Awesome analysis! The correlation pointed out is between cash decrease and repo risk increase. How does the Fed not understand this correlation? Most likely is that they fully understand but are penned in.
For Powell's part he has acknowledged for the first time that I recall that they are watching these dynamics. From the Feb 1 FOMC:
"You know, we, of course, will monitor money market conditions carefully as—you know, as the process moves on. For example, the Treasury General Account will shrink down, and then it will grow back up. And we understand there’ll be lots of flows between there and the overnight repo facility and reserves. We understand all that. We’re watching it carefully"
But based on Waller's comments quoted above, it seems like their view is RRP and Reserve balances are fungible - or that the market will work it out. Clearly that should be called into question at this point.
Great piece on RRP and how they trapped themselves, drowning in liquidity. It is appalling to see Waller's ineptitude in misinterpretation of RRP inflow - how can you not see that the MMFs and others are taking a risk-free ride from the Treasury?
What's your take on the TGA now running into deeply negative (deficit monetary policy) territory since all the QT liquidity drainage? I think that will break something in the mid-to-long term.
Afaik they almost never dipped into that vast crevice of negative income in the TGA before 2008/9 and then it recovered thanks to massive QE... which is now ending (rather: being ended).
This is going to be (no) fun since I still see a drop in S&P on 2008/9 levels highly possible with all this.
The question of how the treasury is going to fund itself without the Fed's ongoing support is definitely a huge one over the next several years. With remittances gone, cost of debt soaring, deficits growing, it seems incredibly challenging without some level of monetization from the Fed.
Great takes Bear, as always! Thank you for continuing to put this great content out!
Some questions I'm pondering:
* Wonder what effect, if any, if Fed reinstitutes reserve requirements (off since March 2020)?
* MMF and Money Market Accounts. Different? Kind of? Co-Mingled? A money market account (at a bank) is a demand deposit, right? And is insured (primarily) by FDIC? But a MMF (bought thru broker) is SIPC domain? But then do MMA's end up deploying in MMF's, or skip straight to RRP? WTF, that's a lot of acronyms.
* Ultimately, demand for deposit redemption is what really is "cause" of a run (without digressing into judgement about the bank's asset (mis)management). No bank can service all of those at the same time, b/c no bank has 100% reserve ratio (never-mind mark-to-market effects of HQLA or accounting "nuances"). But unless depositors are demanding physical cash to stash in a mattress/safety deposit box/etc, those dollars are going to end up back in the system elsewhere. The Fed's new facility seems to provide a temporary buffer against the time it takes for those dollars to land elsewhere. But.... how many of those dollars may be ending up in the SIPC's domain (at least as the primary insurer)? Or - right at the US Treasury in a treasury direct account (once the average Joe figures THAT out)?
* Big question is if Fed chooses money destruction or persistent inflation. I cannot see how all that direct delivered money can stay sloshing around otherwise? Is there a formula to calculate how much inflation would be necessary to keep all that stimulus in the system and find an equilibrium?
1. Supplemental Leverage Ratio (SLR) - a part of Basel III was temporarily suspended in March 2020 but that expiration has expired. My understanding is this binding constraint on reserves though and folks have called for it to be lifted again to free up balance sheet (though I'm not sure I agree with that)
2 Absolutely - the depositor actions were pivotal in the run on SVB and FRC - though at least in the case of SVB they really did have a pretty ugly book. You're right that the bank run will simply move cash from weaker banks to stronger banks. My understanding is that treasury direct would be funding the TGA as new primary issuance.
3. I've thought along the same lines - if we recognize that there was a large step change increase in money supply that has driven inflation, but that impulse has stopped for about a year, at what point do we "catch up". You can directly compare CPI to M2 growth but sure there are far better ways to do it.
I have to imagine lifting it again would simply make matters worse (the situation would be even more dire once transaction flow under stress pushed the ratio all the way to broke vs the compliance threshold). Agree with all your takes on the ugliness (caught them on the twitter feed), situation with no good options when the tide is going out for those swimming naked (whether they realize it or not). Thanks for all your insights!
