Tag Archives: repo

The COVID19 Tripwire

“You better tuck that in. You’re gonna’ get that caught on a tripwire.Lieutenant Dan, Forrest Gump

There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which block would cause the tower to give way?

A Coronavirus

Pneumonia of unknown cause first detected in Wuhan, China, was reported to the World Health Organization (WHO) on December 31, 2019. The risks of it becoming a global pandemic (formally labeled COVID-19) was apparent by late January. Unfortunately, it went mostly unnoticed in the United States as China was slow to disclose the matter and many Americans were distracted by impeachment proceedings, bullish equity markets, and other geopolitical disruptions.

The S&P 500 peaked on February 19, 2020, at 3393, up over 5% in the first two months of the year. Over the following four weeks, the stock market dropped 30% in one of the most vicious corrections of broad asset prices ever seen. The collapse erased all of the gains achieved during the prior 3+ years of the Trump administration. The economy likely entered a recession in March.

There will be much discussion and debate in the coming months and years about the dynamics of this stunning period. There is one point that must be made clear so that history can properly record it; the COVID-19 virus did not cause the stock and bond market carnage we have seen so far and are likely to see in the coming months. The virus was the passive triggering mechanism, the tripwire, for an economy full of a decade of monetary policy-induced misallocations and excesses leaving assets priced well beyond perfection.

Never-Ending Gains

It is safe to say that the record-long economic expansion, to which no one saw an end, ended in February 2020 at 128 months. To suggest otherwise is preposterous given what we know about national economic shutdowns and the early look at record Initial Jobless Claims that surpassed three million. Between the trough in the S&P 500 from the financial crisis in March 2009 and the recent February peak, 3,999 days passed. The 10-year rally scored a total holding-period return of 528% and annualized returns of 18.3%. Although the longest expansion on record, those may be the most remarkable risk-adjusted performance numbers considering it was also the weakest U.S. economic expansion on record, as shown below.

They say “being early is wrong,” but the 30-day destruction of valuations erasing over three years of gains, argues that you could have been conservative for the past three years, kept a large allocation in cash, and are now sitting on small losses and a pile of opportunity with the market down 30%.

As we have documented time and again, the market for financial assets was a walking dead man, especially heading into 2020. Total corporate profits were stagnant for the last six years, and the optics of magnified earnings-per-share growth, thanks to trillions in share buybacks, provided the lipstick on the pig.

Passive investors indiscriminately and in most cases, unknowingly, bought $1.5 trillion in over-valued stocks and bonds, helping further push the market to irrational levels. Even Goldman Sachs’ assessment of equity market valuations at the end of 2019, showed all of their valuation measures resting in the 90-99th percentile of historical levels.

Blind Bond Markets

The fixed income markets were also swarming with indiscriminate buyers. The corporate bond market was remarkably overvalued with tight spreads and low yields that in no way offered an appropriate return for the risk being incurred. Investment-grade bonds held the highest concentration of BBB credit in history, most of which did not qualify for that rating by the rating agencies’ own guidelines. The junk bond sector was full of companies that did not produce profits, many of whom were zombies by definition, meaning the company did not generate enough operating income to cover their debt servicing costs. The same held for leveraged loans and collateralized loan obligations with low to no covenants imposed. And yet, investors showed up to feed at the trough. After all, one must reach for extra yield even if it means forgoing all discipline and prudence.

To say that no lessons were learned from 2008 is an understatement.

Black Swan

Meanwhile, as the markets priced to ridiculous valuations, corporate executives and financial advisors got paid handsomely, encouraging shareholders and clients to throw caution to the wind and chase the market ever higher. Thanks also to imprudent monetary policies aimed explicitly at propping up indefensible valuations, the market was at risk due to any disruption.

What happened, however, was not a slow leaking of the market as occurred leading into the 2008 crisis, but a doozy of a gut punch in the form of a pandemic. Markets do not correct by 30% in 30 days unless they are extremely overvalued, no matter the cause. We admire the optimism of formerly super-intelligent bulls who bought every dip on the way down. Ask your advisor not just to tell you how he is personally invested at this time, ask him to show you. You may find them to be far more conservative in their investment posture than what they recommend for clients. Why? Because they get paid on your imprudently aggressive posture, and they do not typically “eat their own cooking”. The advisor gets paid more to have you chasing returns as opposed to avoiding large losses.

Summary

We are facing a new world order of DE-globalization. Supply chains will be fractured and re-oriented. Products will cost more as a result. Inflation will rise. Interest rates, therefore, also will increase contingent upon Fed intervention. We have become accustomed to accessing many cheap foreign-made goods, the price for which will now be altered higher or altogether beyond our reach. For most people, these events and outcomes remain inconceivable. The widespread expectation is that at some point in the not too distant future, we will return to the relative stability and tranquility of 2019. That assuredly will not be the case.

Society as a whole does not yet grasp what this will mean, but as we are fond of saying, “you cannot predict, but you can prepare.” That said, we need to be good neighbors and good stewards and alert one another to the rapid changes taking place in our communities, states, and nation. Neither investors nor Americans, in general, can afford to be intellectually lazy.

The COVID-19 virus triggered these changes, and they will have an enormous and lasting impact on our lives much as 9-11 did. Over time, as we experience these changes, our brains will think differently, and our decision-making will change. Given a world where resources are scarce and our proclivity to – since it is made in China and “cheap” – be wasteful, this will probably be a good change. Instead of scoffing at the frugality of our grandparents, we just might begin to see their wisdom. As a nation, we may start to understand what it means to “save for a rainy day.”

Save, remember that forgotten word.

