personal views of a former fed trader

Category: Notes (Page 1 of 3)

The Primary and Secondary Market for Money

Domestic 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.

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Two Rotations

The 5bps RRP hike created a wedge between the opportunity costs of 2a-7 money market funds (“MMFs”) and non-MMF cash investors that is setting the stage for a tectonic rotation. By August month-end around $1t in Treasuries and Agencies held by MMFs will mature and most of the proceeds will be reinvested into the RRP. The RRP is offering the same yield as bills but allows MMFs to conserve their WAM/WAL dollars for more attractive investments. As the same time, some non-MMF cash investors will be moving out of their 1bps MMF shares or 0% bank deposits and into slightly higher yielding bills. MMF portfolios are earning more from the 5bps RRP hike, but passing on virtually none of it to their investors. This makes 5bps bill yields attractive to non-MMF cash investors. At the same time, bill supply is shrinking as Treasury cuts issuance to stay under the debt ceiling. In this post we preview the two upcoming rotations created by the 5bps RRP wedge, and suggest that these forces will slowly push short-dated bills back towards 0%.

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Who’s Still Borrowing?

The demand for money market funding across all major borrowers is declining even as the supply of money market funding continues to increase. Prior posts described the structural forces increasing the supply of money and pushing money market rates lower, but declining demand for money plays a role as well. The vast majority of money market borrowing is from the U.S. Treasury, GSEs, repo dealers and commercial banks. They have all been reducing their borrowings in money markets, with some reductions likely structural. In this post we review each of these major borrowers and explain why their borrowings have declined.

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Follow The Money

The recent fiscal actions taken by the U.S. are not just remarkable in scale, but also in form. A sizable chunk of the historic $5t in spending actually ended up in the hands of the general public via various types of transfer payments and grants. That money was essentially created out of thin air by the Fed and then spent into the economy by the Treasury. Observing the Fed’s growing balance sheet offers a glimpse as to the scale of the printing, but it does not reveal where the money ends up. Generally speaking, the created money ends up as a deposit liability in the banking system. Banks must file detailed regulatory reports on their deposit liabilities, so it is possible have an idea of the type of depositors who ultimately benefited from the government’s largess. In this post we first review the GFC era policy response, show how the distribution of money this time is now more favorable towards retail, and suggest that this change is contributing to inflation.

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The Elasticity of 5 Basis Points

Large money market investors will move billions for even a basis point. A 5bps increase to the RRP offering rate led to a $200b+ surge in participation, but there is a wrinkle to the story. The bulk of the increase likely came from Government Sponsored Enterprises (“GSEs”) who were leaving hundreds of billions at 0% in their Fed account, so it was not an incremental flow from the private sector. That being said, the 5bps increase puts money market funds (“MMFs”) in a position to offer their investors a few basis points in yield. This will make it easier for banks to continue to push out their high cost deposits. The departed deposits will quickly be replaced by the constant flow of low cost deposits created from Fed financed deficit spending. In this post we shed light behind this week’s RRP surge, the improving funding profiles of banks, and why this means FRA-OIS will continue to narrow.

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Bonds Are Like Meme Stocks

The marginal investor in bonds might be increasingly information insensitive. Last week’s inflation surprised to the upside and there are good reasons to think it will continue to move higher. Nominal GDP growth this year is expected to be around 10%, crude oil prices are steadily ticking higher, and the Administration wants trillions more in spending. Yet bond yields remain range bound. In a prior post we discussed classes of constrained investors who are buying bonds at negative real yields because their alternatives are even less attractive. In this post we describe another captive bond investor, the $1.6t Target Date Fund complex. Then we show that they are just a microcosm of a broader rebalancing story where the wealthiest generation on earth is buying more bonds as they retire. These flows appear agnostic to economic fundamentals and can potentially push bond prices beyond any reasonable valuation.

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The Gravitational Pull of Zero

GSIB High Quality Liquidity Asset (“HQLA”) portfolios are a mechanism through which low rates in the front-end are exerting downward pressure on longer dated yields. Fed QE has filled bank balance sheets with low yielding reserves, and deprived non-banks of any yield at all in the front-end. An unconstrained investor can escape 0% yields by moving along the risk curve to Bitcoin, but GSIBs are confined by Basel III to the most prosaic investments. GSIBs have both limited balance sheet space and HQLA requirements, so they are optimizing their portfolio by exchanging 0.1% yielding reserves for Treasures. Over the past year they have purchased $350b in Treasuries, tilted towards longer dated maturities. In this post we review why GSIBs are purchasing Treasuries and illustrate the scale and maturity profile of those holdings based on recent regulatory filings.

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ON RRP Take-Up Will Go Much Higher

The humble ON RRP is in the spotlight as take-up marches steadily upwards. It will go much, much higher. Increasing participation is largely a function of two structural forces in the financial system: on-going Fed QE ($120b/month) and Basel III constraints. On the margins, changes in the level of the TGA have some impact as well. Water pouring into a glass remains in the glass, until the glass is full and then every incremental drop overflows. The Fed has been adding tremendous amounts of liquidity into the financial system over the past year, and there was initially very little take-up in the ON RRP. But now it appears the banking system is full – Basel III constraints are becoming binding. The incremental QE deposits are flowing out of banks and into MMFs, and then down the ON RRP drain. The system is working as intended. In this post we review the cause of increasing ON RRP take-up, note that high take-up will be a permanent feature going forward, and suggest that money market rates will fall below the ON RRP offering rate.

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Another Standing Repo Facility

The April FOMC minutes suggest the Fed is planning a new standing repo facility (“SRF”), which would be the Fed’s third SRF. The contours of the new SRF are still up in the air, but we can infer them from a stated desire to backstop Treasury repo and the coverage gaps of the other SRFs. The Fed currently operates each day a de facto SRF for primary dealers and another for foreign central banks. This leaves non-primary dealers and investment funds as the obvious candidates for a new facility, as the two are the remaining active participants in Treasury repo. In this post we describe what a SRF is, how the current SRFs operate, and suggest that a new SRF would have a very limited market impact.

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Fed Cannot Fight Today’s Inflation

Inflation is on the market’s mind, but the Fed isn’t worried because it thinks it has the the tools to tackle inflation. Raising the funds rate seemed to work in the 1980s, but there are reasons to think it may not work well today. The prior financial landscape was bank centered – raising the funds rate increased the marginal opportunity costs of banks, which discouraged credit creation and thus dampened economic activity. But we are moving into a world where most money is created through deficit spending, which is indifferent to interest rates. In addition, the large stock of high duration fixed income securities pose financial stability risks. Higher rates redistribute wealth between private debtors/lenders, but inflict net losses to investors in public debt as the sovereign does not react to changes in its wealth. These net losses cascade and compound through the financial system in ways that are difficult predict. In this post we further describe these two structural changes that constrain the Fed’s ability to fight today’s inflation.

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