“Is it an imminent disaster?”, Jeff Gundlach asked, during a Tuesday webcast for his $54 billion DoubleLine Total Return Bond Fund.
Normally, when Jeff asks if something is a “disaster”, his answer is “yes”, or “probably” or, at the least, he alludes to the prospect of something bad happening. But in this case, his answer was “No”.
He was talking about the acute funding stress in money markets that prompted the New York Fed to intervene just a day ahead of the September FOMC decision in the interest of allaying fears and reasserting control over rates.
The situation – which saw GC repo surge, dragging the effective fed funds rate to the upper end of the range – was addressed with an overnight repo operation, an intervention the NY Fed will repeat on Wednesday just hours ahead of the Fed decision.
Gundlach called the chaos in funding markets a “warning sign”.
“The freeze-up can only be viewed as a negative”, he said. “The Fed is going to use this to go back to some balance sheet expansion”.
As mentioned here previously on any number of occasions, the interventions and any additional IOER tweaks are just stopgap measures – Band-Aids to buy time on the way to instituting a standing repo facility or else launching new asset purchases. That’s what Jeff is talking about.
“They are baby-stepping their way to doing QE”, Gundlach remarked.
There were a variety of factors that contributed to what happened over the last several days. The disorderly conditions came amid large coupon settlements, this month’s corporate tax payment date and on the heels of the biggest bond selloff since the election. This at a time when dealer balance sheets are stuffed to the gills.
But at the heart of the problem are legacy/structural issues.
“The recent spike in repo is due to a substantial decline in reserves and indicates that the amount of cash in the baking system is too limited”, BofA’s Mark Cabana wrote on Tuesday evening, adding that “the increase in funding pressure as reserves declined to ~$1.35tn likely suggests that the market is on the upward sloping part of the reserve demand curve, below the minimum amount of reserves needed for an ‘abundant reserve regime”.
The number might sound large, but banks need around $1.35 trillion of reserves just to “meet regulatory and liquidity needs”, Cabana goes on to say, before noting that while Tuesday’s repo operations “bring us closer to the flat portion of the reserve demand curve”, it’s temporary, and “the repo operation has not yet sufficiently quelled repo pressures”.
That, in turn, means the Fed will be forced to persist in cash injections in order to ensure reserves are abundant.
So, what does this mean for the Fed meeting? Well, if you ask BofA, Jerome Powell and co. may very well still tweak IOER on Wednesday, but again, that’s just a Band-Aid and by nature, the overnight repo isn’t a lasting fix for lower reserves.
And so, get ready for the Fed to announce outright asset purchases (i.e., permanent balance sheet growth) aimed at stabilizing the level of reserves.
Only maybe not immediately. BofA doesn’t see that coming at the September meeting, but does say there’s a “substantial risk of such an action”.
As far as the amount is concerned, Cabana says “the Fed will likely need to purchase $250bn in assets in the secondary market to return to an ‘abundant’ reserve level plus a buffer, and will need to continue outright purchases of ~$150bn/yr to maintain this reserve level”.
In an interview with Reuters on Tuesday, Gundlach said a return to balance sheet expansion – “QE lite” in this iteration – will probably happen “pretty soon”.
If “pretty soon” ends up being Wednesday, BofA’s Cabana notes that it would be included in the Fed’s “implementation note”. Obviously, Powell would then need to discuss it in the press conference, although given what’s unfolded over the past two days, he surely has his funding squeeze talking points in order. Or so you’d think.