Excellent article. Its hard for me to be bullish with the Federal Reserve "trapped" while there are bank failures, bailouts, and liquidity injections worldwide. IMO these market rallies need to be used as exit liquidity. I can't figure out how this ends well without a major 20-30% correction worldwide in risk assets.
I hear ya. I will admit that I have almost no conviction in the short term, and my long term view has less conviction than it used to.
Though I certainly don't envy Powell's position either. It must be awkward to deal with a bank crisis and 6% inflation at the same time. Lagarde seemed pretty shook yesterday.
Just wait for Q1 earnings and guidance start to roll in! I think we see guidance warnings and results weaker than expected, which will ignite recessionary fears. Fun stuff!
Great article! Your articles are the first thing I read every Friday morning.
Sorry for the basic question, but why wouldn't the Fed just lower the RRP rate to make moving funds back to bank deposits more attractive and keep QT going?
So the Fed could lower RRP rate, but this is effectively the same as lowering the Federal Funds Rate since the RRP is the mechanism that enforces short term rate. In other words - if the Fed cuts the RRP, the Fed is cutting.
Even in this scenario there still needs to be an economic incentive for funds to move out of the RRP i.e. TBill rates need to remain substantially higher than the RRP.
The better alternative would be to reduce the counterparty limit - currently $160bn per entity. This would force money out mechanically as opposed to coaxing it out economically. It would have to be done gradually - say knock $10bn off the limit every month, otherwise it would cause chaos.
What a read!! Is incredibly how you wrap things up so easy to understand. Again, thank you so much TLBS for these articles, it helps us to better understand the financial theater that we live in!
A sub cohort of financial pundits talk about Sovereign Debt. There are claims the US has borrowed WAY too much (no argument) and that we are finally running out of room to kick the can further (arguable).
If it comes right down to it, would you expect reneging on debts or allowing inflation to rip?
Or is the situation well within bounds such that there's no need to think about it?
The solution has already been underway for the past 15 years or so... the Fed will (indirectly) monetize the portion of sovereign debt necessary to keep interest rates where they want them. But this issue will become more pronounced over the coming decade given the recent uptick in inflation, the widening deficit, higher interest costs etc.
I remember Waller talked about the FED could cut rate while doing QT one or two months ago. Do you think it’s possible this time around since the last week BS expansion is not QE?
And btw, i remember you talked about the liquidity in the market = Fed BS - TGA - RRP. We just saw BS increased. But if this expansion turns into bank deposits, and depositors take this money to MFFs. Then the increase in liquidity we saw will be offset?
I could see them maintaining rates while modifying or abandoning QT based on the most recent developments. But in general I think the Fed would be okay "decoupling" the policies if it felt the circumstance called for.
If deposits were provided to MMFs, and those MMFs allocated it to the RRP then yes they would offset. Though its worth noting that RRP volume has been flat for the past several quarters (though not shrinking as the Fed expected),
I have a fundamental question about short term T-bill interest rates and RRP interest rate. On Friday, RRP was 4.55% whereas 1-month T-bill offered 4% interest. The spread is larger than what can be explained by the possibility of a rate cut this week. Is it because the RRP deposits are held by the FED which is considered for some reason to have higher risk than lending to the US government through T-bills?
No, I think this particular dislocation can happen because of short term supply/demand dynamics. If a ton of people decide to pile into Tbills all at once, it can push that rate below the RRP award rate, because there market hasn't yet "balanced it out" yet. Though if you look at 1mo TBill vs. RRP award rate over the past year you will see that the two rise in tandem.
The problem now is that there is a big economic incentive for MMFs to allocate more to the RRP, which could exacerbate the liquidity dynamics. This doesn't happen overnight, and some counterparties may already be at their $160bn limit, but its not a good thing directionally.
Yes - currently there is a major spread between short term Tbill rates and the RRP so there is economic incentive.
The other incentive of course is counterparty - there is no better counterparty than the Fed - when combined with daily liquidity, it is the best alternative to a MMF, if prices are equal across similar investments.
After disclosing I know nothing and am an idiot to boot, I'd like to ask a question. Based on what you've explained, it sounds to me like there is no shortage of liquidity, only a shortage of cheap liquidity. The banks could attract plenty of capital by raising their deposit rates or offering MMFs a rate higher than the RRP. Why is that the wrong take?
