Fed Guy

personal views of a former fed trader

The Reserve Gap

A rapid decline in the level of bank reserves would be an obstacle to QT that may prompt action from the authorities. An aggressive QT was premised on first draining the large RRP balances, but the monetary plumbing suggested that was never likely. Banks can easily maintain their own reserve levels, but their own target levels are significantly below those of the Fed. This implies that bank reserve levels will likely fall below the Fed’s comfort level far before QT is slated to end. In this post we sketch out the Fed’s dilemma, show why its options are limited, and suggest that Treasury buybacks or SLR adjustments would likely be used to boost bank reserve levels.

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Fed Balance Sheet FAQs

This post answers four frequently asked questions on the Fed’s balance sheet. The answers to the first two questions will affirm that the Fed is executing QT exactly as promised, even if it may not appear that way. The apparent discrepancy is due to TIPS appreciation and details in MBS settlement mechanics. The answers to the second two questions will show how the Fed balance sheet behaves when the Fed has and negative net interest income or capital losses. The Fed has special accounting rules where losses appear as “deferred assets” that will be repaid out of future earnings.

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The Marginal Buyer

Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector. This post reviews the basics of Treasury buybacks and explains how it could be an important tool in managing Treasury market stability and Fed liquidity flows.

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The Money Still Flows

The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation. Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power – credit, wages, and wealth – all appear to easily support elevated inflation. These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate. The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked. This post reviews the strength of household purchasing power along the three sources and suggests a dovish Fed pivot is far away.

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One Armed Fed

The Fed’s current focus on inflation over full employment may be a preview of monetary policy in a world where the supply of labor is structurally declining. An aging population implies a persistent decline in the supply of labor, even as demand for labor remains strong because retirees continue to consume. The economic implications of this new regime are previewed through the recent wave of early retirements: lower unemployment, higher wages, higher inflation, and weaker growth. These circumstances reduce the employment costs of tighter policy, potentially changing the Fed’s reaction function by freeing policy to more aggressively target inflation. Recall, the Fed’s mandate is full employment and price stability, not positive economic growth. In this post we review a theory on how aging demographics raise inflation, illustrate its implications with the recent wave of early retirements, and suggest higher interest rates will become structural.

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Don’t Fight The Fed

The Fed has developed enough new tools that there are almost no limits to how far it can tighten. Prior tightening cycles often led to financial instability that prompted sudden easing, but that was before the revolution of March 2020. At that time the Fed acted as lender of last resort to not just the typical financial sector entities, but also to real economy entities including municipals, corporations, and even small businesses. The emergency facilities were intended to transmit low rates to the real economy even when the financial system malfunctioned, but those facilities can also be used to transmit higher rates. An aggressive tightening will likely lead to cracks in financial markets before inflation is tamed. In that case, the Fed now has the tools to support the real economy and keep tightening until the last ounce of inflation is squeezed out. This post reviews the Fed’s tool kit, notes still it lacks one important tool, and suggests Fed tightening can be more aggressive than expected.

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Turbo Tightening

The money supply is set to contract just as investors are clamoring for cash to hide from declines in both equities and bonds. A combination of increasing MMF allocation to the RRP and QT may drain ~$1t of bank deposits by the end of the year. The Treasury’s decision to further cut bill issuance will keep money market rates very low and likely push the RRP to over $2.5t by the end of the year. Furthermore, recent history suggests QT will largely be funded by deposits held in banking system rather than the RRP. The combination of these two mechanisms suggests a net contraction in bank deposits despite elevated bank credit creation. Investors looking to hide in cash will have to compete for a shrinking pool of cash by further lowering the asking prices of their assets. In this post we describe the mechanics behind the impending rapid withdraw of cash and suggest the market rout will continue.

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Draining the RRP

The $1.7t in the RRP can help finance the upcoming deluge of coupon Treasuries, but it won’t be easy. Treasury bills will easily be funded, but the bulk of the upcoming supply from net issuance and QT is likely coupons. There are only two ways the RRP can finance coupon Treasuries: 1) funding repo loans to leveraged Treasury investors or 2) funding money fund redemptions to cash Treasury investors. Both mechanisms are subject to frictions that suggest a messy process. Leveraged investors may encounter dealer balance sheet constraints, and cash investors may need a much steeper curve. In this post we describe the two mechanisms and highlight the potential for an “air pocket” in the Treasury market where the marginal buyer is many, many ticks away.

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The Great Steepening

In the coming months a record amount of coupon Treasuries will flood the market even as demand for those securities appears to be faltering. Recent remarks from Chair Powell suggest quantitative tightening will proceed at a pace of $1t a year, double the annual pace of the prior QT. That could imply a process that quickly ramps up to around $700b in Treasuries and $300b in Agency MBS in annual run-off. At the same time, Treasury net issuance is expected to remain historically high at ~$1.5t a year. This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers. In this post we preview the coming QT, sketch out potential investor demand, and suggest a material steepening of the curve is likely.

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Breaking The System

The banking system is built on trust that the money one places in the care of others will be there when needed. This is as true for the retail investor with deposits at the local commercial bank, as it is for the sovereign with FX deposits at a foreign central bank. Hard earned trust is part of the magic that enables developed market sovereigns to massively deficit spend with limited consequence. The world happily holds their liabilities, be it in the form of deposits or sovereign debt. But that trust is weakened when sovereigns are seizing the assets of their own citizens and other sovereigns without due process of law. The liabilities of the banking sector and sovereign then cease to be risk free assets. Foreign sovereigns must now diversify as a matter of national security, and some citizens must now diversify as a matter of self preservation. This regime change can force a wild scramble into stores of value outside of the banking system including gold, real estate and even crypto.

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