As those things transpire – maybe slowly, maybe rapidly – people will also begin to see the folly in the expedience of monetary and fiscal policy of the past 40 years. Expedience such as the Greenspan Put, quantitative easing, and expanding deficits with an economy at full employment. Doing “what works” in the short term often times conflicts with doing what is best for the most people over the long term.

Why QE Is Not Working

The process by which money is created is so simple that the mind is repelled.” – JK Galbraith

By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.

Most investors seem unable to grasp why the Fed’s actions have been, thus far, ineffective. In this article, we explain why today is different from the past. The Fed’s current predicament is unique as they have never been totally up against the wall of zero-bound interest rates heading into a crisis. Their remaining tools become more controversial and more limited with the Fed Funds rate at zero. Our objective is to assess when the monetary medicine might begin to work and share our thoughts about what is currently impeding it.

All Money is Lent in Existence.

That sentence may be the most crucial concept to understand if you are to make sense of the Fed’s actions and assess their effectiveness.

Under the traditional fractional reserve banking system run by the U.S. and most other countries, money is “created” via loans. Here is a simple example:

  • John deposits a thousand dollars into his bank
  • The bank is allowed to lend 90% of their deposits (keeping 10% in “reserves”)
  • Anne borrows $900 from the same bank and buys a widget from Tommy
  • Tommy then deposits $900 into his checking account at the same bank
  • The bank then lends to someone who needs $810 and they spend that money, etc…

After Tommy’s deposit, there is still only $1,000 of reserves in the banking system, but the two depositors believe they have a total of $1,900 in their bank accounts.  The bank’s accountants would confirm that. To make the bank’s accounting balance, Anne owes the bank $900. The money supply, in this case, is $1,900 despite the amount of real money only being $1,000.

That process continually feeds off the original $1,000 deposit with more loans and more deposits. Taken to its logical conclusion, it eventually creates $9,000 in “new” money through the process from the original $1,000 deposit.

To summarize, we have $1,000 in deposited funds, $10,000 in various bank accounts and $9,000 in new debt. While it may seem “repulsive” and risky, this system is the standard operating procedure for banks and a very effective and powerful tool for generating profits and supporting economic growth. However, if everyone wanted to take their money out at the same time, the bank would not have it to give. They only have the original $1,000 of reserves.

How The Fed Operates

Manipulating the money supply through QE and Fed Funds targeting are the primary tools the Fed uses to conduct monetary policy. As an aside, QE is arguably a controversial blend of monetary and fiscal policy.

When the Fed provides banks with reserves, their intent is to increase the amount of debt and therefore the money supply. As such, more money should result in lower interest rates. Conversely, when they take away reserves, the money supply should decline and interest rates rise. It is important to understand, the Fed does not set the Fed Funds rate by decree, but rather by the aforementioned monetary actions to incentivize banks to increase or reduce the money supply.

The following graph compares the amount of domestic debt outstanding versus the monetary base.

Data Courtesy: St. Louis Federal Reserve

Why is QE not working?

So with an understanding of how money is created through fractional reserve banking and the role the Fed plays in manipulating the money supply, let’s explore why QE helped boost asset prices in the past but is not yet potent this time around.

In our simple banking example, if Anne defaults on her loan, the money supply would decline from $1,900 to $1,000. With a reduced money supply, interest rates would rise as the supply of money is more limited today than yesterday. In this isolated example, the Fed might purchase bonds and, in doing so, conjure reserves onto bank balance sheets through the magic of the digital printing press. Typically the banks would then create money and offset the amount of Anne’s default.  The problem the Fed has today is that Anne is defaulting on some of her debt and, at the same time, John and Tommy need and want to withdraw some of their money.

The money supply is declining due to defaults and falling asset prices, and at the same time, there is a greater demand for cash. This is not just a domestic issue, but a global one, as the U.S. dollar is the world’s reserve currency.

For the Fed to effectively stimulate financial markets and the economy, they first have to replace the money which has been destroyed due to defaults and lower asset prices. Think of this as a hole the Fed is trying to fill. Until the hole is filled, the new money will not be effective in stimulating the broad economy, but instead will only help limit the erosion of the financial system and yes, it is a stealth form of bailout. Again, from our example, if the banks created new money, it would only replace Anne’s default and would not be stimulative.

During the latter part of QE 1, when mortgage defaults slowed, and for all of the QE 2 and QE 3 periods, the Fed was not “filling a hole.” You can think of their actions as piling dirt on top of a filled hole.

These monetary operations enabled banks to create more money, of which a good amount went mainly towards speculative means and resulted in inflated financial asset prices. It certainly could have been lent toward productive endeavors, but banks have been conservative and much more heavily regulated since the crisis and prefer the liquid collateral supplied with market-oriented loans.

QE 4 (Treasury bills) and the new repo facilities introduced in the fall of 2019 also stimulated speculative investing as the Fed once again piled up dirt on top of a filled hold.  The situation changed drastically on February 19, 2020, as the virus started impacting perspectives around supply chains, economic growth, and unemployment in the global economy. Now QE 4, Fed-sponsored Repo, QE infinity, and a smorgasbord of other Fed programs are required measures to fill the hole.

However, there is one critical caveat to the situation.

As stated earlier, the Fed conducts policy by incentivizing the banking system to alter the supply of money. If the banks are concerned with their financial situation or that of others, they will be reluctant to lend and therefore impede the Fed’s efforts. This is clearly occurring, making the hole progressively more challenging to fill. The same thing happened in 2008 as banks became increasingly suspect in terms of potential losses due to their exorbitant leverage. That problem was solved by changing the rules around how banks were required to report mark-to-market losses by the Federal Accounting Standards Board (FASB). Despite the multitude of monetary and fiscal policy stimulus failures over the previous 18 months, that simple re-writing of an accounting rule caused the market to turn on a dime in March 2009. The hole was suddenly over-filled by what amounted to an accounting gimmick.

