Fed Guy

personal views of a former fed trader

Tapering Towards Neutral

The market impact of the Fed’s taper will be moderated by a significant decline in Treasury and Agency MBS issuance. An imminent taper is very likely now that a press trial balloon has been floated right before blackout and even the ECB is tapering. At the same time, Treasury is expected to lower coupon issuance and Agency MBS production is expected to continue to slow. In light of this, tapering can be thought of as maintaining the level of QE accommodation amidst significant declining issuance. While the mechanical impacts of taper will be blunted, the Fed’s taper announcement will still tighten financial conditions by bringing forward rate hike expectations. The Fed hopes to avoid another taper tantrum by separating taper from lift-off, but that is hard when one necessarily precedes the other. In this post we show how declining Treasury and MBS issuance will off-set Fed tapering and review the Fed’s communications challenge.

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Too Much Money

There is a plumbing explanation for the conundrum of lower nominal yields and higher inflation. Many factors affect yields, but they are in part determined by who has money and the investment constraints they face. QE mechanically increases the investible “cash” of investors who are most inclined to buy bonds, and they have been buying bonds. In our two-tiered monetary system $1 of QE creates $2 of money – $1 of reserves (money for banks) and $1 of bank deposits (money for non-banks). On the reserves side, some banks have significantly changed their behavior and begun deploying their reserves into bonds. On the bank deposit side, the wealthy ended up with the bulk of the newly created bank deposits. The wealthy tend to spend their money on assets, and they appear to be rebalancing some of the deposits into bonds. In this post we show how low rates are pressuring banks into adding bonds to their growing regulatory liquidity portfolio, how the skewed ownership distribution of new bank deposits may be leading to more bond buying, and suggest that low yields may not be a reflection of economic conditions.

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China Repo Facility

The new FIMA Repo Facility helps patch up a weakness in the Fed’s global dollar safety net. Since the GFC, the Fed has assumed the role of lender of last resort to the off-shore dollar banking system through it’s FX Swap Facility. Foreign central banks (“CBs”) could borrow from the Facility and use the proceeds to backstop the dollar needs of banks within their country. This helps prevent dollar panics abroad, which would affect the Fed’s ability to control domestic dollar interest rates. The Facility covers virtually all major dollar users, except China. The dollar needs of Chinese banks are backstopped by the Chinese government’s large Treasury holdings. This set-up works, until the Treasury selling is so acute that the market malfunctions and everyone has trouble monetizing their Treasuries. In this post we review the role of the Fed’s FX Swap Facility and show how the new FIMA Repo Facility is largely a China Repo Facility designed to both strengthen rate control and the Treasury market.

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Reserve Demand Post-SRF

The Fed’s new domestic Standing Repo Facility (“SRF”) makes Treasuries more fungible with reserves and will thus slightly impact the composition of GSIB liquidity portfolios. Post-Basel III GSIBs are required to hold large High Quality Liquid Asset (“HQLA”) portfolios that in practice largely consist of reserves. Although reserves and Treasuries are equal under the letter of Basel III, regulators prefer banks to hold reserves because they are more liquid. This distinction was further highlighted last March when many investors had trouble liquidating their Treasuries. An SRF addresses this concern by allowing GSIBs to instantly convert HQLA securities to reserves. The primary mechanism through which the SRF impacts markets is thus through GSIB HQLA portfolios. An SRF means GSIBs can hold fewer reserves, and more Treasuries. In this post we review the SRF, show that reserve demand is not currently constraining GSIB HQLA portfolios, and suggest the SRF’s market impact will be slight.

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The Primary and Secondary Market for Money

Domestic businesses have steadily increased their borrowings even though overall bank business lending appears to be declining. In general, businesses seeking to borrow money (bank deposits) have two main sources: banks or the debt capital markets. A bank loan leads to the creation of new bank deposits and increases the overall money supply, while issuing a corporate bond changes the ownership of existing bank deposits. These two markets for money operate under different constraints and serve different but overlapping borrower segments. In the past year, larger businesses rotated away from from banks to the capital markets while smaller businesses continued to borrow from banks. In this post we describe the two markets for money and show that together they show significant strength in the demand for money from domestic businesses.

