Monetary Policy & Inflation | US
As we head into the final days of trading in 2019, the Fed is taking no chances. But at the same time, they are avoiding jumping to QE4 (and SRF is further afield). The Fed is still acting as if this is a plumbing issue that should be handled with repo operations, leaving QE for macro measures.
The day after the FOMC, the NY Fed surprised front-end investors by unveiling an even larger round of repo operations for the current period, lasting from 13 December 2019 thru 14 January 2020. Year-end overnight repos will increase to at least $150bn and there will be a $75bn forward settlement repo on 30 December 2019 – all to help get markets over the hump. There is also a series of term repos thrown in for good measure.
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As we head into the final days of trading in 2019, the Fed is taking no chances. But at the same time, they are avoiding jumping to QE4 (and SRF is further afield). The Fed is still acting as if this is a plumbing issue that should be handled with repo operations, leaving QE for macro measures.
The day after the FOMC, the NY Fed surprised front-end investors by unveiling an even larger round of repo operations for the current period, lasting from 13 December 2019 through 14 January 2020. Year-end overnight repos will increase to at least $150bn and there will be a $75bn forward settlement repo on 30 December 2019 – all to help get markets over the hump. There is also a series of term repos thrown in for good measure.
The NY Fed can further adjust these repos in order to ‘mitigate the risk of money market pressures that could adversely affect policy implementation’. All told, there is about half a trillion dollars of liquidity for those that need it.
These are bold actions and it’s great that the Fed means business and are determined that repo markets will remain orderly. Yet, it is also concerning that the Fed needs to use such a heavy hand to ensure nothing goes off the rails. Year-end money market activity has always had some funding frictions that would work themselves out without leaving a lasting mark on market functioning or financial conditions in the days after. We seriously hope their approach this year is just a one-off year-end scramble like Y2K.
However, with the SOFR launch ahead (and that rate being closely tied to a well-run repo market, which for the Fed means lower repo rate volatility and less intra-day imbalances), these year-end specific Fed repos may return.
If you include the TRM bill purchases, there is the potential for over $600bn in Fed-related support for money markets through year-end into January. However, we predict the actual number will be less for these reasons:
(1) Primary dealers and investors have likely been preparing for these next two weeks of the year from perhaps as early as the middle of November (and they have had help along the way via Fed repos).
(2) A recent repo operation was not fully utilized and that could be an indication that the dealer network is squared up and won’t fully tap all of the new enlarged Fed repo operations around year-end.
(3) The chance of a repeat of the September outsized move in repo rates – or even last December’s jump – is low with the Fed’s safety net in place now (and reserves have been growing for months, too).
Some Repo-Related Questions May End Up Taking Longer to Answer
2019 has been a year of many marvels. Equities have been ignoring the global slowdown/earnings decline and instead took their cues from trade deal tweets and Fed liquidity which inflated P/Es and pushed stocks higher.
The levitation of risk asset valuations would have been the story of the year were it not for the repo crisis in these past few months. In our view, nothing has left more wonder in the minds of all investors (as well as in the financial media) than the question of what exactly is going on in the repo markets.
We have heard all of the logical reasons for the crisis and listed many of them here. In September, it was the so-called ‘perfect storm’ of corporate tax payment combined with UST settlements. However, we had the same setup this past Monday with a combined $100bn plus in corporate tax payments and UST settlements and repo rates barely moved. It’s possible that with everyone focused on it now (and the Fed’s repo providing support), that’s the reason the 16 December flow was a non-event. In reality, what is different versus September is that TGA is now stocked up.
Yet there are still many unanswered questions, many of which we probably won’t have the answers to for some time. These include the following:
• Reg-related: Why wasn’t the Fed aware of the reserve levels needed for banks to meet their regulatory obligations and intra-day liquidity needs, particularly when they have oversight and are a key regulator?
• Perfect storm fallacy: Why have the dealers grown dependent on daily Fed repo operation when before they functioned without them?
• Liquidity shortfalls beget credit risks: Is something more serious at play? Are there entities which are so levered up that if they lose liquidity they become credit risks to those that are providing funding?
BIS Review and the Role of Levered Players in the Repo Crisis of 2019
Previously we reviewed the liquidity haves and have-nots theme where post GFC banks are overly cautious, leading to hoarding of reserves.
But this idea that all of a sudden there was not enough reserves in the US banking system is incomplete. In a recent BIS quarterly review report, they highlighted that the repo crisis of 2019 was likely not just about reserves scarcity but also about how levered players use and are given funding. In their assessment, the top 4 US banks dominate the US repo market. In addition, these large banks have become large buyers of UST securities.
