The funding storm has passed, but much work needs to be done to guard against volatility in short-term money markets.
“Following the upsizing of both overnight and term repo offerings on Thursday and Friday after earlier operations that were oversubscribed, calm appeared to be returning to repo markets”, Goldman wrote, in a note dated Friday evening.
As things settled down, and the media’s attention turned to Donald Trump, Fed officials (both current and former) weighed in on next steps.
John Williams continued to lay the groundwork for balance sheet expansion, Jim Bullard talked up the merits of a standing repo facility, former Minneapolis Fed chief Narayana Kocherlakota cited an onerous regulatory regime in warning that “something is very wrong” and a pair of former Fed officials advanced a series of proposals for addressing the situation, in the process rolling out the by-now-familiar call for $250 billion in near-term asset purchases to alleviate reserve scarcity and reestablish a buffer.
(Bank reserves falling much faster than total Fed balance sheet – S&P included in bottom pane as there are those who enjoy pointing out that stocks seemingly noticed this in Q4 2018 and then stopped caring again in 2019 after the Fed indicated a willingness to cease runoff)
The immediate goal, BofA’s Mark Cabana reminds you, in his latest note, is to “get off the upward sloping part of the reserve demand curve and to create a reserve buffer such that small changes in Fed liabilities will not risk money market volatility”. Reduced to the lowest common denominator, that is the issue. As BNP puts it, “small changes in demand for cash have large impacts on rates as we approach reserve scarcity”.
Cabana, who documented the daily repo drama in near real-time this month, notes that the Fed “is well underway in this initial push to return to ‘abundant’ reserves [having] added over $100 billion through overnight and term repos”. That will need to continue through year-end in keeping with Treasury’s cash rebuild.
Although most keen observers can now regurgitate the list of culprits for the September funding squeeze, the general investing public is still largely confused about the whole thing and why it matters. BNP’s postmortem (time-stamped September 25) goes back over things in granular fashion, using bullet points, for clarity and brevity.
“Acute pressure in financing markets [was] due to a combination of temporary factors around 15 September”, the bank reminds you, enumerating those factors as follows: “Corporate tax payment – up to USD100bn (including large withdrawal from institutional money market funds); UST settlement – USD84bn of note and bond Treasury issuance that settled on 16 September; Bill issuance – USD80-100bn of net bill issuance as the government rebuilds its cash reserves post debt ceiling resolution”.
The bank goes on to warn everyone that the excess supply of collateral isn’t going anywhere. We’re witnessing that “highest US Treasury supply ever at USD230bn/month of UST auctions to finance an increasing fiscal deficit”, BNP writes, adding that the increased front-end supply has seen “outstanding T-bills growing from 11% to 15%+ of total debt!” (exclamation point is in the original). Meanwhile, reserves have fallen from 64% of Fed balance sheet liabilities to just 36%.
The end result, BNP notes, is “increased financing needs for an ever-increasing pool of collateral-type assets with declining liquidity”. Inventories have swelled and there’s now more dependence on repo markets to fund primary-dealer activity.
And so, with the pressure from financing the budget deficit set to persist, the oversupply of collateral against overburdened banks who are now wary of how they deploy their reserves has stressed the repo market. “This and the current low levels of excess reserves will have to be addressed more permanently by the Fed”, BNP notes, on the way to delivering their projected “fix”, which is largely in line with expectations from other desks and market observers. To wit:
In order to avoid reserves scarcity and maintain an abundant reserves system we estimate, the Fed needs to inject USD250bn of reserves and commit to USD120bn/year in organic balance sheet growth:
- USD100bn to move away from scarcity +
- USD150bn volatility buffer +
- USD120bn (USD10bn/month): organic balance sheet growth to stabilize reserves offsetting liquidity (expected at the October FOMC meeting)
Again, this just underscores the extent to which the Fed will have to announce the resumption of permanent open market operations at the October meeting. It’s now baked into most banks’ base cases.
Goldman on Friday noted that POMO resumption starting in November “should be a net positive [for swap spreads] as it decreases Treasury free float, all else being equal [but] how the spread curve evolves will be influenced by various Fed decisions on repurchases.” The bank then games out some scenarios. “If the Fed tries to rebuild a ‘reserve buffer’ over a short period, say over either 3 months or 6 months, it would need to purchase roughly $60bn and $35bn of USTs respectively on a monthly basis (both in addition to the ~$20bn/month of MBS being replaced), the impact would be somewhat larger over the next year than if the Fed bought at our baseline speed of roughly $15bn/month”, Goldman says.
For his part, BofA’s Cabana notes that SOFR and FF-IOER spreads will probably stabilize next month between 7bps and 4bps assuming the Fed keeps outstanding reserves steady ahead of the October meeting. The bank sees POMOs at $25 billion/month starting in November, and reserves staying largely unchanged between $1.5 trillion and $1.6 trillion.
“Due to TGA growth and the transition from repos to outright purchases, it may take until late 2020 before reserves increase further outside of repos”, he writes, adding that “SOFR and FF to IOER spreads should stabilize around 5 and 2bps” thereafter.
The bottom line here is that with the funding levee having clearly broken in September to much financial media fanfare, and with the debate on how to permanently “fix” the situation having gone just about as mainstream as this debate can possibly go, it’s imperative that the Fed doesn’t somehow fumble the handoff or drop the baton on the transition from repos to POMOs or from the current repo regime to a standing facility.
The September short-term funding panic didn’t spillover into broader markets, but the Fed won’t want to tempt fate by slow-walking things next month, that’s for sure.