Summary

Are Fed actions making headway on filling the hole, or is the hole growing faster than the Fed can shovel as a result of a tsunami of liquidity problems? A declining dollar and stability in the short-term credit markets are essential gauges to assess the Fed’s progress.

The Fed will eventually fill the hole, and if the past is repeated, they will heap a lot of extra dirt on top of the hole and leave it there for a long time. The problem with that excess dirt is the consequences of excessive monetary policy. Those same excesses created after the financial crisis led to an unstable financial situation with which we are now dealing.

While we must stay heavily focused on the here and now, we must also consider the future consequences of their actions. We will undoubtedly share more on this in upcoming articles.

Why “Not-QE” is QE: Deciphering Gibberish

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

  • That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
  • In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
  • Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
  • Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
  • One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
  • Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
  • Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
  • “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

  1. “increasing the volume of reserves in the banking system”
  2. “altering the mix of assets held by investors”
  3. “influence investors’ expectations about monetary policy”

Simply:

  1.  providing banks the ability to make more money
  2.  forcing investors to take more risk and thereby push asset prices higher
  3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

When It Becomes Serious You Have To Lie: Update On The Repo Fiasco

Occasionally, problems reveal themselves gradually. A water stain on the ceiling is potentially evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has appeared to vanish. Yet, every day the stain reappears and the Fed’s work begins anew. One is left to wonder why the leak hasn’t been fixed. 

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.  

At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that they lacked a reasonable explanation for the disruption. Since then, our surprise has turned to concern and suspicion.

We harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing. 

As we were putting the finishing touches on this article, the Bank of International Settlements (BIS) reported that the overnight repo problems might stem from the reluctance of the four largest U.S. banks to lend to some of the largest hedge funds. The four banks are being forced to fund a massive surge in U.S. Treasury issuance and therefore reallocated funding from the hedge funds to the U.S. Treasury.  Per the Financial Times in Hedge Funds key in exacerbating repo market turmoil, says BIS: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” – was a key factor behind the chaos, said Claudio Borio, Head of the monetary and economic department at the BIS.

In the article, the BIS implies that the Fed is providing liquidity to banks so that banks, in turn, can provide the hedge funds funding to maintain their leverage. The Fed is worried that hedge funds will sell assets if liquidity is not available. Instead of forcing hedge funds to deal with a funding risk that they know about, they are effectively bailing them out from having to liquidate their holdings. If that is the case, and as the central bank to central bankers the BIS should be well informed on such matters, why should the Fed be involved in micro-managing leverage to hedge funds? It would certainly represent another extreme example of mission creep.

Excuse #1

In the article linked above, we discussed the initial excuse for the funding issues bandied about by Wall Street, the banks, and the media as follows:

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons.”

While the excuse seemed legitimate, it made little sense as we surmised in the next sentence:

“We are not convinced by either excuse as they were easily forecastable weeks in advance.”

If the dearth of liquidity in the overnight funding markets was due to predictable, one-time cash demands, the problem should have been fixed easily. Simply replenish the cash with open market operations as the Fed routinely did prior to the Financial Crisis.

Since mid-September, the Fed has elected instead to increase their balance sheet by over $320 billion.  In addition to conducting daily overnight repo auctions, they introduced term repo that extends for weeks and then abruptly restarted quantitative easing (QE).

Imagine your plumber coming into your house with five other plumbers and a bull dozer to fix what you assumed was a leaky pipe.

The graph below, courtesy Bianco Research, shows the dramatic rise in the Fed’s balance sheet since September.

Based on the purported cash shortfall excuse, one would expect that the increase in the Fed’s balance sheet would have easily met demands for cash and the markets would have stabilized. Liquidity hole filled, problem solved.

However, as witnessed by the continuing growth of the Fed’s balance sheet and ever-increasing size of Fed operations, the hole seems to be growing. It is worth noting that the Fed has committed to add $60 billion a month to their balance sheet through March of 2020 via QE. In other words, the stain keeps reappearing and getting bigger despite increasing amounts of paint. 

Excuse #2

The latest rationale used to explain the funding problems revolves around banking regulations. Many Fed members and banking professionals have recently stated that banking regulations, enacted after the Financial Crisis, are constraining banks’ ability to lend to other banks and therefore worsening the funding situation. In the words of Randy Quarles, Federal Reserve Vice Chair for Banking Supervision, in his testimony to the House Financial Services Committee:

We have identified some areas where our existing supervision of the regulatory framework…may have created some incentives that were contributors

Jamie Dimon, CEO of JP Morgan, is quoted in MarketWatch as saying the following:

“The turmoil may be a precursor of a bigger crisis if the Fed doesn’t adjust its regulations. He said the liquidity requirements tie up what was seen as excess reserves.”

Essentially, Quarles and Dimon argue that excess reserves are not really excess. When new post Financial Crisis regulatory requirements are factored in, banks only hold the appropriate amount of reserves and are not exceeding requirements.

This may be the case, and if so, the amount of true excess reserves was dwindling several months prior to the repo debacle in September.  Any potential or forecasted shortfalls due to the constraints should have been easily identifiable weeks and months in advance of any problem.

The banks and the Fed speak to each other quite often about financial conditions and potential problems that might arise. Most of the systemically important financial institutions (SIFI banks) have government regulators on-site every day. In addition, the Fed audits the banks on a regular basis. We find it hard to believe that new regulatory restraints and the effect they have on true excess reserves were not discussed. This is even harder to believe when one considers that the Fed was actively reducing the amount of reserves in the system via Quantitative Tightening (QT) through 2018 and early 2019. The banks and the regulators should have been alerting everyone they were getting dangerously close to exhausting their true excess reserves. That did not occur, at least not publicly.