Chart 1: Reserves Vs. UST Holdings ($Bn.)
Chart 2: Bank UST Holdings as % of Total Reserves (quarterly)
Source: St Louis FRED and Macro Hive
As well as banks potentially cutting back on repo availability (and buying USTs outright instead), the BIS review suggested the changing nature of the repo market and the advent of sponsored repo may have led to money funds cutting back on repo funding for leveraged players in September.
Foreign Buyers of US Debt and Foreign Reverse Repo Program (F-RRP)
One less known area of the Fed’s balance-sheet liabilities is the foreign repo pool. Foreign central banks (FCBs) are able to park cash at the Fed at a rate that is competitive in comparison to markets. These overnight cash alternatives also come with the added bonus of not having to deal with counterparty or liquidity risks whenever they need access to their cash.
Chart 3: FCBs Park Cash at the Fed Vs. Buying USTs ($Bn)
Source: St Louis FRED and Macro Hive
As seen in chart 3, FCB holdings of USTs at the Fed peaked in March of 2018 at around $3.1tn and have since declined by over $150bn (and $50bn of that decline was since the September repo crisis). Meanwhile, from the Fed’s lift-off until recently, FCB cash at the Fed has gone up over $200bn.
In fact, the peak of FCB cash at the Fed was during the same week as the repo crisis, 18 September, at $306bn. Since then, there has been a decline of over $40bn in F-RRP. That has actually helped to release some reserves into the system. But where did that cash go if their UST holdings are down?
Meanwhile FCBs are back in buying MBS. FCBs scaled back their MBS holdings post the housing crisis and as per chart 4 were one of the net sellers into the QE programs. However, since the announcement of QT, FCB MBS holdings at the Fed have risen by $100bn. In general yield starved foreign investors, especially non-FCBs, have been acquiring MBS in large quantities. Yes, US housing is now indirectly being supported by overseas investors again. However, that will be a story for another day.
Chart 4: The Hand-off: Fed’s MBS to FCB Buyers ($Bn)
Source: St Louis FRED and Macro Hive
The Bottom Line:
As with Y2K, the Fed has enacted measures to ensure this year-end goes over as best as it can. That said, all of the Fed’s actions and Fed member speeches suggest they are avoiding the jump to proper credit-based QE compared to just continuing reserve management via repo and TRM. Moreover, the Fed’s aim is to get us over the hump. At that point we imagine they will look at better alternatives than daily overnight repos..
The Fed’s balance-sheet is ground zero for the interaction between the short-term and long-term structural issues impacting USD funding. Short-term swings in the Treasury’s general account (TGA), and to a lesser extent debt issuance and auction settlements, lead to reserve volatility. Also, tax payments are adding to further gyrations when reserves are low. The Fed may explore coordination with Treasury on some of these fronts.
Although the cumulative effect of the QT aftershock and debt ceiling/TGA event brought the repo crisis to the surface in September, years of foreign central banks draining reserves (via F-RRP) along with over $1tn in new cash put into circulation after GFC made this event happen sooner than it would have otherwise, in our view. It’s harder for the Fed to directly mandate where FCBs put their excess cash, but perhaps the recent declines in F-RRP usage were as a result of a friendly Fed nudge (and we all know that US deficits could surely use the helping hand of FCBs too).
Through its regulatory arm, the Fed can look at ways of optimizing some of the regulations that drive banks to hoard reserves beyond requirements.
Some things are still out of the Fed’s control. It’s possible that there are too many leaky pipes to fix and repo operations do not decline once private sector balance-sheets reset in early 2020. And even with positive rates, paper money continues to grow (with a lot of that cash heading overseas).
The labyrinths known as the offshore markets (Eurodollar and Asiadollar) have their own modus operandi and if there is an issue in these markets the Fed can only do so much. Ironically, this is one of the reasons why the Fed wants to win back its monetary power by having the US system set to SOFR versus LIBOR (though repo volatility is making SOFR challenging).
Lastly, the true sign of success will be if these overnight repos fade away in 2020 and the Fed achieves a happy medium of reserve levels via TRM. The issue at such a point will be if the bill market becomes too rich and thus driving the Fed to buy up the curve (as suggested in our pre-FOMC report), which subsequently Chair Powell also alluded was an option. But as we said, if that happens will overall markets be happy with less liquidity?
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He 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.)