personal views of a former fed trader

Category: Notes (Page 2 of 4)

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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The Right LIBOR Successor Emerges

SOFR has long been the anointed successor to LIBOR, but it just hasn’t been very successful despite a maximum pressure campaign from the official sector. GSEs issued a lot of SOFR linked debt, SOFR futures launched, clearing houses transitioned to SOFR discounting, and New York State passed legislation to automatically move legacy LIBOR contracts to SOFR. Yet, LIBOR exposure has grown from $199t in 2016 to $223t today. Amidst the on-going transition, Bloomberg launched its own LIBOR replacement to immediate market support. Although SOFR is great for market transparency, it is ultimately something that the market did not need and cannot use as a LIBOR replacement. In this post we review the official sector’s motivation for dropping LIBOR, highlight the fatal flaws of SOFR and the explain why the Bloomberg Short-Term Bank Yield Index (“BSBY”) is a better LIBOR replacement.

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Why Are Banks Issuing So Much Debt?

U.S. GSIBs recently issued a torrent of debt, with record breaking issuance sizes from JPM and then BAC. Yet, at the same time we know that the banking system has too much liquidity, and that banks are pushing out poor quality deposits to money market funds, who ultimately pour the excess liquidity down the ON RRP drain. The two behaviors can be reconciled by understanding the very strong regulatory incentives put on GSIBs to issue longer term liabilities. In response to the Financial Crisis, regulators devised a set of complementary regulations (Basel III) aimed at preventing future bank runs by setting limits on the size and composition of their balance sheets. Unsecured long term debt is favorably treated under all those constraints, and is especially compelling at near record low yields. We have already discussed how the Liquidity Coverage Ratio encourages longer term debt issuance. In this post we review the what and why of a few more Basel III constraints: the Net Stable Funding Ratio, GSIB Short-Term Wholesale Funding Indicator, and Total Loss Absorbing Capacity.

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The ON RRP Will Never Be A Floor

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.

The ON RRP has been a very leaky floor for money markets
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Taxes Go Up So Rates Stay Down

Advanced economy governments do not need taxes to fund spending. For over 10 years the U.S. has heavily relied on the Fed to finance its ever increasing public spending, with limited effects on consumer prices or the value of the dollar. The same observation can be made in a number of advanced economies. A fiat system that holds the confidence of the public does not need taxes to fund itself (but things change when that confidence is eventually lost). Yet, the Administration is keen on raising personal and corporate taxes to “fund infrastructure.” Another way to view these efforts is simply as a public policy tool to carry out the Administration’s plan on reducing wealth inequality, a byproduct of accommodative monetary policy. In this post we review the policy trade offs in a lower for longer stance, how income inequality leads to asset price inflation, and how taxing the rich in turn moderates asset price inflation.

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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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The End of Bottomless Balance Sheets is Approaching

Basel III is the global standard for bank regulation, but each country implements it in slightly different ways. Previous posts showed how the SLR and LCR create constraints that impact short-term rates, but different methods of implementing those regulations also affect markets. European banks calculate their leverage ratio in a way that has made their balance sheets significantly more elastic between quarter-end dates. This difference was a key driver of quarter-end dynamics in recent years. But that elasticity is going away in the coming months even as forever QE continues to fill bank balance sheet with reserves. In this post we recap the recent TGA deluge, review how European banks calculate their leverage ratio, and show why the impending end to this loophole will force much higher ON RRP participation.

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