Theories and Speculation

A golden rule we follow is that when we think we are being misled, especially by market participants, the Fed, or the government, it pays to try to understand the motive.  “Why would they do this?” Although not conclusive, we have a few theories about the faulty explanations for the funding shortage. They are as follows:

  • The banks and the Fed would like to reduce the regulatory constraints imposed on them in recent years. Disruptions demonstrating that the regulations not only inhibit lending but can cause a funding crisis allow them to leverage lobbying efforts to reduce regulations.
  • There may be a bank or large financial institution that is in distress. In an effort to keep it out of the headlines, the Fed is indirectly supplying liquidity to the institution. This would help explain why the September Repo event was so sudden and unexpected. Rumors about troubles at certain European banks have been circulating for months.
  • The Fed and the banks grossly underestimated how much of the increased U.S. Treasury debt issuance they would have to buy. In just the last quarter, the Treasury issued nearly $1 trillion dollars of debt. At the same time, foreign sponsorship of U.S. Treasuries has been declining. While predictable, the large amount of cash required to buy Treasury notes and bonds may have created a cash shortfall. For more on why this problem is even more pronounced today, read our article Who Is Funding Uncle Sam. If this is the case, the Fed is funding the Treasury under the table via QE. This is better known as “debt monetization”.
  • Between July and November the Fed reduced the Fed Funds rate by 0.75% without any economic justification for doing so. The Fed claims that the cuts are an “insurance” policy to ensure that slowing global growth and trade turmoil do not halt the already record long economic expansion. Might they now be afraid that further cuts would raise suspicion that the Fed has recessionary concerns? QE, which was supposedly enacted to combat the overnight funding issues, has generously supported financial markets in the past. Maybe a funding crisis provides the Fed cover for QE despite rates not being at the zero bound. Since 2008, the Fed has been vocal about the ways in which market confidence supports consumer confidence. 

The analysis of what is true and what is rhetoric spins wildly out of control when we allow our imaginations to run. This is what happens when pieces do not fit neatly into the puzzle and when sound policy decisions are subordinated to public relations sound bites. One thing seems certain, despite what we are being told, there likely something else is going on.

Of greater concern in this matter of overnight funding, is the potential the Fed and banks were truly blindsided. If that is the case, we should harbor even deeper concern as there is likely a much bigger issue being painted over with temporary liquidity injections.

Summary

In the movie The Outlaw Josey Wales, one of the more famous quotes is, “Don’t piss down my back and tell me it’s raining.”

We do not accept the rationale the Fed is using to justify the reintroduction of QE and the latest surge in their balance sheet. Although we do not know why the Fed has been so incoherent in their application of monetary policy, our theories offer other ideas for thinking through the monetary policy maze. They also have various implications for the markets, none of which should be taken lightly.

We are just as certain that we are not entirely correct as we are certain that we aren’t entirely wrong. Like the water spot on the ceiling, financial market issues normally reveal themselves gradually. Prudent risk management suggests finding and addressing the source of the problem rather than cosmetics. We want to reiterate that, if the Fed is papering over problems in the overnight funding market, we are left to question the Fed’s understanding of global funding markets and the global banking system’s ability to weather a more significant disruption than the preview we observed in September.

UPDATE: To Buy, Or Not To Buy- An Investors Guide to QE 4

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

  • Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
  • There is general uniformity amongst the equity indexes
  • Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
  • The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
  • Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
  • Defensive sectors are trading relatively weaker as occurred during prior QE
  • The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
  • The yield curve steepened as expected
  • In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

Warning! No Lifeguards On Duty

In a poll administered by the CFA Institute of America {Link}, readers, many of whom are professional investors, were asked which behavioral biases most affect investment decisions. The results are shown in the chart below.

We are not surprised by the results, but we believe a rational investor would put these in reverse order.

Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”

At Real Investment Advice, we have covered a lot of ground on investor behavioral biases. In 5 Mental Traps Investors are Falling In To Right Now, Lance Roberts lucidly points out, “Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.”

Lance’s quote nicely sums up the chart above. These same biases driving markets higher today also drove irrational conduct in the late 1920s and the late 1990s. Currently, valuations are at or near levels reached during those two historical market peaks. Current valuations have long since surpassed all other prior valuation peaks.

One major difference between the late 1920s, the late 1990s, and today is the extent to which the Federal Reserve (Fed) is fostering current market conditions and imprudent investor behavior. To what extent have investors fallen into the overconfidence trap as the herd marches onward?

This “ignorance is bliss” type of behavior raises some serious questions, especially in light of the recent changes in Fed policy.

Not QE

As predicted in QE By Any Other Name, the Fed recently surprised investors with a resumption of quantitative easing (QE). The announcement of $60 billion in monthly Treasury bill purchases to replenish depleted excess reserves and another $20 billion to sustain existing balances was made late in the afternoon on Friday October 11. With a formal FOMC meeting scheduled in less than three weeks, the timing and substance of this announcement occurred under unusual circumstances.

The stated purpose of this new round of QE is to address recent liquidity issues in the short-term funding markets. Up to this point, the Fed added additional liquidity through its repo facility. These are actions not taken since the financial crisis a decade ago. The liquidity problems, though not resolved, certainly have largely subsided.

So why the strange off-cycle announcement? In other words, why did the Fed seemingly scramble over the prior few days to announce a resumption of QE now? Why not wait to make this announcement through the normal FOMC meeting statement and press conference process? The answer to those questions tells us more about current circumstances than the actual policy change itself.

