“This episode indicates that the operational framework established by the Federal Reserve is not as resilient as it could be”, Joseph Gagnon and Brian Sack write, in a post for the Peterson Institute for International Economics’ website.
Gagnon was visiting associate director of the Division of Monetary Affairs at the Fed from 2008-2009 and held a hodgepodge of other positions at Fed and Treasury dating back to 1987. Sack is currently Director of Global Economics for the D. E. Shaw group, but from 2009 to 2012 was executive vice president at the New York Fed, where he served as the head of the Markets Group and the manager of the Federal Reserve’s System Open Market Account.
“Volatility in [the repo] market threatens the functioning of markets more broadly and could ultimately hurt the economy”, Gagnon and Sack warn, a day after the New York Fed upsized Thursday’s repos after a series of oversubscriptions.
Read more: As Fed Upsizes Repos, Kocherlakota Says ‘Something’s Very Wrong With The Financial System’
The two former Fed officials reiterate what short-end rates strategists have noted for weeks, namely that ad hoc, reactive, “as need” liquidity injections aren’t a sustainable solution. “Relying on discretionary operational responses by the Desk allows market strains and uncertainty to persist to a degree that is unnecessary”, they caution. “A better approach is needed”.
After mid-October (when the scheduled O/N repos end and the three term ops conducted this week will likely need to be rolled absent an announcement around next steps), the Fed needs to make its intentions clear.
First, Gagnon and Sack make the case for the standing repo facility, which they note “would provide a guardrail” against the “unexpected developments” which can pop up even in ample reserve regimes. A standing facility, they argue, “would make the operational response transparent, predictable, and forceful, which would in turn stabilize the behavior of market participants”. That’s just the old Hank Paulson “bazooka” argument, and Jim Bullard rolled it out earlier this week in the course of throwing his support behind the introduction of a standing facility.
As far as “organic” balance sheet expansion is concerned, Gagnon and Sack guesstimate that the Fed should embark on “QE-Lite” (they don’t use that term) imminently in order to get clear of possible reserve scarcity.
“The minimum level of reserves is conceptually murky, impossible to estimate, and likely to vary over time [so] the best approach is to steer well clear of it, especially since maintaining a higher level of reserves as a buffer has no meaningful cost”, they write, before making the case for the Fed to increase the general level of reserves by $250 billion “over the next two quarters through outright purchases of Treasury securities”. After that, they argue the Fed should “continue to grow its balance sheet as needed to expand reserves in line with nominal GDP”.
That’s generally consistent with analyst estimates as delivered in a deluge of rates notes over the past 10 or so market days.
And they go further. Gagnon and Sack argue that September’s mid-month funding squeeze should be a wake up call regarding the inadequacy of the current framework wherein the Fed only conducts operations to keep the fed funds rate in the target range. It may be preferable, they write, for the Fed to make it clear that the central bank intends to control the repo rate.
They note that the FOMC’s directive to the NY Fed’s open market desk “would suggest that last week’s money market conditions were largely acceptable [as] the desk missed the target range on only one day and by only a small amount”. The idea that last week’s conditions count as acceptable “would be an absurd perspective”, Gagnon and Sack note.
And so, they say that at minimum, the Fed’s directive to the open market desk “should explicitly state” that the FOMC intends to control the repo rate. Further, Gagnon and Sack say the Fed “should consider even going as far as adopting the repo rate” as the target policy instrument.
In other words, they’re arguing that the Fed should consider making SOFR the policy rate.
There’s more in their full post, but the overarching point is that last week’s chaotic action in funding markets shouldn’t be taken lightly by officials and requires a comprehensive, proactive and sustainable fix, as opposed to Band-Aid measures and reactive policymaking.
Relive the repo drama
‘A Whatever It Takes Signal’: Fed’s ‘Big Bazooka Of Liquidity’, Sets Up ‘QE-Lite’ In October
‘We’re Gonna Need A Bigger Boat’: First Of Three Term Repos Two Times Oversubscribed
Fed’s ‘Band-Aid’ Approach To Repo Chaos Opens Door To More Volatility, But Fear Likely Overblown
New York Fed Forced To Intervene After Funding Squeeze Accelerates
‘The Levee Has Broken’: Misbehaving Repo Market Underscores Loss Of Fed Control
Ah, now the truth is starting to come out.
There is so much demand in the repo markets because some banks have all kinds of bad loans (assets) on their books, so they need to borrow but no other bank wants to risk getting stuck with the problems. And thus the Fed rides to the rescue.
This whole thing sounds like TARP Lite.
It is difficult to understand why the Macro Economic wizards seem to make lightly of all this yet all the dummies in the peanut gallery see flashing red lights….The answer is it is either different this time around (and it is ,I think) or the big time game plan is to socialize debt.
