personal views of a former fed trader

Tag: quantitative easing

Tapering Towards Neutral

The market impact of the Fed’s taper will be moderated by a significant decline in Treasury and Agency MBS issuance. An imminent taper is very likely now that a press trial balloon has been floated right before blackout and even the ECB is tapering. At the same time, Treasury is expected to lower coupon issuance and Agency MBS production is expected to continue to slow. In light of this, tapering can be thought of as maintaining the level of QE accommodation amidst significant declining issuance. While the mechanical impacts of taper will be blunted, the Fed’s taper announcement will still tighten financial conditions by bringing forward rate hike expectations. The Fed hopes to avoid another taper tantrum by separating taper from lift-off, but that is hard when one necessarily precedes the other. In this post we show how declining Treasury and MBS issuance will off-set Fed tapering and review the Fed’s communications challenge.

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Too Much Money

There is a plumbing explanation for the conundrum of lower nominal yields and higher inflation. Many factors affect yields, but they are in part determined by who has money and the investment constraints they face. QE mechanically increases the investible “cash” of investors who are most inclined to buy bonds, and they have been buying bonds. In our two-tiered monetary system $1 of QE creates $2 of money – $1 of reserves (money for banks) and $1 of bank deposits (money for non-banks). On the reserves side, some banks have significantly changed their behavior and begun deploying their reserves into bonds. On the bank deposit side, the wealthy ended up with the bulk of the newly created bank deposits. The wealthy tend to spend their money on assets, and they appear to be rebalancing some of the deposits into bonds. In this post we show how low rates are pressuring banks into adding bonds to their growing regulatory liquidity portfolio, how the skewed ownership distribution of new bank deposits may be leading to more bond buying, and suggest that low yields may not be a reflection of economic conditions.

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QE Zombifies Money Markets

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.

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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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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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