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RRP take-up reduces liquidity held by banks, but does not change the quantity of liquidity held by Non-Banks. This difference arises from our two tiered monetary system, where banks and non-banks hold different types of money. Banks lose reserves (money for banks) when they settle payments to the Fed on behalf of Non-Bank RRP participants. But from the perspective of Non-Banks, the RRP just replaces bank deposits (money for non-banks) with what are essentially secured deposits at the Fed. At the zero lower bound, the RRP is a cash equivalent and RRP take-up is largely a function of bank balance sheet constraints. In this post we walk through the balance sheet mechanics of RRP participation from the perspective of Non-Banks, Banks, and the Fed. The current context suggests the RRP is largely acting as a tool to manage the side effects of QE.

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Two Rotations

The 5bps RRP hike created a wedge between the opportunity costs of 2a-7 money market funds (“MMFs”) and non-MMF cash investors that is setting the stage for a tectonic rotation. By August month-end around $1t in Treasuries and Agencies held by MMFs will mature and most of the proceeds will be reinvested into the RRP. The RRP is offering the same yield as bills but allows MMFs to conserve their WAM/WAL dollars for more attractive investments. As the same time, some non-MMF cash investors will be moving out of their 1bps MMF shares or 0% bank deposits and into slightly higher yielding bills. MMF portfolios are earning more from the 5bps RRP hike, but passing on virtually none of it to their investors. This makes 5bps bill yields attractive to non-MMF cash investors. At the same time, bill supply is shrinking as Treasury cuts issuance to stay under the debt ceiling. In this post we preview the two upcoming rotations created by the 5bps RRP wedge, and suggest that these forces will slowly push short-dated bills back towards 0%.

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Who’s Still Borrowing?

The demand for money market funding across all major borrowers is declining even as the supply of money market funding continues to increase. Prior posts described the structural forces increasing the supply of money and pushing money market rates lower, but declining demand for money plays a role as well. The vast majority of money market borrowing is from the U.S. Treasury, GSEs, repo dealers and commercial banks. They have all been reducing their borrowings in money markets, with some reductions likely structural. In this post we review each of these major borrowers and explain why their borrowings have declined.

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Follow The Money

The recent fiscal actions taken by the U.S. are not just remarkable in scale, but also in form. A sizable chunk of the historic $5t in spending actually ended up in the hands of the general public via various types of transfer payments and grants. That money was essentially created out of thin air by the Fed and then spent into the economy by the Treasury. Observing the Fed’s growing balance sheet offers a glimpse as to the scale of the printing, but it does not reveal where the money ends up. Generally speaking, the created money ends up as a deposit liability in the banking system. Banks must file detailed regulatory reports on their deposit liabilities, so it is possible have an idea of the type of depositors who ultimately benefited from the government’s largess. In this post we first review the GFC era policy response, show how the distribution of money this time is now more favorable towards retail, and suggest that this change is contributing to inflation.

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The Elasticity of 5 Basis Points

Large money market investors will move billions for even a basis point. A 5bps increase to the RRP offering rate led to a $200b+ surge in participation, but there is a wrinkle to the story. The bulk of the increase likely came from Government Sponsored Enterprises (“GSEs”) who were leaving hundreds of billions at 0% in their Fed account, so it was not an incremental flow from the private sector. That being said, the 5bps increase puts money market funds (“MMFs”) in a position to offer their investors a few basis points in yield. This will make it easier for banks to continue to push out their high cost deposits. The departed deposits will quickly be replaced by the constant flow of low cost deposits created from Fed financed deficit spending. In this post we shed light behind this week’s RRP surge, the improving funding profiles of banks, and why this means FRA-OIS will continue to narrow.

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