I think our beloved H….. who tries to bridge the gap here could gives us one extra hint… The problem is understanding the consequences of the various action/inaction that could ensue in different scenarios ….
I am confused.
A bank that wants to sell UST to raise cash reserves can simply sell them. This is the most liquid asset class in the world.
Why, then, does the Fed need to buy UST on the open market to boost bank cash reserves?
If the Fed is trying to lower yields, then the Fed buying on the open market makes (some) sense – that’s QE. But the Fed has not indicated it is trying to lower UST yields or further invert the curve.
The big concern to me is if Treasury and primary dealers are having trouble finding buyers for new UST issues, and are using the Fed to soak up UST supply. I don’t think (all) the Fed governors would be silently complicit in such a use of the Fed.
While treasuries are liquid, they are far less liquid than cash, which is what’s at the core of this puzzle, i.e., hoarding cash and now the campaign by various parties to encourage the Fed to buy treasury debt. I wonder if the Treasury wants to be a larger part of the repo arbitrage game. The post by H yesterday suggested something to the effect that there is a trillion in Fed reserves and this matter at hand, is a matter of a few billion, being mismanaged. If you look at the trade volume from last week and the amount of money involved on this “Fed disaster” it’s peanuts and this looks to be more a matter of conspiracy-like manipulation … which I think relates to Dodd-Frank rules and a desire by wall street to change the rules, where banks can have more play money available to make riskier bets — and to place themselves in positions where they can be bailed out by taxpayers, AGAIN. Perhaps there isn’t a big smoking gun here, but there does appear to be a concerted campaign to strongly suggest the Fed borrow more stuff from Treasury, when it doesn’t really seem to be needed. Adjustments to their repo process maybe in order, but a QE-like effort seems highly dramatic and unusual!
The general financial press is starting to discuss that concern, e.g. Bloomberg https://www.bloomberg.com/opinion/articles/2019-09-26/repo-meltdown-shows-budget-deficit-has-limits
Has there ever been a period when the ability of the US government to find enough buyers for new issue UST was ever even slightly in question?
If that ability does become seriously questioned, what will that do to yields, volatility, liquidity, safety of UST market?
Cash is KING and it’s important to keep and eye on the ball, i.e., this statement from yesterday is at the core of this mystery:
” … Kocherlakota writes, adding that “reserves are siloed in the flush banks, so the financial system is acting more like it has $1.3 billion in excess reserves than the actual $1.3 trillion”.”
The following are comments by Jeffrey P. Snider at alhambrapartners. I like Jeff and seemingly he’s been onto something, but that something always is shrouded in mystery, which builds on itself in each blog post. After reading his blog for years, I never could grasp what his solution was for world order. I find it interesting to read his blog and have learned many things, but calling the Fed a bunch of boneheads on a regular basis doesn’t always explain the points that he dramatically spins out. Nonetheless, Jeff’s name was somewhat elevated in a recent Wall Street snip, where he offered his version of what the Fed should do if he were running things:
“So what should they do? Encourage the Treasury to issue more of the long bonds the market is demanding: 30- or even 100-year. Feed the beast. Then stop quantitative easing: It doesn’t work and soaks up collateral. Next, stop paying interest on reserves. Maybe even create a nontradable “Treasury-R” to act as reserve currency elsewhere, freeing up more bonds. If history repeats, there are about 90 days until China repos roll over again.”
The following are several of his recent blog comments related to this repo topic — and then an old link to his series. My general thinking has ended up being focused on banks hoarding easy QE cash and I agree with him that banks are sponges that soak up Fed and Treasury liquidity and the bonehead concept of paying interest on reserves is boneheaded. However, the concept of issuing 100 year debt is absurd as a way to fix liquidity. The idea to feed the beast with a different flavor of debt misses the whole point by a long shot and makes me think Jeff is a bonehead!
==> [Fed funds is nothing, irrelevant, the sparest of spare liquidity. And yet, it has been increasingly clear that if dealers won’t go into fed funds there must be a pretty big constraint on the monetary element which does matter — the balance sheet capacity which drives all monetary conditions.
John Williams, president of the New York Fed, on Friday questioned the hesitance of the banks in an interview with the FT. “The thing we need to be focused on today is not so much the level of reserves [held at the Fed],” he said. “It’s how does the market function.”
After the near meltdown and repo rumble, more than twelve years too late, FRBNY is only now wondering, where were the dealers?]
The second channel is as you see above in Figure 1-5. Having substituted MBS securities for a reserve asset, policymakers expected that Bank A would then seek to further convert those reserve assets back into a working portfolio of non-toxic securities. The policy asset swap was meant as the first step to a second asset swap, the latter of which into risky securities.