I think this is practically impossible because it would put all banks into a huge negative interest margin position. Since their return on assets is probably fixed somewhere below 5%, if they increased their cost of funding to 5%, it would cause them to lose money. I guess in a free market, it would be up to banks to make these hard decisions or fail, though we don't exactly live a free market.
Excellent piece. But I was wondering about this: "The entities that are losing liquidity are the former borrowers of MMFs who have been boxed out by the Fed, and those borrowers’ banks who would have held that money. The liquidity needs of these entities (and their banks) have not changed, but they have no say in the matter. " Isn't the primary borrower from MMFs the US Government (to the extent they still mainly hold Treasuries)? I realize they also hold commercial paper, so maybe that's what you're referring to? Plus if the MMFs aren't buying Treasuries then someone else has to, which will have ripple effects.
I was also (like the other commenter) wondering to what extent the Fed can decouple QT and interest rate policy, though I was thinking more that they could still raise rates while embarking on QE. I just don't know how sustainable that is, or the reverse: Eventually continuing QT without raising rates.
Yes the primary borrower is the US Government. And exactly as you said - if MMFs aren't funding the government, than someone else has to!
I think its reasonable for the Fed to decouple interest rates from QT/QE. Actually from my Perspective, I wish they would away with QT and QE entirely, as it seems to cause more instability in both directions.
Awesome analysis! The correlation pointed out is between cash decrease and repo risk increase. How does the Fed not understand this correlation? Most likely is that they fully understand but are penned in.
Watch out for Sept 2019 redux.
For Powell's part he has acknowledged for the first time that I recall that they are watching these dynamics. From the Feb 1 FOMC:
"You know, we, of course, will monitor money market conditions carefully as—you know, as the process moves on. For example, the Treasury General Account will shrink down, and then it will grow back up. And we understand there’ll be lots of flows between there and the overnight repo facility and reserves. We understand all that. We’re watching it carefully"
But based on Waller's comments quoted above, it seems like their view is RRP and Reserve balances are fungible - or that the market will work it out. Clearly that should be called into question at this point.
Great piece on RRP and how they trapped themselves, drowning in liquidity. It is appalling to see Waller's ineptitude in misinterpretation of RRP inflow - how can you not see that the MMFs and others are taking a risk-free ride from the Treasury?
What's your take on the TGA now running into deeply negative (deficit monetary policy) territory since all the QT liquidity drainage? I think that will break something in the mid-to-long term.
Afaik they almost never dipped into that vast crevice of negative income in the TGA before 2008/9 and then it recovered thanks to massive QE... which is now ending (rather: being ended).
This is going to be (no) fun since I still see a drop in S&P on 2008/9 levels highly possible with all this.
The question of how the treasury is going to fund itself without the Fed's ongoing support is definitely a huge one over the next several years. With remittances gone, cost of debt soaring, deficits growing, it seems incredibly challenging without some level of monetization from the Fed.
Great takes Bear, as always! Thank you for continuing to put this great content out!
Some questions I'm pondering:
* Wonder what effect, if any, if Fed reinstitutes reserve requirements (off since March 2020)?
* MMF and Money Market Accounts. Different? Kind of? Co-Mingled? A money market account (at a bank) is a demand deposit, right? And is insured (primarily) by FDIC? But a MMF (bought thru broker) is SIPC domain? But then do MMA's end up deploying in MMF's, or skip straight to RRP? WTF, that's a lot of acronyms.
* Ultimately, demand for deposit redemption is what really is "cause" of a run (without digressing into judgement about the bank's asset (mis)management). No bank can service all of those at the same time, b/c no bank has 100% reserve ratio (never-mind mark-to-market effects of HQLA or accounting "nuances"). But unless depositors are demanding physical cash to stash in a mattress/safety deposit box/etc, those dollars are going to end up back in the system elsewhere. The Fed's new facility seems to provide a temporary buffer against the time it takes for those dollars to land elsewhere. But.... how many of those dollars may be ending up in the SIPC's domain (at least as the primary insurer)? Or - right at the US Treasury in a treasury direct account (once the average Joe figures THAT out)?
