Quarrel With Quarles Over Too Little, Not Too Many

It wasn’t the first time the ground had already been eroding underneath his feet. Randall Quarles took at turn at the Treasury Department during the Bush Administration, rising to Undersecretary for Domestic Finance during the most maniacal part of the eurodollar-fueled housing bubble. Not surprisingly, among the last things he did there was tell the public how great everything was going.

But then Quarles jumped from Treasury to…Carlyle. Because everyone has been told 2008 was about subprime mortgages, this one name just doesn’t register the way it really should – subsidiary CCC, in particular. However, to anyone who paid attention to repo in the months and weeks leading up to Bear Stearns, Quarles’ new firm had been seen everywhere for all the wrong reasons.

I recalled a few years ago:

CCC had invested in “highly rated mortgage instruments”, a fact which scared the pants off everyone for good reason. If “highly rated” meant little against illiquidity and insolvency, then everything was fair game; or, the exact opposite of what Randal Quarles assured everyone was the case in 2006. The system wasn’t resilient at all but fraught with risks no one seemed to able or even interested enough to understand even from the inside, let alone officials who could offer no answers about anything.

Liquidity is not solvency, and solvency doesn’t guarantee liquidity especially in the repo market where the ability to sell collateral tomorrow without any prior notice is paramount above everything – especially the Fed’s worthless bank reserves. If the repo market lending you cash and accepting your collateral isn’t assured that liquidation can be done on predictable terms tomorrow using that class of collateral, repo as a whole is going to go bonkers.

The inability to post any other acceptable collateral in March 2008 spelled CCC’s demise leading directly to the same problem at Bear Stearns. And while Ben Bernanke declared victory in Bear’s aftermath, it had instead been the point of no return for the entire system.

They really have no idea what they are doing. True story.

But, as is usually the case, the well-connected like Randy Quarles found himself right back on the job as one of the pedigree-d few. Appointed to the Federal Reserve’s Board of Governors (of course) in 2017, the guy was right back at it in February 2018 telling everyone how great things were:

I am fairly optimistic about the current state of the economy. Along many dimensions, it has been quite some time since the economic environment has looked as favorable as it does now.

And at the very moment he was making the claim, just as in 2006, the situation had already shifted significantly toward the highly unfavorable. One way we could tell was, among others, the Japanese leaning heavy into selling a lot of their considerable stash of US Treasuries.

Because Economics has done such an atrocious job of keeping up with how the system actually works, what should have been a bright flashing warning (about liquidity) was instead misinterpreted as something it absolutely wasn’t. The Wall Street Journal (of course) reported on February 27, 2018:

Japanese investors may be America’s bond bears.

They are shifting toward selling U.S. Treasury bonds and other dollar-based debt after fears have picked up in recent weeks that the Trump administration’s budget and other policies add up to a weak dollar.

Ridiculous, demonstrably so (see below). This assumption dates and traces back to a larger one about the US government’s fortunes. Unlike Japan, “they” always said, the US Treasury market wasn’t self-funded in that foreigners are required to lend it money otherwise it’s lights out at Treasury; BOND ROUT!!!! with ten instead of the usual four punctuating exclamations kind of thing.

While that sounds right, it isn’t. History has conclusively shown that in the eurodollar tightening era (since August 2007), the conventional narrative gets it all wrong. When foreigners buy fewer or outright sell their US Treasuries, the yields on them over not too much time especially at the longer end will fall significantly.

Not rise. No rout.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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