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Investors fret over future of Fed crisis lending

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Jay Powell and Steven Mnuchin had plenty of reasons to argue over the past three years, from Donald Trump’s personal attacks on the chairman of the Federal Reserve, to trade tensions and the president’s handling of the pandemic.

But it was not until the past week that a rift between America’s top two economic policymakers boiled over, after the Treasury secretary pulled the plug on a portion of the central bank’s crisis lending facilities with about two months left in office, against Mr Powell’s wishes.

The move by Mr Mnuchin jeopardised a very effective partnership with Mr Powell that was crucial to securing a hefty US policy response to the coronavirus crisis early on. The central bank made no secret of the fact that it wanted to preserve the credit facilities being axed by the Treasury secretary as a key weapon in its arsenal to keep markets healthy during the pandemic

“There have always been tensions between the Treasury and the Fed but there has always been a strenuous attempt to keep them private,” said David Wessel, director of the Hutchins Center for Fiscal and Monetary Policy, a Washington think-tank. “This seems extremely dangerous . . . like telling the firehouse we’re cutting off the water between now and inauguration, and hope we don’t have any fire,” he said. 

If the economic recovery proceeds without backsliding due to a new surge in infections and lack of fiscal support, the worries about the impact of Mr Mnuchin’s decision may end up being moot.

But if financial markets were to experience new turmoil in the coming months, the Fed might struggle to limit the damage to investors in corporate debt, municipal and state debt, and asset-backed securities, whose markets were propped up by the lapsing facilities. And the fallout could be broader, given the nearly $40tn US equity market has been buoyed by the Fed’s intervention as well.

“This is a policy error, there’s no question around that,” said Ed Al-Hussainy, an analyst with Columbia Threadneedle. “These are facilities that provided an emergency backstop [and] as far as we know the emergency is not over. It is prematurely thinning out the Fed’s toolkit.”

Federal Reserve's alphabetti spaghetti of emergency measures updated as of November 18th.

The greatest solace for markets may be that the Treasury did agree to a three-month renewal of Fed credit facilities set up to support short-term funding markets, like commercial paper and money market mutual funds, which experienced great trouble back in March.

But the loss of the schemes terminated by Mr Mnuchin could be significant, even if their usage had been low until now. Of particular concern will be the end of two facilities created to buy corporate debt, including some junk bonds, and one to give access to credit to state and local governments at a time when they are increasingly cash-strapped with no federal aid money coming their way. 

Markets were relatively listless on Friday after the spat between Messrs Powell and Mnuchin spilled into the open, with portions of the Treasury yield curve flattening. Investors said there was some expectation the Fed could be prompted into greater bond buying — particularly in longer-dated 10- or 30-year bonds — to help compensate for the decision by the Treasury.

Stocks slipped and spreads on junk bonds, which measure the premium investors demand to own the risky debt over haven Treasuries, widened marginally to end the week. 

Bryan Whalen, a portfolio manager with TCW, said that regardless of the limited use of the programmes, their existence had been enough to instil confidence in markets in March, and that alone made them a “home run”.

“The bonds that were bought or loans that were made in and of itself, weren’t meaningful,” he said. “But collectively when you look at the list of programmes, and not just the funds that were allocated from the Treasury and Fed but the amount of sectors they were touching collectively it meant so much.”

Column chart of Assets, $bn showing Debate over Fed facilities emerges as usage stalls

Among the schemes, the Main Street Lending Program was perhaps the most derided, given its small outlays. Many companies and lawmakers had urged the Fed and Treasury to ease the terms of the facilities to boost demand and use up its $600bn capacity, but take-up remained paltry as some struggling businesses — including commercial real estate groups and retailers — thought it was not generous enough. Century 21, the famed New York City department store, filed for bankruptcy after failing to meet the facilities’ standards.

But while the MSLP may not be missed — the corporate and municipal debt facilities were more market-sensitive and it could be more risky to let them lapse. 