In short, bank reserves are nothing unless Bank A turns them into something. That “something” includes other forms of money dealing. All the things that go into that action are what counts, not the reserves. That is the dollar shortage in a nutshell.
https://www.alhambrapartners.com/2018/05/08/bank-reserves-part-1-the-great-tease/
Ultra-Loose Terminology, Not Policy
By Jeffrey P. Snider|April 6th, 2017
“Banks are declaring in no uncertain terms that they will not part with the most liquid instruments, including government bonds at similar or worse negative “yields”, no matter how much the ECB might believe it is “stimulating” the economy by punishing them for doing that. Without bank acquiescence, meaning balance sheet capacity, whatever the ECB does is reduced to mere symbolism.”
That seems like the big question here. Is the repo stress due to 1) technical malfunctions in the plumbing and machinations by market players, 2) oversupply of UST, 3) rising risk perception that is driving reserve hoarding, 4) other?
Here’s another example of – in this case, a financial blogger – linking repo stress with oversupply of UST. Never heard of this person before, ostensibly a former insider at Fed and principal dealer – so grain of salt etc.
https://media.realvision.com/wp/20190920144905/Draghi-and-the-Dominos.ad_.pdf
I didn’t go to the link, as I didn’t want to sign in, but well aware of Sniderism. I think there is a case for a dollar shortage of sorts, but as I mentioned above, Snider often shrouds his wisdom in confusion and non-commitment, alluding to a dollar shortage but never connecting it to a way to create a dollar surplus. His Dollar Shortage Theory seems a -if it’s been (recently) connected directly to the repo “crisis” and thus, his reply in the WSJ sort of surprised me, because I don’t think he’s ever put up any graph, chart or story on the mechanics of how Treasury duration plays a role in The Dollar Shortage. Thus, his WSJ solution to feed the beast with longer-dated 100-year makes no sense to me, in terms of how longer-dated issuance floods the world with dollar liquidity and then solves layers of complex problems which I think are probably way over his head — all this is way, way over my head, but for some reason I have more faith in people at the Fed. The world of modern global finance is obviously very messy and chaotic and super complex, with computer models that are doing thongs that few humans probably grasp … even trump the super 3-D genius. In that light, sophisticated crazy economics is something that we shouldn’t want, i.e., we as taxpayers shouldn’t have to be on the hook for a complex computer simulation, where the game doesn’t work out as anticipated, and thus, the root of this current problem shouldn’t end up being a way to dilute Dodd-Frank and allow banks to have more casino chips to make risky bets with. Perhaps one reason the market has not blown apart in this trump era, is because there is some systemic stability and perhaps it’s really smart to keep banks in a position where they can’t manipulate markets with a flip of a switch — if anything, all those banks that did fail and were bailed out, need to stay contained and the beast doesn’t need to be fed by The Fed!
Go look at Sleeping Beauty Bonds and explain to me why a tsunami of 100-year Treasuries will create mkt liquidity …
Small bit of perspective: (????)
“Last month the U.S. Treasury laid out its plans to borrow $814 billion between July and December, after the Trump administration and Congress agreed to a two-year postponement of the U.S. debt ceiling, ensuring no government shutdown or a federal default.
Not only does the Treasury needs to borrow to cover the fiscal deficit created by Trump’s 2017 tax cuts and the inability of Congress to agree on spending cuts, but Treasury needs to rebuild its cash balance which was run down to pay the governments bills when the debt ceiling was hit in May.
The coming deluge of Treasury issuance has stoked worries on Wall Street about whether there is enough liquidity in the system in the short term to meet the supply without pushing up short-term borrowing costs and inverting the yield curve even further”
At the risk of being banned for life here, here’s another thought/clue: I like chess and strategy, so was just pondering the timing of the massive never-before seen spikes in this repo garbage that nobody seems to totally understand:
In terms of timing and PR events, isn’t it a little unusual that most of the mini-crisis exploded days before Powell was to have his fireside chat? Whom might have the extraordinary power and influence to totally screw up money market rates and make the Fed look like idiots on the day of the fed fireside chat? There had been blips on the radar that IOER and FFR, etc were acting a little stranger the last year or so and thus there had been technical adjustments … but, out of thin air, the weak of the highly hyped trump-driven rate cut, a great deal of drama was added-into the mix, catching the Fed somewhat off balance — the timing of that strategic is sequence is suspect, as-if it was a message that needed drama, but why? That timing seems coordinated and conspiratorial to me. I’m not a Fed groupie or a Fed hater, but I suspect there is a political and financial motive from organizations involved in rep tri-party arbitrage.
The End
Trying mightily to understand the repo market, so take this with a grain of salt, but after what we saw in 2008, seems like a lousy way to finance the day-to-day operations of our banking system.