“What a week”, BofA’s Mark Cabana wrote on Friday evening, reflecting on a five-day stretch that afforded front-end rates strategists a rare moment in the limelight (Mark was on Bloomberg TV this week).
On Friday, the Fed sought to reassert control over funding markets, which went haywire to start the week as the collision of idiosyncratic factors (e.g., corporate tax date, coupon settlements and the previous week’s bond rout) and structural/legacy issues (e.g., ambiguity around what counts as “ample” when it comes to reserves, the ongoing deluge of supply from Treasury to fund the deficit and an onerous regulatory regime) triggered a pretty epic squeeze that grabbed all manner of headlines in the 48 hours prior to the September Fed decision.
Four straight days of overnight repos helped ease the squeeze (as it were), but between Thursday and Friday’s operations being oversubscribed, jitters about month- and quarter-end pressure and Jerome Powell’s seeming ambivalence in the post-FOMC press conference, market participants remained on edge, eventually prompting the Fed to release a schedule for liquidity injections which included a trio of term operations.
So, what now? Well, the widening in two-year swap spreads (which touched a record nadir on Thursday) after the Fed effectively said it would remain in the market through month- and quarter-end, suggests the quake is behind us, even if there will be aftershocks up to and until a more permanent solution is rolled out in the form of balance sheet expansion or a standing facility.
BofA’s Cabana called Friday’s Fed announcement “a big bazooka of liquidity that shifts them away from being reactive to funding market stresses and into a position to proactively manage reserves and money markets”.
“We interpret this as a ‘whatever it takes’ signal from the Fed and now assume the Open Market Desks will roll term repos in October and start permanent balance sheet growth as necessary”, he went on to write, adding that “the Fed responded to the suggestions that we and many other market participants offered yesterday and sent a signal that they do not want funding stresses to materially spike or worsen again”.
Of course, this means that come mid-October, the Fed will need to roll the three term operations coming next week, or else pre-announce outright asset purchases ahead of the FOMC meeting.
“The introduction of temporary OMOs to inject about $75bn of daily liquidity and three upcoming 14-day term repo offerings should alleviate stress over the quarter-end [but] there will be a sharp drop-off in liquidity around the middle of next month based on our reserve projections and stated expiry of the term offerings [which] suggests to us that the Fed will either have to roll over some term offerings on expiry, or potentially upsize its daily offering”, Goldman said on Friday night.
The bank goes on to reiterate what is now obvious to everyone. “A more permanent solution is the resumption of asset purchases to offset reserve depletion [and] we expect the Fed will announce this at the October meeting”.
It goes without saying that if the Fed inexplicably decides to leave markets twisting in the wind midway through next month, it would not be a good look. “We believe the market would be very disappointed and repo vol would increase if term repos or outright purchases do not continue after mid-October”, BofA’s Cabana cautions.
As for how things will proceed in the near-term assuming the Fed doesn’t “plan” on screwing this up, BofA got a bit more granular with it on Friday.
“We expect an initial $250bn in purchases will be needed to return to an ‘abundant’ level plus a buffer, with $100bn to back away from the upward sloping portion of the demand curve, and a $150bn buffer to account for variation in other liabilities”, the bank said, reiterating a previous estimate before predicting that these purchases “will occur more rapidly to protect against a future funding squeeze, with a possible pace of $25bn per month… likely concentrated in bills, to further stem repo pressure”.
That latter bit about the bills is important. Thursday’s four- and eight-week sales didn’t go particularly well and as Bloomberg notes, “before quarter-end, the market will have to absorb more than $200 billion of bill and note auctions, starting with Monday’s three- and six-month debt”.