Negative US T-Bill Rates Are Signs Of Worsening European Distress

European Union

Photo: Wikimedia Commons

Interbank lending may be experiencing the start of another freeze.  Without an explicit pledge from the European Central Bank to accept PIIGS debt, private interbank lending arrangements are left to the whims of overnight cash owners, the institutions most connected to the Federal Reserve. After more than two years of liquidity interventions, this is a troubling development.

We know that fear is infecting the unsecured interbank funding market, shown by the widening of various LIBOR spreads (which have only begun to move) and the individual actions of overseas primary lenders.  The Telegraph reported on June 18 that Barclays and Standard Chartered were withdrawing billions from the unsecured segment of the eurodollar credit markets.  Standard Chartered reduced its unsecured lending exposures by two-thirds.  You can be assured that they, and many other banks, are closely evaluating counterparties and how much sovereign restructuring will impact them.

While the PIIGS debt is denominated in euros and is not directly related to the eurodollar market, the banks that own these sovereign bonds obtain a significant portion of their funding arrangements there.  Having a concentrated amount of questionable debt hidden within bank books forces interbank lenders to guess and re-assess whether or not they want to have any funding relationships with the PIIGS owners.  What interbank lenders are now saying, as with Standard Chartered and Barclays, is that to obtain any kind of eurodollar funding, PIIGS owners need to begin posting acceptable, dollar-denominated collateral:  US treasury bonds.  Questionable borrowers are being required to move from unsecured dollar arrangements to collateralized dollar arrangements.

This leads to a scramble for acceptable liquid collateral.  Negative t-bill rates, like what we saw in late 2008, simply means that there are not enough of the US issues to fulfil every demand.  In the considerations of profit and losses, t-bill buyers do not care that they are receiving negative interest rates on these bonds because there are much larger issues at stake:  namely short-term liquidity.

This problem is made all the worse by the change in the accounting rules.  To hide assets from mark-to-market meant shifting them between the trading book and the “bank book”.  Once in the “bank book”, PIIGS bonds have to be held to maturity.  If they are sold, by switching them back to the trading book, it will lead to a lot of messy disclosures.  That would lead to public, affirmative acknowledgments of just what the liquidity-starved banks are actually in possession of.  Considering the amount of potential losses from PIIGS debt, from the perspective of the banking system this is something to be avoided at all costs. 

So negative US treasury bill rates are a perfectly acceptable, indirect alternative to full disclosure.  Unfortunately, this is nothing more than a rerun of the panic of 2008, albeit on a far smaller scale (for now).  In 2008, the eurodollar market was awash in AAA and AA-rated, dollar-denominated mortgage bonds as repo collateral (repurchase agreements are simply collateralized loans).  When it became clear that the ratings were not true representations of risk, interbank lenders effectively shut down both the repo and unsecured markets, except for borrowers with acceptable, liquid dollar-denominated collateral:  US treasury debt.

This belies the myth of the “flight to safety” to the US dollar – a better term would be a “flight to acceptable”.  If the eurodollar market had happened to be denominated in yen instead of dollars, Japanese t-bonds would have seen negative yields from the “flight to safety” (and that would have been an extremely fitting irony).

This growing liquidity problem demonstrates and justifies the contagion fears that policymakers have held throughout.  Greece may be a relatively small country, but its failure can knock down dominoes the world over.  Interbank markets connect globally, transmitting distress across national and continental boundaries.  Almost three years after the panic, fear still persists and still leads to irrational outcomes. 

Monetary efforts have been focused on ensuring adequate liquidity to avoid the irrational from regaining a foothold in market psychology.  However, the one constant from central bank liquidity measures, besides guaranteed miscalculations, is that they will always be non-uniform.  No matter how much money is created, it ends up being hoarded by those most connected to the central bank.  Central banks may be confident that the banking system is fully liquid, but these negative t-bill rates say otherwise.  Irrationality is impervious to incomplete solutions.

If pressed about this at the next press conference, I am sure that Mr. Bernanke will admit that he does not have a precise read on why the liquidity problem is persisting.  Continually propping up a failing system will ensure that crises persist and escalate.  “Extend and pretend” is coming to an end, and, despite all the promises to the contrary, it is likely to get much uglier.  Sometimes there is just no good way out.

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