QE is intended to put downwards pressure on longer dated yields, but its most obvious impact is on the front end. Repo and short dated bills are pinned around the leaky ON RRP floor, with the zombification spreading up along the bill curve. This outcome stems from of our two-tiered monetary system interacting with the constraints of Basel III. In general, every dollar of QE creates two dollars of money – one dollar of reserves (money for banks) and one dollar of bank deposits (money for non-banks). Banks and non-banks can be thought of as two distinct classes of investors, each with their own constraints and opportunity costs. Banks and non-banks take the new money and rebalance their portfolios. Their eligible investment universe most strongly overlaps at the front end, leading to a flood of investments into money markets. Massive QE eventually pushes all front end rates to the ON RRP floor (or below). In this post we review QE money creation, the investment constraints of the bank/non-bank investor classes, and how the QE experience abroad is a preview of what is to come in dollar money markets.
The Fed would like the ON RRP to play a bigger role in its rate control framework, but the ON RRP has been and will always be a very leaky floor for money market rates. From 2016 to early 2018, Treasury bills and agency discount notes consistently traded several basis points below the ON RRP. Today, even tri-party GC repo is occasionally dipping below the floor. The floor will only get leakier as money floods into the front end: QE continues to pour $120b a month into the banking system, the TGA continues to decline, and banks continue to shed low quality deposits. In this post we review how the ON RRP transmits policy rates, why the global nature of the dollar system means it will always be a leaky floor, and why even a ON RRP rate adjustment may not protect the 0 percent lower bound.
Asset prices rise when there is more money in the system, but you have to understand what ‘money’ is. M1/M2 is not a good measure as it is heavily influenced by Fed policy, which changes the composition of money rather than the overall quantity (see here for a walkthrough). The vast majority of money we come in contact with are bank deposits (the numbers in your bank account). Bank deposits are created by commercial banks when they either make loans or purchase assets. For the institutional investor, Treasuries are money – risk free, highly liquid, and fairly stable in value. Big money cannot just deposit billions at a bank and take unsecured credit risk. Treasuries are created when the Federal Government (“FedGov”) spends more than it receives in taxes. In essence, FedGov has a money printer and pays for its spending by printing Treasuries (see here). In this post, I briefly recap the moneyness of Treasuries, introduce a real time measure of FedGov printing, and explore asset price implications of the recent surge in spending.
There are a few forms of money in the modern financial system, but not all of them are well known. We all know about currency (paper bills) and bank deposits (the numbers in your checking account). If you reading this blog then you also know about central bank reserves (money commercial banks use to pay each other). These are assets that are considered money in large part because they are both risk free and highly liquid. However, they cannot be used as money by institutional investors or the very rich. A big investment fund would not put stacks of $100 bills in the office, nor place huge sums in a bank account (bank deposits are only guaranteed by the government up to $250,000), and is ineligible to hold central bank reserves. When big money looks for safety and liquidity, they look at U.S. Treasuries. In the modern financial system, Treasuries are money.
In this post I will discuss the structural features of the Treasury market that allow it to become money, how the U.S. Treasury became the biggest printer in town, and what this means for economic growth.