The Drowning Man

As is always the case with human beings, actions speak louder than words. If you observe the physical behavior of someone in distress and know what to look for, you learn far more about their circumstance than you would by listening to their words. As an example, the signs of drowning are typically not what we would expect.  A person who is drowning can often appear to be playing in the water. When a person in the water is in distress, their body understands the threat and directs all energy toward staying alive.

People who drown seldom flail and scream for help as is often portrayed on television. If you ask a drowning person if they are okay, you might not receive a response. They are often incapable of producing the energy to speak or scream as all bodily functions are focused on staying afloat.

Since the Financial Crisis, investors, market analysts, and observers are helplessly watching the Fed, a guardian that does not realize the market is drowning. The Fed, the lifeguard of the market, is unaware of the signs of distress and unable to diagnose the problem (see also The Voice of the Market – The Millennial Perspective).

In this case, it is the global banking system that has become so dependent on excess reserves and dollar liquidity that any shortfall, however temporary, causes acute problems. Investor confidence and Fed hubris are blinding many to the source of the turbulence.

Lifeguards

Fortunately, there are a few other “lifeguards” who have not fallen into the behavioral traps that prevent so many investors from properly assessing the situation and potential consequences.

One of the most articulate “lifeguards” on this matter is Jeff Snyder of Alhambra Investments. For years, he has flatly stated that the Fed and their army of PhDs do not understand the global money marketplace. They set domestic policy and expect global participants to adjust to their actions. What is becoming clear is that central bankers, who more than anyone else should understand the nature of money, do not. Therefore, they repeatedly make critical policy errors as a result of hubris and ignorance.

Snyder claims that without an in-depth understanding of the dollar-based global lending market, one cannot grasp the extent to which problems exist and monetary policy is doomed to fail. Like the issues that surfaced around the sub-prime mortgage market in 2007, the funding turmoil that emerged in September was a symptom of that fact. Every “solution” the Fed implements creates another larger problem.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

We added the emphasis in the quote because we believe that to be a critically important point of consideration. Inflation is the one thing no one is looking for or even considering a possibility.

Summary

Today, similar to the months leading up to the Financial Crisis, irrational behavioral biases are the mindset of the market. As such, there are very few “lifeguards” that know what to look for in terms of distress. Those who do however, are sounding the alarm. Thus far warnings go largely unheeded because blind confidence in the Fed and profits from yesteryear are blinding investors. Similar to the analogy James Grant uses, where he refers to the Fed as an arsonist not a firefighter, here the Fed is not the lifeguard on duty but the invisible undertow.

Investors should frequently evaluate a list of cognitive biases and be aware of their weaknesses. Humility will be an enormous asset as this economic and market expansion ends and the inevitable correction takes shape.  We have attached links to our other behavioral investing articles as they may be helpful in that difficult task of self-evaluation.

Finally, we must ask what asset can be a life preserver that is neither being chased higher by the herd nor providing any confirmation bias.

Gold is currently one of the most hated investments by the media and social media influencers. The only herd following gold are thought to be relics of ancient history and doomsday preppers. Maybe, as we saw in the aftermath of the prior valuation peaks, those who were ridiculed for their rigor and discipline will once again come out on top.

Gold provides ballast to a portfolio during troubling times and should definitely be considered today as the distress becomes more pronounced and obvious.

Please find below links to some of our favorite behavioral investing articles:  

Dalbar 2017: Investors Suck at Investing and Tips for Advisors

8 Reasons to Hold Some Extra Cash

The 5-Laws Of Human Stupidity & How To Be A “Non-Stupid” Investor

The Money Game & the Human Brain

The Definitive Guide to Investing for the Long Run

To Buy, Or Not To Buy- An Investors Guide to QE 4

In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

  • Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
  • Defensive equity sectors underperformed during QE.
  • On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
  • Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
  • Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
  • On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
  • In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
  • QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
  • The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
  • Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

  • As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
  • Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
  • QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
  • Equity valuations are significantly higher today than during QE 1, 2, and 3.
  • The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
  • Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

  • The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
  • QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
  • Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

QE By Any Other Name

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

  1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
  2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

The Great LIBOR Liquidation

We are thrilled to introduce Jess L. as a new contributor to RIA. Jess started her career nearly two decades ago as a market maker at Goldman Sachs, followed by a stint at Merrill Lynch. After that, she moved over to the buy-side as a Portfolio Manager at Caxton Associates before ending her career at Millennium Partners. Throughout her career, she has had the opportunity to trade a number of different asset classes, but the one nearest & dearest to her heart is the front-end of the USD rates curve. She now lives in Malibu with two children, adoring husband, and border collie – Rosie.

Follow Jess on Twitter at @MacroMorning

______________________________________________________________________

The fate of LIBOR is likely to precipitate one of the largest one-off structural changes to the interest rates market in our lifetimes. Regulators are growing increasingly concerned because we’re ill-prepared for what comes next. Thus, more ad lib experimentation by policymakers.

It’s a tectonic shift in a $400 trillion+ market.

On Monday, New York Fed President John Williams gave a speech entitled “LIBOR: The Clock is Ticking” to address the ultimate liquidation of a ubiquitous benchmark rate. He summed up the motive behind invoking time-bomb imagery as follows.

“Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.”

https://www.newyorkfed.org/newsevents/speeches/2019/wil190923


Here’s what you need to know

If nothing else, there are really just a few take-away bullet points.

The shift from LIBOR to SOFR rates is happening & has massive implications.