The question plaguing investors is how quickly the programmes could be restarted if markets dive again. The Treasury department, whether under Mr Mnuchin until January 20 or his successor in the administration of Joe Biden after that, could tap the Exchange Stabilization Fund without congressional approval to revive the facilities, but they would have smaller capacity than they did this year. Getting Congress to sign off on greater funding could be difficult with many Senate Republicans opposed to their renewal. 

“Politically the hurdle rate for invoking [these facilities] next time is much higher,” Mr Al-Hussainy said. “There will be people in Congress who correctly say these programmes disproportionately benefited large corporations.”

 Mr Powell could have escalated the dispute with Mr Mnuchin further this week by refusing to send the unused funds from the facilities back to the Treasury department, in effect stopping them from expiring. But instead, in a letter on Friday afternoon that could spare him a fierce political battle with the outgoing Trump administration, he said he would abide by Mr Mnuchin’s decision — and applauded their work together on the facilities in the first place.

“Our efforts helped to prevent severe disruptions in the financial system and unlocked trillions of dollars of private lending to households, businesses, and municipalities at a moment when the economy needed it most,” the Fed chair said.



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BNP under fire from Europe’s top wine exporter over lossmaking forex trades

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BNP Paribas is facing allegations that its traders mis-sold billions of euros of lossmaking foreign exchange products to Europe’s largest wine exporter, the latest accusations in a widening controversy that has also enveloped Goldman Sachs and Deutsche Bank.

J. García Carrión, founded in Jumilla in south-east Spain in 1890, is in dispute with the French lender over currency transactions with a cumulative notional amount of tens of billions of euros. It claims the lossmaking trades were inappropriately made with one of its former senior managers between 2015 and 2020, according to people familiar with the matter.

BNP is one of several banks facing complaints from corporate clients in Spain over the alleged mis-selling of foreign exchange derivatives, which pushed some companies into financial difficulties.

Deutsche Bank has launched an internal investigation of the alleged mis-selling that this week led to the departure of two senior executives, Louise Kitchen and Jonathan Tinker.

An internal investigation at JGC found that BNP conducted more than 8,400 foreign exchange transactions with the company over the five-year period, equivalent to about six each working day.

That level of activity was far higher than what the company would have needed for normal hedging of exchange-rate risk on international wine exports, the people said, adding that the Spanish company had shared the results of its internal probe with BNP.

While the vast majority of the lossmaking trades related to euro-dollar swaps that moved against the bank, some were in currency pairs where JGC has little or no operations, such as the euro-Swedish krona.

As a direct result, the €850m-revenue company made about €75m of cash losses in those five years, while BNP could have made more than €100m of revenue from transactions, the people added. Many of the deals were made through trading desks in London.

Executives have demanded compensation for at least some of the losses, arguing that BNP’s traders or compliance department should have spotted and reported the disproportionately high level of transactions and profits from a single client, according to multiple people with knowledge of events.

JGC says the deals were designed as bets on currency markets, rather than for hedging, and is considering a lawsuit to try to recover some of the money, one of the people said.

“BNP Paribas complies very strictly with all regulatory obligations relating to the sale of derivatives and foreign exchange instruments,” the bank said in a statement. “We do not comment on client relationships.”

JGC declined to comment.

Separately, the Spanish wine producer is suing Goldman Sachs in London’s High Court for a partial refund of $6.2m of losses caused by exotic currency derivatives. Goldman has maintained the products were not overly complex for a multinational company with hedging needs and were entered into with full disclosure of the risks.

In Madrid, the wine company has also brought a case against a former senior executive who was responsible for signing off the lossmaking deals. JGC alleges this person conducted the deals in secret and covered them up internally by falsifying documents and misleading auditors.

In the London lawsuit, JGC alleges its executive was acting “with the encouragement and/or pursuant to the recommendations” of Goldman staff “for the purposes of speculation rather than investment or hedging”.

Deutsche Bank has been investigating for months whether its traders in London and Madrid sidestepped EU rules and convinced hundreds of Spanish companies to buy sophisticated foreign exchange derivatives they did not need or understand.

The Financial Times has reported that the German bank has settled many complaints brought against it in private and avoided going to court.

People familiar with the matter told the FT that the departures of Kitchen and Tinker were linked to the probe into the alleged mis-selling, which appears to have occurred in units that at the time were overseen by the two.

