will happen if the rising demand for Treasuries slams into reduced supply?
In the 1990s, as a result of those two opposing dynamics happening, capital markets filled the void by manufacturing increasing amounts of guess what? AAA-rated mortgage-backed securities and other then highly rated asset-backed securities (ABS).
Only they weren't the same thing as Treasuries.
Are we headed down that path again? We sure are.
Because the demand for Treasuries will result in institutions hoarding them, lending against less liquid collateral will cause interest rates to rise and credit conditions to tighten.
Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced while at the same time new regulations to make banks safer increases demand for Treasuries, we will face unforeseen capital markets dislocations and economic uncertainties.
There will be tremendous trading opportunities amidst all these disruptions, which we'll be ever-ready to take advantage of.