* Big question is if Fed chooses money destruction or persistent inflation. I cannot see how all that direct delivered money can stay sloshing around otherwise? Is there a formula to calculate how much inflation would be necessary to keep all that stimulus in the system and find an equilibrium?
Thanks Dustan.
Responding to your thoughts:
1. Supplemental Leverage Ratio (SLR) - a part of Basel III was temporarily suspended in March 2020 but that expiration has expired. My understanding is this binding constraint on reserves though and folks have called for it to be lifted again to free up balance sheet (though I'm not sure I agree with that)
2 Absolutely - the depositor actions were pivotal in the run on SVB and FRC - though at least in the case of SVB they really did have a pretty ugly book. You're right that the bank run will simply move cash from weaker banks to stronger banks. My understanding is that treasury direct would be funding the TGA as new primary issuance.
3. I've thought along the same lines - if we recognize that there was a large step change increase in money supply that has driven inflation, but that impulse has stopped for about a year, at what point do we "catch up". You can directly compare CPI to M2 growth but sure there are far better ways to do it.
I have to imagine lifting it again would simply make matters worse (the situation would be even more dire once transaction flow under stress pushed the ratio all the way to broke vs the compliance threshold). Agree with all your takes on the ugliness (caught them on the twitter feed), situation with no good options when the tide is going out for those swimming naked (whether they realize it or not). Thanks for all your insights!
Excellent article. Its hard for me to be bullish with the Federal Reserve "trapped" while there are bank failures, bailouts, and liquidity injections worldwide. IMO these market rallies need to be used as exit liquidity. I can't figure out how this ends well without a major 20-30% correction worldwide in risk assets.
I hear ya. I will admit that I have almost no conviction in the short term, and my long term view has less conviction than it used to.
Though I certainly don't envy Powell's position either. It must be awkward to deal with a bank crisis and 6% inflation at the same time. Lagarde seemed pretty shook yesterday.
Just wait for Q1 earnings and guidance start to roll in! I think we see guidance warnings and results weaker than expected, which will ignite recessionary fears. Fun stuff!
Great article! Your articles are the first thing I read every Friday morning.
Sorry for the basic question, but why wouldn't the Fed just lower the RRP rate to make moving funds back to bank deposits more attractive and keep QT going?
Its not a basic question - its a great question.
So the Fed could lower RRP rate, but this is effectively the same as lowering the Federal Funds Rate since the RRP is the mechanism that enforces short term rate. In other words - if the Fed cuts the RRP, the Fed is cutting.
Even in this scenario there still needs to be an economic incentive for funds to move out of the RRP i.e. TBill rates need to remain substantially higher than the RRP.
The better alternative would be to reduce the counterparty limit - currently $160bn per entity. This would force money out mechanically as opposed to coaxing it out economically. It would have to be done gradually - say knock $10bn off the limit every month, otherwise it would cause chaos.
Good stuff. You might enjoy my latest piece: “Risk management shines as markets unravel.”
https://finiche.substack.com/p/risk-management-shines-as-markets
Awesome, thanks for sharing!
What a read!! Is incredibly how you wrap things up so easy to understand. Again, thank you so much TLBS for these articles, it helps us to better understand the financial theater that we live in!
Always with a coffe in hand ;)
Fantastic! The financial theater has elements of comedy and tragedy, perhaps ultimately a farce
One of the best explanations of the RRP that I have heard. And your visual was excellent! 👍🏽
Glad you found it useful. Thanks as always for reading!
A sub cohort of financial pundits talk about Sovereign Debt. There are claims the US has borrowed WAY too much (no argument) and that we are finally running out of room to kick the can further (arguable).
If it comes right down to it, would you expect reneging on debts or allowing inflation to rip?
Or is the situation well within bounds such that there's no need to think about it?
The solution has already been underway for the past 15 years or so... the Fed will (indirectly) monetize the portion of sovereign debt necessary to keep interest rates where they want them. But this issue will become more pronounced over the coming decade given the recent uptick in inflation, the widening deficit, higher interest costs etc.
Thanks. I felt sure this would be your answer. 😀
I remember Waller talked about the FED could cut rate while doing QT one or two months ago. Do you think it’s possible this time around since the last week BS expansion is not QE?
