“Though they didn’t announce a standing repo facility, what they did in essence is set up a ‘sitting’ one that can stand up when it needs to”, BMO’s Jon Hill said, of the Fed’s express willingness to continually intervene with liquidity injections in order to alleviate the acute funding stress that rippled across money markets ahead of the Fed meeting this week.
During the post-meeting press conference, Jerome Powell sought to play down the drama, which grabbed headlines on Monday and Tuesday and stoked speculation that the Fed would move quickly to roll out a standing repo facility or announce balance sheet expansion to definitively address reserve scarcity.
Instead, Powell demurred, going so far as to say “funding pressures have no implications for monetary policy” and generally failing to address the structural factors and legacy issues that are contributing to the problem.
Maybe it was overly optimistic to think that a Fed which, collectively, has demonstrated a penchant for recalcitrance during Powell’s tenure, would rush in to save the day.
But the reserves scarcity debate has being going on for a long, long time. They’ve had plenty of opportunity to consider it, and this week offered a rather poignant example of what happens when structural factors collide with idiosyncratic issues to wreak havoc.
To be fair, this week has been somewhat anomalous, but what the anomalies illustrated by the red triangles in Exhibit 2 below suggest is that the market may have hit a tipping point all of a sudden (we’ve highlighted several versions of the chart in the right pane over the past 48 hours, so if it looks familiar, that’s why):
After observing that big swings in the Treasury General Account aren’t actually that rare, especially on tax days (see left pane above), Goldman explains the problem, as outlined in similar terms by everyone on the street this week. To wit, from a Wednesday note:
Why then have markets reacted so violently? One reason could be that we are closer to the “lowest comfortable level of reserves” in aggregate than the Fed’s Senior Financial Officer Survey implied. Exhibit 2 backs out an implied demand curve for reserves from the survey, and the latest fed funds (FF)-IOER spread versus our estimate of where reserve balances are likely to be today. As can be seen, until last week the relationship between FF-IOER and aggregate reserves largely seemed to track the curve imputed from the survey, which suggested a substantial buffer (i.e., the “steep” part of the curve was probably at reserve levels below $1.2tn). However, at current levels of aggregate reserves (which we estimate had dropped to about $1.34tn this week), the realized FF-IOER spread, at 15bp on Monday and 20bp on Tuesday, is nearly 7bp to 12bp above where we would have anticipated it to be based on the survey.
Given all of that, Wednesday’s promise of more ad hoc, “as needed” liquidity injections (they’ll be a third consecutive overnight repo operation on Thursday) and another IOER tweak was something of a disappointing outcome to a market that was looking for a heavy-handed response or, at the least, rhetoric from Powell that clearly indicated the Fed is on the cusp of “fixing” this in a sustainable way.
Absent a “real” fix, some fret more volatility is all but inevitable, even if “as needed” operations like those carried out on Tuesday and Wednesday keep things from spiraling too far.
“Of the various Fed options, we believe resuming permanent OMOs to offset a passive decline in reserves is the most likely solution”, Goldman said Wednesday morning, warning that “an IOER adjustment in itself may prove insufficient to curb front-end volatility in the near term”.
“The committee stopped short of decisive action – either resuming balance sheet growth or adopting a standing repo facility [and] Powell indicated that the FOMC is considering balance sheet growth in the near-term, but did not treat this as an urgent problem”, Credit Suisse remarked, adding that Powell “also made it clear that rates policy would not be used to address money market stress”.
“I expect repo vol to stay high and then rise again at quarter end and year end”, TD’s Priya Misra sighed, expressing a bit of incredulity that Powell didn’t address the issue more forcefully in the presser. Earlier, she told the media in an e-mail that she’s “really surprised the market expected the Fed to announce asset purchases today” as that would have been “a huge departure from what they have been saying so far that reserves are ample”.
“The Treasury market interpreted the FOMC meeting as hawkish as it signaled a Fed that is insufficiently responsive to macroeconomic and funding market uncertainties”, BofA said, in a brief Wednesday evening note.
The bank agrees with TD’s Misra that more volatility is in the cards. “The reduction of the IOER and O/N RRP are likely to prove to be only ‘band aids’ in the near term to address the underlying issue of a banking system that is running low on its desired amount of reserves”, BofA cautioned, noting that the Fed “will continue to be responsive to funding market conditions and the repo market is likely to remain volatile as the NY Fed Open Market Desk remains reactionary to funding strains”. Again: Reactive versus proactive is likely conducive to volatility.
Still, this isn’t a disaster and probably doesn’t presage anything dire as long as the Fed doesn’t fall completely asleep at the wheel.
With that relatively benign bottom line assessment in mind, we’ll leave you with an excerpt from another note by Credit Suisse’s James Sweeney (the reference to “Zoltan” is to Zoltan Pozsar, who knows a thing or five hundred about this subject):
There is nothing to fear in this. It does mean that the overnight injection of reserves that we have seen [this week] is likely to be only the start of the Fed’s attempt to regain a strict hold on overnight rates. Zoltan has laid out various options including QE, a permanent repo facility, or an aggressive reduction in short term rates, to deal with this problem. But one way or another, the classic solution of a steady increase in reserves supply to match an apparent increase in demand is most likely. In our view the Fed would be wise to leave interest rate setting to the usual process, which is focused more on growth and inflation concerns than plumbing. Let plumbing decide the balance sheet’s size, stick to a credible interest rate target, and conduct policy accordingly. What we have seen this week is not a crisis but a symptom that we have reentered an old regime for Fed policy operations. To answer the question, is the Fed losing control, we say no it isn’t, but it must now move to allowing its balance sheet to grow in order to maintain its interest rate target.