QT is incrementally improving the transmission of monetary policy by increasing the share of financial assets sensitive to the Fed’s policy rate. Although the policy rate is approaching 5%, trillions of bank deposits continue to offer around 0%. QT strengthens the transmission of policy by mechanically replacing bank deposits with policy rate sensitive Treasuries, and by forcing banks to compete more aggressively for deposit funding. Both outcomes raise the interest rate on assets held by non-Bank investors and will incrementally make risk assets less attractive. This post walks through these two mechanisms and suggests a higher interest rate environment implies a more potent QT.
Continue readingCategory: Advanced Concepts
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.
Continue readingThe 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.
Continue readingDomestic 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.
Continue readingRRP 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.
Continue readingQE 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.
Continue readingThe 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.
Continue readingThere 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.
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