personal views of a former fed trader

Category: Core Concepts

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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$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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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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Negative Net Yields

Money is being poured into the system, and it has no where to go. The ON RRP is the escape valve, but it is fixed at 0% when money market fund (“MMF”) management fees are around 0.2%. The stars are aligned for continued flow into the money fund space, pushing front end rates towards 0% as it ultimately flows down the ON RRP drain. The Fed will continue to pump $120b/month into the banking system, European bank balance sheets will be less willing to hold additional liquidity under daily average reporting (see this post), and SLR/LCR constraints will eventually bind big U.S. banks (see this post). MMFs have been waiving their fees to keep net yields positive (without waivers Fidelity’s flagship Govie fund would yield -0.09%), but that can’t last forever. Negative net yields are coming. Cash investors are unlikely to idly sit and watch their money evaporate. In this post we outline some options for cash investors, show why the marginal flows will move abroad, and suggest that this is functionally a surgical rate cut.

Fidelity’s $130b Institutional Gov Fund (FRGXX) would be increasingly negative yielding without fee waivers
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Negative Bill Yields Are Coming, Here are the Policy Options

It’s likely that bills will trade negative in the coming days as Treasury pays down existing bills, thus reducing their supply by a few hundred billion (see this previous post for more context). In this post I will discuss why large paydowns would push bill yields negative, the mechanics behind how IOR/ON RRP adjustments work and whether they make sense now, and other potential policy options to keep bill yields positive. It does not offer any view on which option, if any, may be taken. This post is meant to educate on a obscure corner of the market.

Is the increase in ONRRP take-up just month-end effects, or the beginning of a deluge?
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Quantitative Easing Step-by-Step

This post describes the nitty gritty of what happens when the Fed purchases Treasuries. I will go into detail on the balance sheet implications for each participant, which will vary depending on whether the market participant is a bank or a non-bank. The bank/non-bank distinction matters because non-banks do not have Fed accounts and thus cannot hold reserves.

The Fed only does QE trades through Primary Dealers, who generally are not banks (they are broker-dealers) and do not have Fed accounts. (The exception is few U.S. branches of foreign banks who house their broker-dealer business in the bank entity, which do have reserve accounts). In practice, Primary Dealers tend to bank with custodian banks like Bank of New York Mellon, who specialize in collateral management services.

But the focus should not be the primary dealers as they are merely conduits. The newly created reserves ultimately end up in the account of whoever sold the Primary Dealer the Treasuries. If the seller is a Bank, then it will end up in the Bank’s Fed account. If the seller is a non-bank, it will end up in the Fed account of the bank that the Non-Bank banks with. The bank’s new reserve asset will be balanced against new bank deposit liabilities owed to the Non-Bank.

Below I walk through four scenarios of QE sales: Non-Bank Investor to Non-Bank Primary Dealer, Bank Investors to Bank Primary Dealer, Bank Investor to Non-Bank Primary Dealer, and Non-Bank Investor to Bank Primary Dealer. This should offer insight into the plumbing of QE.

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What Determines the Level of Bank Reserves

The level of commercial bank reserves is determined by the size of the Fed’s balance sheet, and the proportion of reserves that end up in the Fed accounts of banks. When the Fed purchases securities or makes loans, it creates reserves out of thin air to fund them. A $100 purchase of Treasury securities results in the creation of $100 in reserves. A $100 FX Swap loan also creates $100 in reserves. Reserves can only be created or destroyed by the Fed, but banks are not the only entities eligible to hold reserves.

Reserves can never leave the Fed’s balance sheet, but they can be shifted around the Fed’s balance sheet. Think of it as Bitcoin ledger, where Bitcoins are paid to other wallets but always remain on the ledger. Only entities with an account at the Fed can hold reserves, so the created reserves are shuffled amongst the different Fed account holders as payments are made. For example, when commercial bank A makes a payment to commercial bank B, then reserves are wired from bank A’s Fed account to bank B’s Fed account. The total level of reserves stays the same. Most reserves are held by depository institutions such as commercial banks or credit unions, but there are other notable entities that have Fed accounts. These other entities, such as the Treasury, can at times have large holdings of reserves. The level of reserves held by the banking sector decreases when reserves move into these other Fed accounts.

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Two Tiered Monetary System

We have a two tiered monetary system, where one type of money is used when transacting with the Fed and between commercial banks (reserves), and another type of money is use when transacting with everyone else (bank deposits). This note explains the two types of money, and how they interact with each other.

Fed Reserves

Reserves are an unsecured liability of the Fed that can only be held by entities with an account at the Fed. Think of it as a checking account at the Fed, except that deposits in the account can only be used to pay entities who also have a checking account at the Fed. Broadly speaking, only depository institutions like commercial banks or credit unions are eligible to have accounts at the Fed. But there are also other notable entities such as the U.S. Treasury, GSEs like Fannie Mae, and clearing houses like the CME. When these entities make payments to each other, they pay in reserves.

Since reserves can only be sent to entities who also have a Fed account, the total level of reserves in the financial system cannot be changed by account holders. Reserves can never leave the Fed’s balance sheet and are simply shifted from one Fed account to another on the Fed’s balance sheet. It is a closed system. The total level of reserves is determined by Fed actions, which create or destroy reserves. Reserves are created when the Fed expands its balance sheet by buying assets, and extinguished when those assets are repaid. One exception to this is that reserves can be converted to currency at the request of commercial banks. If a commercial bank needs $1 million in currency, it calls the Fed, who then sends an armored truck carrying $1 million in currency to the commercial bank. The Fed then deducts $1 million in reserves from the commercial bank’s Fed account.

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The Mechanics of Quantitative Easing and M2

In recent months M2 has exploded higher by almost 3 trillion, generating enormous market chatter. This note briefly describes the mechanics of how Fed actions has led to a spike in bank deposits, which in turn has led to a large increase in M2. Note that M2 is largely comprised of different types of bank deposits, including demand deposits, savings deposits and time deposits. I’ll first go over the basic principles of central bank and commercial bank money creation, then apply the principles to recent events.

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