The fate of benchmark rates will be driven by events such as last week’s move in repo. The Fed’s decision to embark on OMOs will extend far beyond October for a number of reasons. Key among them? Protect the sanctity of the incoming LIBOR replacement.

We’re talking about $400 trillion.


What’s $400 trillion between friends?

400 trillion is such a large figure, it’s really, really difficult to conceive.   

Imagine human beings began counting to 400 trillion around the time of the first discovered form of writing (about 32 centuries ago). A weary descendent today would be still counting… with 99.75% remaining.

If (in a more financial, but equally less pragmatic way) you were somehow able to cover the surface of the Earth in gold plating a meter thick, $400 trillion would get enough gold for a second copy as well – and then some.

If (while recreating a cult movie classic) you spent $400 trillion on gas, you’d have enough to drive the distance from here to Alpha Centauri – and back. About 40 times. In a Winnebago.

But perhaps that’s because we’re using the wrong yardstick, using as a basis for comparison concepts that are familiar to us in our daily lives. If we change dimensions, the idea of such a quantity becomes a little easier to picture.

If every neural synapse in the brain cost $1, $400 trillion would get you only enough for a typical NFL Quarterback. Though to be clear, in the case of the Jets, we’d be talking about Ryan Fitzpatrick – not, y’know… anybody else.

Spend a dollar programming every possible chess combination into a supercomputer? You’d only have enough for an opening of four moves (a “Fool’s Gambit” if you reach checkmate).

And if you tallied up the total notional outstanding of interest rate derivative contracts that are about to be significantly altered by coming benchmark reform… well, that’s why we’re here, you’d have about $400 trillion.

It’s a huge number, even in the scheme of other large markets outstanding. And it’s due to be transformed – one might argue – beyond a shadow of its former self.

Here’s why.


It’s (still) all about funding markets

During last week’s repo debacle, here’s how the replacement for LIBOR did (more on the distinction between these two lines below):

Lest you think I’m cherry-picking by showing an overnight rate versus a 3-month tenor, take a look at what the “overnight” LIBOR rate did by comparison. The relative shock wave is of similar magnitude.

Now, in order to combat these types of violent moves, the Fed has embarked upon a series of Open Market Operations (OMOs) to provide funding from now until Thursday October 10th. But if you think this all ends on that date, you haven’t been paying attention.

https://www.newyorkfed.org/markets/opolicy/operating_policy_190920

Last week, ISDA released their final consultation on the remaining thorny issues to be hashed out regarding fallbacks – with responses due from participants no later than October 23rd.

https://www.isda.org/2019/09/18/isda-publishes-consultation-on-final-parameters-for-benchmark-fallback-adjustments

In other words, this is an issue that is very much front & center – now.


Making LIBOR Great Again

The saga around “the end of LIBOR” aka Benchmark Reform has been ongoing for nearly a decade. Really ever since regulators determined that “asking a cabal of bank executives who could pick up a phone call from their trading desks what they’d like the daily rate to be…” underpinning the largest derivatives market in the world left open a little room for bad actors to operate. LIBOR (the “London InterBank Offered Rate”) needed to be replaced. And the replacement would need to be something that was observable & representative of conditions in money markets.

Enter SOFR – the Secured Overnight Financing Rate.

This isn’t the place to get into the minutiae around LIBOR vs SOFR, but a basic understanding is important. LIBOR is a “forecast of unsecured funding” and SOFR is an “actual measure of secured funding”.  In other words, the key is that LIBOR is only a guess at where you could borrow without having to provide collateral and SOFR is where the borrowing actually gets done that’s collateralized by US Treasuries. I’ve included links at the bottom of this article & an excellent series of blog posts on the topic, here & here.

Secured vs Unsecured

You might assume that the SOFR rate (in which you provide collateral) is always lower than the LIBOR rate (in which it’s just based on a bank’s estimate of where they could get funding, based on nothing more than a promise to return it). And, of course, because this is the world we live in – you’d be wrong.

One has to be a little cynical (or at least an active trader in today’s paradoxical market) to grasp the distinction. Banks never want to admit that funding is scarce or that they’d have a tough time tapping capital markets. Bank stocks don’t tend to like that sort of admission. So, forecasts are based on an information waterfall that, as best as we can tell, is “where have things been recently?”

PM: “Wherefore art thou Libor?” 6/28/2019

On the other hand, collateralized funding is not exactly the cheap source of financing you might have thought. Banks already have plenty of what you’re trying to offload in exchange for the cash: collateral. Much of this, however, is required due to the increase in considerations around capitalization post-crisis. Increasingly, it’s due to the fact that the Treasury is aggressively ramping up debt issuance.

Collateral supersaturation

Why this becomes problematic is the fact we’re whirling further & further into an environment where oversupply of collateral is causing these rates to become more & more volatile – see the most recent episode for a point of reference.

To say that last week’s repo debacle was precipitated by either the KSA or by the timing of corporate taxes & bills supply is a little like saying World War I was caused by Gavrilo Princip. Yes, that’s true – but the conditions had to be right & the stage appropriately set.

It’s a bit like the grade school chemistry lesson where you drop additional solute into an already supersaturated solution:

But, this is what regulators have decided we’re going with & we’re a few details away from getting a complete picture of what LIBOR’s replacement will look like.

Back to the future, part 1

Accordingly, efforts have been made to reduce the type of noise we saw last week. Regulators were aware of the fact this could happen well in advance.

For example, what was previously “3-month LIBOR” (i.e. the trimmed mean of daily bank estimates of where they could borrow unsecured cash for 3 months) will now be a daily-compounded in arrears SOFR rate (i.e. the daily fixings over that equivalent period compounded over that same period). Instead of using just one rate that covers the entire 3-month period which is set at the START of the period, we’ll take every business day during that period & compound all the fixings together at the END of the period.