And btw, i remember you talked about the liquidity in the market = Fed BS - TGA - RRP. We just saw BS increased. But if this expansion turns into bank deposits, and depositors take this money to MFFs. Then the increase in liquidity we saw will be offset?
I could see them maintaining rates while modifying or abandoning QT based on the most recent developments. But in general I think the Fed would be okay "decoupling" the policies if it felt the circumstance called for.
If deposits were provided to MMFs, and those MMFs allocated it to the RRP then yes they would offset. Though its worth noting that RRP volume has been flat for the past several quarters (though not shrinking as the Fed expected),
I guess you meant “RRP volume has been flat...”?
Thanks this has been corrected!
I have a fundamental question about short term T-bill interest rates and RRP interest rate. On Friday, RRP was 4.55% whereas 1-month T-bill offered 4% interest. The spread is larger than what can be explained by the possibility of a rate cut this week. Is it because the RRP deposits are held by the FED which is considered for some reason to have higher risk than lending to the US government through T-bills?
No, I think this particular dislocation can happen because of short term supply/demand dynamics. If a ton of people decide to pile into Tbills all at once, it can push that rate below the RRP award rate, because there market hasn't yet "balanced it out" yet. Though if you look at 1mo TBill vs. RRP award rate over the past year you will see that the two rise in tandem.
The problem now is that there is a big economic incentive for MMFs to allocate more to the RRP, which could exacerbate the liquidity dynamics. This doesn't happen overnight, and some counterparties may already be at their $160bn limit, but its not a good thing directionally.
That makes sense, thanks very much.
What are these big economic incentives for MMFs to allocate in RRP over short term TBills? Do you mean the 50bps or so of interest rate spread?
Yes - currently there is a major spread between short term Tbill rates and the RRP so there is economic incentive.
The other incentive of course is counterparty - there is no better counterparty than the Fed - when combined with daily liquidity, it is the best alternative to a MMF, if prices are equal across similar investments.
Insightful as always. Would like to hear your thoughts on AT1 bonds in a future piece.
Buying junior debt and finding out it is junior equity is bad!
Ha! Unfortunately I'm don't have too much of a differentiated view other than what many other smart folks have written up in the past couple days.
Thanks for the excellent piece.
After disclosing I know nothing and am an idiot to boot, I'd like to ask a question. Based on what you've explained, it sounds to me like there is no shortage of liquidity, only a shortage of cheap liquidity. The banks could attract plenty of capital by raising their deposit rates or offering MMFs a rate higher than the RRP. Why is that the wrong take?
I think this is practically impossible because it would put all banks into a huge negative interest margin position. Since their return on assets is probably fixed somewhere below 5%, if they increased their cost of funding to 5%, it would cause them to lose money. I guess in a free market, it would be up to banks to make these hard decisions or fail, though we don't exactly live a free market.
Is this not moral hazard writ large? The entire banking sector would collapse if their funding costs rose to a positive real rate.
Enlightening. Thank you.
Thanks fore reading Andres!
Excellent piece. But I was wondering about this: "The entities that are losing liquidity are the former borrowers of MMFs who have been boxed out by the Fed, and those borrowers’ banks who would have held that money. The liquidity needs of these entities (and their banks) have not changed, but they have no say in the matter. " Isn't the primary borrower from MMFs the US Government (to the extent they still mainly hold Treasuries)? I realize they also hold commercial paper, so maybe that's what you're referring to? Plus if the MMFs aren't buying Treasuries then someone else has to, which will have ripple effects.
I was also (like the other commenter) wondering to what extent the Fed can decouple QT and interest rate policy, though I was thinking more that they could still raise rates while embarking on QE. I just don't know how sustainable that is, or the reverse: Eventually continuing QT without raising rates.
Yes the primary borrower is the US Government. And exactly as you said - if MMFs aren't funding the government, than someone else has to!
I think its reasonable for the Fed to decouple interest rates from QT/QE. Actually from my Perspective, I wish they would away with QT and QE entirely, as it seems to cause more instability in both directions.
Great report! Thank you!
Thanks Greg! Thanks for reading