The bank declined to comment. Kitchen and Tinker did not respond to requests for comment.



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Will the Fed dare to mention tapering?

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Will the Fed dare to mention tapering?

When Federal Reserve officials convene on Tuesday for their latest two-day monetary policy meeting, questions over whether the central bank should start talking about tapering its $120bn monthly bond-buying programme will lead the agenda.

Since the US central bank last met in late April, several senior Fed policymakers, including vice-chair Richard Clarida, have cracked the door more widely open for a discussion about eventually winding down the pace of those purchases, which include US Treasuries and agency mortgage-backed securities.

The recent comments align with those referenced in the latest Fed meeting minutes, which indicated that “a number of participants” believed it might be “appropriate at some point in upcoming meetings” to begin thinking about those plans if progress continued towards the central bank’s goals of a more inclusive recovery from the pandemic.

Recent economic data support this timeline. Consumer prices in the US are rising fast, with 5 per cent year-on-year gains in May revealed in last Thursday’s CPI report — the steepest increase in nearly 13 years. Additionally, last month’s jobs numbers, while weaker than expected, still showed signs of an improving labour market.

Most investors still expect the Fed to only begin tapering in early 2022, with guidance on the exact approach delivered in more detail around September this year at the latest. Goldman Sachs predicts a more formal announcement will come in December, with interest rate increases not pencilled in until early 2024.

“The Fed is signalling they are going to start talking about it,” said Alicia Levine, chief strategist at BNY Mellon Investment Management. “They are softening up the market to expect [something] this summer.” Colby Smith

Are inflation risks rising for the UK?

Consumer prices in the UK have risen at an annual rate of less than 1 per cent for most of the pandemic due to low demand for goods and services and weak wage pressure.

However, with the recent easing of Covid-19 restrictions releasing pent-up consumer demand, the nation’s headline inflation figure doubled in April from the previous month.

When core consumer price inflation data for May are released on Wednesday, some analysts expect an even bigger leap, predicting that annual CPI growth will jump to the Bank of England’s target of 2 per cent.

Robert Wood, chief UK economist at the Bank of America, said such an inflation surge would add to the BoE’s hawkishness. He also forecast further rises later this year as commodity price increases continued to elevate energy and food costs.

Additional price pressure would come from supply chain disruptions and higher transport costs that push up input costs.

“The upside risks to our inflation forecast are growing from all angles,” said Paul Dales, chief UK economist at Capital Economics, who expected consumer price levels to peak at 2.6 per cent in November.

“The reopening may result in prices in pubs and restaurants climbing quicker than we have assumed,” Dales added, while labour shortages in some sectors, such as construction and hospitality, were also starting to push up wages and prices.

However, both analysts expect the increased price strain to be temporary.

“Once higher commodity prices have fed through to consumer prices, inflation will fall back again,” said Wood, forecasting that UK inflation would drop back below the BoE’s target in late 2022. Valentina Romei

Line chart of Annual % change on consumer price index showing UK consumer price inflation is set to rise above target

Will the BoJ keep its rates policy on hold?

Japan’s economic recovery has diverged from Europe and the US this year as it struggles with its Covid vaccination campaign and big cities such as Tokyo continue to be partially locked down under states of emergency due to the pandemic.

Although the nation’s wholesale prices rose at their fastest annual pace in 13 years last Thursday on surging commodity costs, Japan has otherwise faced a lack of price pressures compared with the US.

That means that when the Bank of Japan concludes its two-day meeting on Friday, analysts believe it will not alter monetary policy.

“I don’t expect any change in policy,” said Harumi Taguchi, principal economist at IHS Markit in Tokyo. “They increased flexibility in March and I expect they will continue to watch that.”

After a policy review, Japan’s central bank in March scrapped its pledge to buy an average of ¥6tn ($54.8bn) a year in equities, and the pace of its exchange traded fund purchases dropped sharply in April and May. The moves signalled a shift away from aggressive monetary stimulus in favour of what the BoJ termed a more “sustainable” policy.

