Fed Guy

personal views of a former fed trader

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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Quantitative Hikes

The Fed’s control over interest rates can also be viewed as control over the quantity of a certain type of money. The mere prospect of rate hikes mechanically reduces the market value of Treasuries, which are widely held as money like safe assets. The declines in value are net losses to the financial system that are also unevenly distributed and cannot be hedged system wide. The losses are further transmitted across asset classes as diversified investors rebalance their portfolios by selling other assets. When investors are leveraged and markets are fragile, the rebalancing can lead to significant market volatility. In the coming months the Fed may place further upward pressure along the entire curve by signaling more hikes and aggressive quantitative tightening. In this post we review the mechanics of rate transmission, show how its impact is magnified by high debt levels, and suggest an increasingly aggressive Fed would repeat the 2018Q4 meltdown in risk assets.

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The QT Timebomb

An aggressive quantitative tightening (“QT”) pace would set the stage for another spike in rates, but this time further out the curve. During QT, the U.S. Treasury increases its borrowing from the private sector to repay Treasuries held by the Fed. While the Fed can be repaid with cash held in either the RRP or banks, the current issuance structure suggests repayment will largely come out of the banking system. The lesson of the prior QT was that reducing the cash balances of banks directly impacts markets that were recipients of that cash. In 2019, banks were pouring their extra cash into the repo market amidst surging demand for repo financing. The repo market broke when QT siphoned that extra cash away. This time around banks have poured their cash into Treasuries and Agency MBS amidst surging issuance. In this post we explain why QT will primarily drain bank cash balances, review the September 2019 repo spike and suggest that the stage is set for a potential spike in longer dated rates.

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Quantitative Tightening Step-by-Step

This post describes the mechanics behind quantitative tightening (“QT”) and reviews the prior QT experience. In our two-tiered monetary system, it is helpful to view QT through a framework that takes into account the perspectives of Banks (those who have a Fed account) and Non-Banks (those who don’t have a Fed account). Mechanically, QT reduces the level of cash held by Banks (reserves) and changes the composition of money held by Non-Banks (more Treasuries and fewer bank deposits). The Fed is unsure how low Bank reserve levels can fall before impacting the financial system, so it executes QT at a measured monthly pace. The prior QT experiment began in late 2017 and ended in September 2019, when a sudden spike in repo rates panicked the Fed into restarting quantitative easing.

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The QE Afterparty

There is still $1 trillion in Fed liquidity that will gradually flow into the private sector after QE stops. A large chunk of liquidity created by QE over the past two years never entered the banking system, but instead sat first in the Treasury’s Fed account and later in the RRP Facility. In the coming months Treasury will restart bill issuance and draw those funds out of the RRP into the TGA, and then spend those funds into the banking sector. Over time that will leave the banking sector with about $1t more in reserves, and the non-banks with a $1t more in deposits. If the past is any guide, that suggests more portfolio rebalancing where banks will purchase more Treasuries and non-banks more risk assets. In this post we trace the recent flows of Fed liquidity, show why more liquidity will soon flow into the banking system, and suggest that it will be a tailwind for all asset classes.

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$2 Trillion Pandemic Savings

There are around $2 trillion in pandemic savings held by American households that have yet to be spent. Despite a brief recession, fiscal stimulus supercharged American incomes the past year by maintaining wages through the PPP program, topping off incomes with stimulus checks, and boosting unemployment benefits. At the same time, Americans consumed less than usual as lockdowns limited spending opportunities. As noted by Clarida in two recent speeches (here and here), Americans have accumulated over $2t in pandemic savings that can continue to fuel aggregate demand. In this post we walkthrough how this figure is derived, sketch out the form and distribution of the savings, and suggest that its ‘helicopter’ source implies a further boost to inflation in the coming months.

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Inflationary Hikes

A structural change in the plumbing of the banking system is dampening the impact of monetary policy and may even make rate hikes inflationary. Rates hikes now directly increase the asset returns of banks while leaving their funding costs unchanged – effectively encouraging credit creation. This is because banks have shifted their funding structure away from rate sensitive money market funding to rate insensitive retail deposit funding. The shift is due both to Basel III raising the regulatory costs of money market funding and also the superabundance of retail deposits from pandemic fiscal spending. On the depositor side, the public is also unlikely to see the increases in deposit rates that would arise from a competition for funding. This means the opportunity cost of holding cash will remain low well into the hiking cycle. In this post we review the transition to an asset return implementation regime, show how it changes the incentive structure of banks, and suggest that rate hikes may not be effective in slowing down economic activity.

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Mechanics of a Devaluation

The inflationary process is in its early stages, and it will be particularly strong because it arises in part from a devaluation of the world’s reserve currency. Governments throughout the world printed and spent trillions in their pandemic related efforts, but none of their actions came close to the American response. American households literally received trillions in newly printed money that they are just beginning to spend. Inflation will become more obvious as that money moves through constrained supply chains and the global dollar system. Most foreign countries tether their currency to the dollar, effectively forcing them to at least partially import inflationary U.S. policies. In this post we follow the free money as it makes its way through the domestic and global economy, explain why reserve currency devaluation is particularly inflationary, and suggest prices have further to rise.

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