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Charlie McElligott Talks QE ‘Muscle Memory’ And ‘The Trillion-Dollar Question’ For FOMC Meeting

"The TRILLION DOLLAR QUESTION today is this"...

With speculation running rampant around what the Fed will do or say Wednesday to allay concerns about malfunctioning money markets, it’s worth considering what the reaction might be to an announcement of outright asset purchases or a standing repo facility.

Apparent funding stress tied to a combination of idiosyncratic factors and legacy/structural issues forced two straight days of intervention by the New York Fed as the funds rate pushed through the upper end of the target range, and it’s now abundantly clear that reserves aren’t… well… aren’t “abundant”.

Because more IOER tweaks and the promise of “as needed” repo operations don’t really address the problem with any permanency, there will, at the very least, be a discussion of how the balance sheet can be used to address the situation.

“The market’s ‘muscle memory’ in the post-GFC period has conditioned many participants into believing that ‘balance sheet expansion = QE'”, Nomura’s Charlie McElligott wrote on Wednesday morning.

As noted earlier, it’s important that the nuance doesn’t get lost in the fray. Balance sheet expansion in an effort to offset reserve depletion isn’t the same thing as the Fed injecting incremental liquidity “‘above and beyond’ to actually ‘pump up’ reserves”, McElligott notes, underscoring a point that, while obvious to anyone who understands the dynamics behind the funding squeeze, has the potential to be completely lost on many investors.

That potential for the nuance to be summarily disregarded “risks a ‘BULLISH risk-asset sentiment shock”, Charlie says, before elaborating.

“IF we get that ‘Fed balance sheet expansion’ headline, the Equities market risks an overly-bullish interpretation”, he writes, adding that when considered with “so much $Gamma coming-off following this Friday’s Op-Ex which acts to ‘untether’ currently very ‘sticky’ Stocks” and historically low net exposures, the potential exists for “a slingshot to the upside in Stocks – and fast”.

The point about Op-Ex harkens back to Charlie’s sequencing call for September, and as far as the depressed “nets” go, that’s been discussed here ad nauseam in the context of this month’s epic rotations and factor reversals (one example). But for those who can’t immediately connect those dots, here’s McElligott to explain:

So despite the seasonal which I’ve been speaking about on “typical” post September Op-Ex seasonal seeing SPX index trade LOWER (as the flows from 1-Overwriters roll and buy Delta and 2-Corps accelerate Buybacks ahead of the “blackout” both “disappear” thereafter), this new “Fed as macro catalyst” in the form of a BULLISH SENTIMENT SHOCK for risk-assets could then in fact override, and act as the next wave up to those lumpy strikes at 3025 / 3050.

And in light of the “low Nets” dynamic, I think there is a real risk of a “OVERLY bullish (mis)interpretation” from Equities participants of any “Fed balance sheet expansion” headlines—in conjunction with the potential “un-tethering” of Index post Op-Ex “Long Gamma” gravity—could drive a real overshoot in Stocks in the coming weeks +

Of course, this is predicated in part on the idea that many market participants will simply overreact to any headline about “balance sheet expansion”, as even those who do understand the nuance and the rationale in the context of this week’s funding squeeze will still be unable to restrain themselves from chasing the “QE-Lite” story, if only on the assumption that others will be similarly inclined (call it “POMO FOMO”).

It’s also possible that there is no balance sheet expansion announcement and no indication of when a standing repo facility will be ready. If Powell then doesn’t do enough to address the funding stress in the press conference, the stage would be set for disappointment, especially in light of elevated expectations after the events of the last few days.

All of that is to say nothing of the actual rate cut, forward guidance, dots and new set of projections.

And don’t forget about the possibility that Powell tries to pull a Draghi, by mitigating a disappointingly “small” rate cut with the announcement of other measures, only to again show that he is most assuredly not Mario Draghi. McElligott mentions this, in a roundabout kind of way, while also alluding to the possibility that any POMO announcement may prompt the market to reassess whether balance sheet expansion could make the Fed less inclined to cut rates. To wit, from Charlie:

The TRILLION DOLLAR QUESTION today is this: if our expectations for the Fed are correct today, how does the market respond to a potentially MIXED-MESSAGE where 1) balance sheet is set to be imminently expanded again via larger POMOs (and liquidity is being injected to offset this acute Reserve depletion) YET against a backdrop where 2) the market’s very dovish expectations for a deeper Fed easing-path may now be reassessed / re-priced “lower”?

Again – and this is perhaps the most crucial point – all of the above is relevant regardless of what happens on Wednesday, because irrespective of whether the market gets a formal announcement today, this will be something the Fed has to do eventually unless they intend to continue papering over the problem with overnight repos and IOER tweaks in virtual perpetuity.


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