Here’s a schematic from Oliver Wyman that shows the difference:

Back to the future, part 2

In other words, we’re going from an “expectations based” benchmark to a “present realized” index. While that might not exactly violate the space-time continuum, that does cause some quirks.

Again, the reason for this consideration is to remove some of the daily “noise” around the fixings. That’s “noise” due to things like holidays, reporting periods & unexpected vaporization of liquidity. This is obvious just from a cursory glance at that historical chart of the daily fixings for the SOFR rate compared to the 3-month LIBOR rate.

However, LIBOR doesn’t just have a 3-month term. An overnight term, a 1-month term, a 6-month term & so on also exist.

Consider what events like last week’s move in repo did to LIBOR’s replacement, even after the “smoothing”. Even without looking, you can probably guess it’s not good.

Not exactly “easing”

Let’s play this out. The LIBOR fixing that was delivered on the morning of June 17th was the one which covered an “effective” period that started T+2 (June 19th) for 3-months. Therefore, that rate would pick up all the fixings from last week. That caused the “rate” from nearly 3-months ago to increase a little over 3 basis points. Previously, you wouldn’t have cared much about what happens in the 3-months following your LIBOR fixing. Now, you care quite a bit about any significant moves in SOFR underlying that might transpire over the ensuing period.

The VaR-Shock to rule them all

What’s even more important is that the shorter LIBOR rates are the ones that underpin things like Student Loan Securitizations & Commercial Mortgage-Backed Securitizations. Well, those happen to be two areas of the market precariously balanced at the moment.

Here’s what the 1mL rate & its replacement did…

Consider: the magnitude of the move works out to a little over 12.5bps – or half of what the Fed just cut rates by. That’s a pretty big difference – in the opposite direction of what the Fed’s intending to do as they “ease” policy.

Now, this past week’s episode won’t do much since LIBOR is still clinging on. It won’t even affect the proposed spread adjustment, since that will most likely use a trimmed mean or median observation of the last 5-10 years. Stay tuned: it’s one of the biggest outstanding decisions remaining.

But, it’s a good example of how policymakers have designed a replacement benchmark to take over the largest derivatives market in the world which could deviate from the original. Best summed up in the words of Job & George Bluth.

Trillion Dollar PNL Implications

In the context of a $400 trillion market it’s a lot. Especially, since you’ve just caused the entire index to shift up by 12.5bps when it should have been shifting lower as the Fed “eases” policy. For a 1-month coupon, that difference is $42bn in PNL terms for just this one episode. That episode lasted only about 3 days.

Over a longer period (a few weeks, for example), implications are north of a trillion dollars in market PNL.

Imagine if regulators enacted by decree an instantaneous drop of $1 trillion in market PNL from US equities. You’d take notice.

Furthermore, the index jumped 12.4bps on the day that the 1mL rate moved 1.5bps. A 1.5bps move for 1mL is barely a half a standard deviation move on the long-term history, going back to 1998. That 12.4bps move for SOFR? An 8+ standard deviation event.

Regulators take heed

We live in a world where risk has been increasingly calibrated to historical VaR. That’s a seismic shock that poses a serious threat to future position concentration.

Regulators have told us in no uncertain terms that this is happening. Williams’ speech on Monday is an example of their determination to enact a shift. But, the Fed knows in order to make it stick, one must have a reliable fallback instrument.

Reliable fallback instruments for a $400 trillion market don’t move 8+ standard deviations because of a regularly scheduled tax date. Even if it just so happens to compound a number of other structural issues.

So, it’s in the Fed’s best interests to lean against such moves. That’s yet another reason why we should expect OMOs are really Permanent (with a capital “P” = POMOs). They’re due to extend well beyond the October date that’s currently on the calendar.

With that, regulators are more than happy to issue one final valediction to LIBOR.

LINKS

ARRC FAQ: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf

ISDA Fallback Consultation: https://www.isda.org/2019/09/18/september-2019-consultation-on-final-parameters/

CALCULATION METHODOLOGY

Disclosure/Disclaimers:

This material may contain indicative terms & there is no representation that any transaction could have been executed at such terms. Proposed terms are for discussion purposes only.

OTC Derivatives Risk Disclosures:

Understand clearly the terms of any OTC derivative transaction you may enter into. You should carefully review these terms with your counterparty.

Also, understand the nature of your exposure. Consequently, you should be satisfied that such transactions are appropriate. In addition, you may be required to post margin.

This post was written by me & the material is my own, except where sourced. I am not receiving compensation for it.

Who Could Have Known: What The Repo Fiasco Entails

Imagine approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.

On Monday, September 16th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.

The Plumbing of the Banking System and Financial Markets

Interbank borrowing is the engine that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that all banks have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.

Before proceeding, what follows is a definition of the funding instruments used in the interbank markets.

  • Fed Funds are uncollateralized interbank loans that are almost exclusively done on an overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
  • Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repo can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.

On September 16th, overnight GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”?  Before the 16th, a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16th, many multiples of that premium were not enticing enough.

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. We are not convinced by either excuse as they were easily forecastable weeks in advance.

Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.

To highlight the enormity of the aberration, consider the following:

  • Since 2006, the average daily difference between the overnight GC repo rate and the Fed Funds effective rate was .025%.
  • Three standard deviations or 99.5% of the observances should have a spread of .56% or less.
  • 8% is a bewildering 42 standard deviations from the average, or simply impossible assuming a traditional bell curve.

What was revealed on the 16th?

