The New York Fed took $75 billion of securities in Wednesday’s overnight repo operation, intervening a second time to alleviate the funding squeeze that became the talk of the proverbial town this week, despite bubbling beneath the surface for months on end.
Tuesday’s intervention was the first such operation in a decade, and underscored the urgency of fixing the “plumbing”, as a historic spike in GC repo dragged the effective fed funds rate to the top of the target range, jeopardizing the central bank’s control of rates.
This week’s money market “chaos” has let directly to speculation that the Fed will need to launch outright asset purchases sooner, rather than later, possibly at Wednesday’s meeting. Presumably, the standing repo facility isn’t ready to go yet, and more IOER tweaks are just stopgap measures to buy time. So, speculation abounds that “QE-lite” is in the cards.
Ahead of the Fed, Nomura’s chief economist has shifted his Fed call “to include an announcement that the Fed will resume the expansion of the balance sheet again in coming weeks”. That, on top of the expected 25bps rate cut and probable guidance around the necessity of conducting more repos on an “as needed” basis in order to control rates.
In the linked post above, we detailed the rationale behind an imminent restart to outright asset purchases. BofA’s Mark Cabana – who showed up on Bloomberg TV Wednesday morning to discuss recent developments – flagged a “substantial risk of such an action”, even if it wasn’t the bank’s base case as of Tuesday.
Here’s a good summary of the situation from Nordea, which touches on most of the key stress points:
As far as the amount necessary to ensure ample reserves, Cabana said “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”.
“After a period a relative stability from early May through mid-August, reserves in the banking system have been declining in recent weeks”, Nomura’s Lewis Alexander writes, in the updated Fed call mentioned above. “With the asset side of the Fed’s balance sheet fixed, the recent declines in reserves have been driven by increases in the Fed’s non-reserve liabilities, primarily the Treasury General Account, currency outstanding and deposits held by foreign official institutions”, Alexander continues, adding the following key color:
While the debt limit was binding this year – from March through early August – the TGA was trending lower, and this tended to offset the impact of growth of the Fed’s other liabilities on the level of reserves. When the debt limit was raised in early August it was clear the Treasury was going to increase its cash holdings relatively quickly – we expect them to reach $350bn by end-September – and that was going to put significant downward pressure on reserves. In July, when the Fed ended runoff, we had expected that the Fed would let reserves fall to around $1.3tn before starting to expand the balance sheet again sometime in Q4 2019. Pressures that have emerged in funding markets in recent days, and the Fed’s decision to conduct a short-term repo transaction today, suggest that the Fed may be reassessing the level of reserves that is consistent with good control of the nexus of short-term interest rates.
This brings us right back to the same, inevitable conclusion – namely that the Fed is going to have to deploy its balance sheet, one way or another.
Nomura details four possibilities for the September Fed meeting. First, Powell could indicate the Fed will continue to conduct repos as necessary. Second, the FOMC could launch “QE-lite”, where that means “the FOMC could say they they will start to expand the Fed’s balance sheet as soon as practicable, in line with the growth of the Fed’s non-reserve liabilities”. Third, we could get another Band-Aid IOER tweak. Fourth, the Fed could announce a standing repo facility.
For Alexander, options one and two are “likely”. Promising to conduct more “as needed” repos is simply stating the Fed is prepared to keep doing what they did on Tuesday and Wednesday, so it’s hard to see why they wouldn’t reiterate that.
As far as option two, Nomura notes that logistically, it’s not a challenge. “The New York Fed is already purchasing assets to offset the runoff of its existing Treasury and MBS securities [so] it would be relatively simple to expand the size of those purchases to take account of increases in other liabilities”, Alexander says, adding that “the Treasury’s plans for their cash balance will likely continue to put downward pressure on reserves in coming weeks [and] the pressures that affected funding markets in the last few days may be an indication that reserves have fallen ‘enough'”.
While the launch of “QE-lite” still isn’t most desks’ base case, the chatter approximated a veritable cacophony on Wednesday, and irrespective of whether the market gets a formal announcement, this will be something that Powell has to address at the press conference.
It’s important that the nuance doesn’t get lost in the fray. “‘Balance sheet expansion = QE’ is NOT actually the case per se, as what we think the Fed plans to do is much more ‘QE-Lite’ in order to offset the Reserve depletion dynamic”, Nomura’s Charlie McElligott wrote on Wednesday morning. That, he reminds you, is something different from the Fed injecting incremental liquidity “‘above and beyond’ to actually ‘pump up’ reserves”.