How The Fed’s “Not QE” Boosts Risk Markets

The Fed is moving to an RP (repo) operational target, which requires a bigger balance sheet. In the context of the ongoing risk rally this is likely to translate into further USD weakening against EMs.

Up to the September RP volatility, the Fed balance sheet strategy was aiming for ‘the minimum level of reserves needed to continue operating in a floor system’. This was based on surveys of banks suggesting aggregate minimum reserves need to be around USD900 bn. In November, however, a senior NY Fed official signalled a change of strategy: ‘the quantity of reserves needed to maintain an ample reserves framework is subject to uncertainty and may change over time’, noting that ‘the level of reserves needed is more than the sum of individual banks’ demand, particularly when there are frictions that result in inefficient redistribution of reserves.’

This new strategy is consistent with the Fed moving to an RP operational target. This requires a larger balance sheet than an FF (federal funds) target since the RP market is bigger and more liquid than the FF market.

Recent liquidity operations also suggest that the Fed is moving to an RP target. Since mid-September, reserves have increased by USD260 bn due to USD170 bn of TBill purchases, USD220 bn of RPs, and USD130 bn changes in other liabilities and assets (Chart 1). As a result, FF has moved to the bottom of the target range and RP has moved closer to FF (Chart 2).

Nevertheless, the Fed is not reducing its liquidity injections by much, as shown by its latest RP schedule. Furthermore, the Fed is reportedly considering expanding its RP counterparties to small banks, securities dealers, and hedge funds, from currently only primary dealers. This change would further confirm that the Fed is targeting the RP rate.

This de facto move to an RP operational target could reflect the following:

• The RP market is much more important for the US and global financial systems than the FF market. Over the past year, the volume of daily Fed Funds transactions has been about USD60 bn; by contrast, the volume of daily SOFR transactions is typically in excess of USD1 tn.

• As stressed by a former NY Fed senior official, the current setup where the FOMC officially targets FF but where the Fed actually implements an RP target is confusing to markets.

• The selection of FF as a post-crisis operational target has been the subject of much internal Fed debate. Recent market volatility could have led the Fed to reconsider its choice.

Chart 3: Reserves and Spreads to IOER

Source: Macro Hive

The Fed wants to increase reserves well past the level where most changes in non reserves liabilities can be absorbed without impacting money market rates. The balance sheet runoff shows that responsiveness of RP/IOER spread to the level of reserves started around mid-2018, when reserves fell through USD1900 bn and the Fed had to start cutting IOER (chart 3). In addition, since 2010, 80% of the weekly increases in non reserves liabilities (Treasury General Account, Foreign RRP and others) have fallen below USD65 bn.

This suggests the Fed could be aiming for reserves in a USD1900–2000 bn range, which suggests an expansion of the current TBills purchase program of USD60 bn a month, and possibly coupon purchases, as well as continued RP lending. Furthermore, once the target level of reserves has been reached, the balance sheet is likely to increase at a faster pace than based on currency issuance alone. The RP market now represents only about 30% of outstanding Treasury debt, against 110% before the crisis: a major channel of absorption of new government issuance is now clogged. As a result, funding large budget deficits without impacting RP will likely require further Fed liquidity provision.

Chart 4: EM FX and Local Currency Bond Indices

Source: Macro Hive

In contrast with my views, the NY Fed December 2019 primary dealers survey showed median expectations of Tbill purchases and RP funding decreasing to USD15 bn/month and USD125 bn respectively by June 2020.  Higher than expected expansion in the money base has typically brought about USD weakness. Furthermore,

in the context of the ongoing risk rally, the USD is more likely to weaken against EMs than against G10 currencies, and carry’s strong 2019 performance is likely to extend into 2020. This view could be expressed as short USD against a basket of EM currencies, or, since EMs are likely to take advantage of a weaker USD to ease policy, as a basket of local currency bonds (Chart 4).