Understanding Fed Policy: QE Returns Thanks To QT Aftershocks And Repo Shock

2019 has seen major reversals by central banks the world over. None, however, are more noteworthy than the Fed’s, particularly as they relate to the recent repo flare-ups due to the system’s liquidity needs.

The Fed paused its hiking cycle early in 2019, delivered token rate cuts, and stopped balance-sheet roll-off (known as QT). Now, the Fed is reinvesting MBS dollar proceeds back into US Treasuries. It has launched the Treasury reserve management (TRM) program – a low calorie organic QE into T-bills to provide reserves to the system. And then there are also the massive repo injections.

Throughout, the Fed has claimed these policy moves are more akin to tweaks than a precursor to an all-out easing campaign. Their goal has been to sustain the recovery and they do not see any major issues with the financial markets. But even if that’s truly what they believe, it’s highly unlikely that the easing put in place so far will suffice to allay either the liquidity needs or the ongoing QT aftershocks.

 

Repo: Caught Between a Cyclical Rock and Structural Hard Place(s)

Ever since mid-September, much ink has been spilled trying to explain what caused the US repo spike. A confluence of events and circumstances resulted in liquidity-haves and liquidity-have-nots. The liquidity-haves – many of them super-tanker globally systematically important banks (G-SIBs) – hold the majority of the excess reserves in the system and are unincentivized to offer liquidity. The excess reserves have become like liquidity coverage ratios (LCR) frozen ponds rather than liquidity to provide to others. Meanwhile, the liquidity-have-nots are levered players that still operate on the margin. Overall policymakers have given a false sense of security that the financial system was flush enough after years of liquidity. Actually, the system has become leaner and more locked up due to regulation and more risk-averse banking.

 

Chart 1: Fed Balance-sheet Size vs. UST & MBS holdings vs E-reserves

 

Source: St Louis FRED, Macro Hive

 

But how did the idea of excess reserves become not ‘excess’ enough? And how can $1.3 trillion excess dollars be inadequate? As with everything in markets, first it was slow and then it was fast. The following factors contributed to this:

• Currency growth of nearly $1 trillion over a decade pulled liquidity out and into hard-cold cash (floating mostly out of the US).

• The Treasury expanded its strategic reserves of cash in the Treasury general account (TGA).

• Foreign official banks deposited over $200bn with the Fed (also reducing reserves).

• The Fed’s QT extinguished over $600 bn in reserves from late 2017 through mid-2019 (see Chart 1).

• Hard to track offshore USD funding needs also contributed. External users of dollars were probably a drag on liquidity.

• Lastly, but probably one of the main culprits, the new regulatory environment, which meant to strengthen the system but instead resulted in hoarding as banks keep excess liquidity on ice.

 

All this coupled with years of complacency and a lack of appreciation for marginal liquidity capacity led to repo markets getting caught between a rock and a hard place. The dealers are in many ways ground zero on this.

 

Chart 2: US Primary Dealer Liquid-product Holdings vs MBS-only Holdings

 

Source: St Louis FRED, Macro Hive

 

The repo disruptions are also connected to Treasury supply and the liquid-product holdings of US primary dealers.  As seen in Chart 2, there have been several major waves of primary dealer balance-sheet expansion in the last year.

The first wave took place after the last enlargement of QT in 4Q18. At the time, most of that growth in holdings was UST driven: UST supply was growing at a much faster rate while the Fed was also shrinking its UST holdings at its fastest pace.

The second wave took place in 2Q19 when curve inversion became more entrenched reducing the appeal of carry trades. However, in this second phase both UST and MBS holdings at dealers were seeing large increases. The sizeable footprint of primary dealer bond holdings – many of which are off-the-run less liquid bonds – combined with a perfect storm of large corporate tax payments and bond settlement dates, exposing how thin liquidity in repo had become.

Even though the Fed has provided some balance-sheet funding relief by introducing overnight and term repo, it’s important to watch primary dealer holdings of MBS. These have more than doubled this past year. Although overall liquid-product holdings are declining, as seen in Chart 2, it’s mostly a reduction in holdings of USTs since the MBS holdings are still rising. Recall that MBS securities are earmarked to continue to roll off and get reinvested into USTs. It is looking like a lot of the Fed’s MBS is piling up with dealers. This alone could be enough to keep funding pressures up into year end.

 

Fed Response: First Piecemeal and Now a Version of QE

In an earlier piece, I mentioned that if the repo tension persisted then the Fed would expand the program and possibly even hold an emergency meeting. Well, the FOMC conducted its first emergency intra-FOMC meeting since the financial crisis on 4 October. They also created what I referred to as a supplemental reserve program (SRP), which they called the Treasury reserve management (TRM) programme. This will expand the balance sheet again by purchasing $60bn T-bills per month through at least 2Q20 ‘in order to maintain over time ample reserve balances’. The Fed will also extend its current repo offerings through at least January.

Chair Powell and others are determined to characterise this latest version of balance-sheet expansion as ‘not QE’. However, many – including former chair Bernanke – define QE as actions taken to expand reserves. Therefore, with the system full of excess reserves and the Fed aiming to increase reserves further by targeting the quantity of reserves for liquidity purposes, this is a form of QE. It might be old school QE like Japan’s in 2001-2006, but it is still QE.

 

Bottom Line

Are Fed actions sufficient to handle the liquidity needs of the system as we head into year-end? The jury’s still out. If MBS keeps growing on primary dealer balance-sheets and G-SIBs scale back, the system will begin to rely on Fed repos for funding. As we get closer to year-end, there could be a preference to use overnight repo rather than term repos, which could still leave a footprint on the books of the large dealers. Furthermore, this additional Fed liquidity could encounter bottlenecks as excess reserves may end up sitting back at the large banks.

The Fed’s actions have been undeniably bold. As seen in their B/S monthly growth (Chart 3), it looks like QE. But these tools are blunt and slow-natured. We can compare this to 2007-8. Remember that the various liquidity programs like the TAF started off small and grew to levels that nobody imagined possible. Once TAF got off the ground, dealers began to depend on it for funding. With Treasury supply never-ending, a version of QE will need to stay in place unless there are regulatory changes and/or a standing repo facility launch. Until then, the risk is the system gets hooked on the temporary Fed repo injections. With repo rates still trading well north of the Fed Funds rate and money market spreads still wide, it’s a tall order for the Fed to fix this plumbing issue and keep the curves steep without further rate cuts. Therefore, we are not out of the woods and further easing is likely.

 

Chart 3: Fed B/S Monthly Change Versus the Level of the 3m10y Curve

Source: St Louis FRED, Macro Hive

George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He has worked both on the buy-side and sell-side.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)