“Japan is one of the few countries whose property prices have not risen, and since rent is a major component of the consumer price index, it is not likely to see much inflation ahead,” said John Vail, chief global strategist at Nikko Asset Management in Tokyo.

“Interest rates can remain extremely low, which in turn keeps the yen on a weak trend,” Vail added. Robin Harding

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Dollar traders chill after the tantrum

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It was a classic case of buy the rumour, sell the fact.

In February this year, investors and analysts were concerned that the US economy was beginning to hot up, sparking fears that inflation would pick up and force the Federal Reserve to quicken its policy tightening. This, in turn, led to a surge in US government yields, which propelled the dollar to the year’s high against its peers a month later.

Fast-forward to the end of the first half of the year and inflation in the US is running at its fastest pace since the global financial crisis, but the dollar has weakened for two straight months after appreciating in the first quarter.

Most of the shift is down to US central bankers who rushed to reassure investors that they would keep conditions extremely accommodating, soothing the flare-up in Treasury yields and the dollar’s exchange rate.

As a result, analysts are pretty confident that Fed chair Jay Powell and his board will “look through” the rise in prices at the central bank’s rate-setting meeting next week, keeping the dollar on its current weakening path.

“The combination of steady Fed expectations and a broadening global economic recovery should allow recent dollar weakness [to] continue,” said Zach Pandl, co-head of foreign exchange strategy at Goldman Sachs, in a research note. He expected the euro to benefit the most against the US currency.

Still, some strategists cannot help but wonder whether they should stick to selling the fact, or if it is time to start buying the rumour — and the dollar — again. Despite inflation powering to above 5 per cent year on year, yields on 10-year Treasuries fell to their lowest in three months, in a counterintuitive reaction fuelled by the anticipation that policymakers will shrug off the building heat in the economy.

“Getting US inflation right may be the most important market call for the rest of the year,” said Athanasios Vamvakidis, global head of currency strategy at Bank of America in London.

A decision from the US central bank to keep its policy unchanged would allow the dollar to continue with its weakening path, but maybe not as much as traders anticipated at the beginning of 2021. Vamvakidis notes that currency markets are quietly pricing in less dollar weakness than at the start of the year, with the consensus view now calling for the euro to trade at around current levels $1.21 by the end of December rather than at $1.25.

“For now, high US inflation and a still dovish Fed keep real US rates highly negative and this supports the euro. The question is for how long this is sustainable if US inflation proves persistent,” he said, adding that the bank expected the euro to finish the year at $1.15.

Line chart of Dollar index (DXY) showing The dollar has weakened after first-quarter gains

There are signs that investors might be getting too relaxed. Options markets display little nervousness about the Fed meeting, and Mark McCormick, global head of currency strategy at TD Securities said negative bets on the dollar had begun to build up heavily again in recent weeks.

This adds to the risk of a sharp snapback in the currency’s exchange rate if the Fed does hint at tapering its asset purchases on Wednesday or before analysts expect.

“Don’t expect much more dollar weakness into the summer,” said McCormick.

There are also some offbeat signs that there is a risk of traders betting too heavily on the Fed’s commitment to keeping liquidity ample. Analysts at Standard Chartered noted that Treasury secretary Janet Yellen, a former Fed chair, mentioned the potential benefits of a higher interest rate environment twice in recent weeks.

John Davies, a US rates strategist at Standard Chartered, said that it was most likely that the Treasury chief was defending the Biden administration’s fiscal plans rather than criticising Fed policy, but it was highly unusual.

“It is still striking when the Treasurer of a public or private entity argues for higher borrowing costs,” said Davies.

Investors now expect the US central bank to start cutting its asset purchase amounts in the first quarter of next year, with an announcement pencilled in for potentially September, when the Fed meets for its annual symposium at Jackson Hole, according to Oliver Brennan, head of research at TS Lombard.

But while an earlier than expected announcement would cause some ructions, the real risk is that investors will have to start anticipating the timing of rate increases in the US, which could come sooner and harder than they anticipated.

“The taper sets the clock ticking for the first rate hike and real rates rise [and] big changes in Fed policy are rarely smooth-sailing,” said Brennan.

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