Fed Risks Stop Outs, ‘Disorderly Unwinds’ In Slow Response To Funding Squeeze, One Bank Warns

As expected, the tomato throwing around the Fed’s “Band-Aid”, stopgap approach to alleviating the funding market stress which grabbed headlines earlier this week ahead of Wednesday’s FOMC decision has not abated. If anything, it’s getting worse.

The New York Fed is set to inject liquidity for a fourth consecutive day on Friday after Thursday’s $75 billion operation was oversubscribed, with dealers submitting $83.9 billion of securities, the most of the three repos conducted this week. That clearly indicated another operation was likely, despite signs that stress is abating in overnight funding rates.

Thursday’s bill sales underscored concerns, while sliding swap spreads betrayed palpable disappointment at the lack of clarity from the Fed around the timeline on the introduction of a standing repo facility to address funding concerns with more permanency.

Read more: Fed’s ‘Band-Aid’ Approach To Repo Chaos Opens Door To More Volatility

Getting to the above-mentioned tomato throwing, Jefferies Thomas Simons sounds pretty irritated with the situation. “The next 11 days are going to be a disaster”, Bloomberg quotes him as saying, an apparent reference to the likely resumption of the funding squeeze into month- and quarter-end.

Meanwhile, BofA’s Mark Cabana – who is enjoying some publicity this week amid the tumult – was out with another good piece on Thursday afternoon, just prior to close.

As you can imagine, he’s not particularly enamored with the Fed’s foot-dragging as exhibited in Wednesday’s IOER tweak and pledge to keep conducting OMOs in perpetuity rather than nipping this situation in the bud with a standing facility or an announcement around imminent balance sheet expansion.

“Chair Powell did not signal elevated concern over these pressures”, Cabana writes, juxtaposing the Fed’s “reactive” approach with a more desirable “proactive” bent aimed at striking at the structural/legacy issues at the heart of the problem. We decried Powell’s lackluster response to Steve Liesman’s badgering in real-time on Wednesday here, calling the Fed chair “inexplicably coy”.

What really concerns Cabana and BofA’s US rates team, though, is the knock-on effect of persistent uncertainty around the Fed’s reactive, Whac-a-mole approach to tamping down funding stress.

“Our biggest concern in the near-term is broader ‘collateral damage’ or disorderly positioning unwinds”, Cabana writes, adding that while rates markets have been reasonably calm once you get out beyond the very front end, volatile funding markets aren’t conducive to stability in a highly leveraged market.

“We do not believe that the proliferation of highly levered rates markets basis trades (e.g. UST cash vs futures positions) can withstand persistently elevated repo funding levels and expect that some of these trades are in the process of or run the risk of getting stopped out”, he warns, before noting that “the stopping out of such leveraged trades could have broader market impact and result in ripple effects across broader funding markets”.

And see, this is why it was somewhat disconcerting when Powell said, in response to Liesman, the following on Wednesday:

So as I mentioned, we don’t see this as having any implications for the broader economy or for the economic outlook, nor for our ability to control rates. The strains in the money markets reflect forces that we saw coming, and they just had a bigger effect than I think most folks anticipated, strong demand for cash to purchase treasuries and pay corporate taxes. We took appropriate actions to address those pressures, to keep the fed funds rate within the target range, and those measures were successful. If we experience another episode of pressures in money markets, we have the tools to address those pressures.

It’s somewhat hard to fathom the idea that Powell doesn’t understand the risks, and it’s almost impossible to imagine that his colleagues, given some of their backgrounds, aren’t cognizant of the situation, but when you hear that kind of dismissive rhetoric, you’re left to wonder.

In any event, BofA’s Cabana went on to detail the prevalence of levered basis trades in rates, and the bottom line is simply that up to and until the Fed decides to address the problem head-on, funding costs may well stay elevated, increasing the odds of knock-on effects (e.g., stop outs) which will in turn feed back into money markets, and so on and so forth.

As far as Powell’s admission that the Fed may be forced to start “organically” growing the balance sheet “earlier” than expected, BofA thinks “earlier” might actually mean as soon as next week.

“We interpret [Powell’s remarks] as signaling the Fed will start growing their balance sheet on a permanent basis no later than the October FOMC meeting”, Cabana assessed, on the way to saying that “there is a real possibility the Fed could re-start purchases in coming weeks if funding pressures persist into quarter end and the first few days of October as we anticipate”.

Read more: Fed Balance Sheet Expansion Is Coming, But Nuance May Get Lost