The U.S. and global banking systems revolve around fractional reserve banking. That means banks need only hold a fraction of the cash deposits that they hold in reserve accounts at the Fed. For example, if a bank has $1,000 in deposits (a liability to the bank), they may lend $900 of those funds and retain only 10% in reserves. This is meant to ensure they have enough funding on hand to make payments during the day and also as a buffer against unanticipated liquidity needs. Before 2008, banks held only just as many reserves as were required by the Fed. Holding anything more than the required minimum was a drag on earnings, as excess reserves were unremunerated at the time.

Quantitative Easing (QE) and the need for the Fed to pay interest on newly formed excess reserves changed that. When the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed securities and credited the selling bank’s reserve account. The purpose of QE1 was to ensure that the banking system was sufficiently liquid and equipped to deal with the ramifications of the ongoing financial crisis. Round one of QE was logical given the growing list of bank/financial institution failures. However, additional rounds of QE appear to have had a different motive and influence as banks were highly liquid after QE1 and had shored up their capital as well. That is a story for another day.

The graph below shows how “excess” reserves were close to zero before 2008 and soared by over $2.5 trillion after the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the hundreds of millions. The amount is so small it is not visible on the graph below. The reserves produced by multiple rounds of quantitative easing may have been truly excess, meaning above required reserves, on day one of QE. However, on day two and beyond that is not necessarily true for any particular bank or the system as a whole, as we are about to explain.

Data courtesy: St. Louis Federal Reserve

The Fed, having pushed an enormous amount of reserves on the banks, created a potential problem. The Fed feared that once the smoke cleared from the financial crisis, banks would revert to their pre-crisis practice of keeping only the minimum amount of reserves required. This would leave them an unprecedented surplus of excess funds to buy financial assets and/or create loans which would vastly increase the money supply with inflationary consequences. To combat this problem, they incentivized the banks to keep the reserves locked down by paying them a rate of interest on the reserves that were higher than the Fed funds rates and other prevailing money market rates. This rate is called the IOER or the interest on excess reserves.

The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.

From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.

Beginning in 2018, the Fed began reducing their balance sheet via QT and the amount of excess reserves held by banks began to decline appreciably.

Solving Our Mystery

It is nearly impossible for the public to figure out how much in excess reserves the banking system is truly carrying. Indeed, even the Fed seems uncertain. It is common knowledge that they have been declining, and over the last six months, clues emerged that the amount of “truly excess reserves,” meaning the amount banks could do without, was possibly approaching zero.  

Clue one came on March 20th, 2019 when the Fed said QT would end in October 2019. Then, on July 31st, 2019, as small problems occurred in the funding markets, the Fed abruptly announced that they would halt the balance sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after it began. The Fed’s balance sheet declined only $800 billion as a result of QT, less than a quarter of what the Fed added to their balance sheet during QE.

Clue two was the declining spread between the IOER rate and the effective Fed Funds rate as the level of excess reserves was declining, as seen in the chart below. The spread between IOER and the Fed Funds rate was narrowing because the Fed was having trouble maintaining the Fed Funds rate within the targeted range. In March 2019, the spread became negative, which was counter to the Fed’s objectives. Not surprisingly, this is when the Fed first announced that QT would end.

Data courtesy: St. Louis Federal Reserve

The third and final clue emerged on September 16, 2019, when overnight repo traded at 7%-8%. If banks truly had excess reserves, they would have lent some of that excess into the repo market and rates would never have gotten close to 7-8%. It seems logical that banks would have been happy to lend on a collateralized basis at 3%, much less 7-8%, when their alternative, leaving excess reserves to the Fed, would have earned them 2.25%.   

Further confirmation that something was amiss occurred on September 17th, 2019, when the Fed Funds effective rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This marked the first time the Fed Funds rate traded above its target since 2008.

On September 17th, the Fed entered the repo markets with a $53 billion overnight repo operation, whereby banks could pledge Treasury collateral to the Fed and receive cash. The temporary liquidity injection worked and brought repo rates back to normal. The following day the Fed pumped $75 billion into the markets. These were the first repo transactions executed by the Fed since the Financial Crisis, as shown below.

These liquidity operations will likely continue as long as there is demand from banks. The Fed will also conduct longer-term repo operations to reduce the amount of daily liquidity they provide.

The Fed can continue to resort to the pre-QE era tactics and use temporary daily operations to help target overnight borrowing rates. They can also reduce the reserve requirements which would, at least for some time, provide the system with excess reserves. Lastly, they can permanently add reserves with QE. Recent rhetoric from Fed Chairman Powell and New York Fed President Williams suggests a resumption of QE in some form may be closer than we think.

Why should we care?

The QE-related excess reserves were used to invest in financial assets. While the investments were probably high-grade liquid assets, they essentially crowded out investors, pushing them into slightly riskier assets. This domino effect helped lift all asset prices from the most risk-free and liquid to those that are risky and illiquid. Keep in mind the Fed removed about $3.6 trillion of Treasury and mortgage securities from the market which had a similar effect.

The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.

Summary

Short-term funding is never sexy and rarely if ever, the most exciting part of the capital markets. A brief recollection of 2008 serves as a reminder that, when it is exciting, it is usually a harbinger of volatility and disruption.

In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.” 

Today, a decade after the financial crisis, we see that Bernanke and Powell have little appreciation for the inner-workings of the financial system. 

In the Wisdom of Peter Fisher, an RIA Pro article released in July, we discussed the insight of Peter Fisher, a former Treasury, and Federal Reserve official. Unlike most other Fed members and politicians, he discussed how hard getting back to normal will be. As we are learning, it turns out that Fisher’s wisdom from 2017 was visionary.

“As Fisher stated in his remarks, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”

Prophetic indeed.