“Don’t fight the Fed you say, they are adding liquidity through repos and bill purchases, and what’s not in the system now will be there on year-end, and the turn will be just fine”, a sarcastic Zoltan Pozsar chides, in the latest edition of his “global money notes” for Credit Suisse.
Suffice to say that Pozsar – whose name is almost synonymous with short-term funding markets – is not convinced that everything is going to be ok over the turn.
“Not so fast!”, he exclaims, in the three-word sentence that follows the excerpted passage above.
Long story short – and really, at “just” 11 pages including charts and disclaimers, Pozsar’s latest feels short as far as his work goes – Zoltan thinks what’s needed to ensure stability are FX swap lines and QE4. By “QE4”, he means QE proper – not bill purchases, but coupon purchases or, more to the point, purchases of the assets that dealers have been choking on.
Pozsar starts by diving into the discussion that Jamie Dimon mentioned on JPMorgan’s third quarter call and the Jerome Powell has discussed at various intervals since the September funding squeeze.
“The payments system used to be a credit system”, he writes, before elaborating as follows:
Banks routinely incurred daylight overdrafts – that is, negative balances – in their reserve accounts at the Fed. The Fed’s intraday credit provision to the payments system ensured that payments between banks never bounced. Large money center banks like J.P. Morgan Chase Bank were the biggest and most active users of daylight overdrafts, and a once deep overnight (o/n) fed funds market was where large banks with negative reserve balances borrowed from small banks with positive reserve balances to get the reserves necessary to pay down their daylight overdrafts at the Fed by sunset.
But that’s changed to a “token” system under Basel III, he continues, noting that “liquidity rules require G-SIBs to pre-fund their 30-day outflows, intraday liquidity needs and resolution liquidity needs [so] banks would never incur daylight overdrafts at the Fed for if were to, they would be in breach” of those needs.
And so, that sets up a scenario where the bank with the most reserves is effectively the lender of next-to-last resort. That bank can lend its reserves in repos and FX swaps, but only those reserves it doesn’t need to satisfy the above-mentioned intraday and resolution liquidity requirements.
That, Pozsar contends, makes the whole concept of excess reserves “an oxymoron”. To wit:
The lender of next-to-last resort’s excess reserves are someone’s required reserves and make the difference between money markets trading normally or falling into disarray. Given that J.P. Morgan was by far the largest user of daylight overdrafts before Basel III, it should not be a surprise that it became the largest holder of reserves under Basel III: if daylight overdrafts were the shock absorber that allowed the payments system, and, by extension, the repo and FX swap markets to deal with imbalances and clear seamlessly, it follows that if under Basel III no bank would ever tap the Fed for daylight overdrafts, J.P. Morgan’s excess reserves became the system’s shock absorber.
The implications of this setup have been lost on the Fed or, if that’s too strong, Pozsar says officials have been “slow” to appreciate the possible ramifications.
In a worst-case scenario, the “world stops spinning” – and yes, that is an actual quote from the note. Pozsar emphasizes it’s “not an overstatement”. Here’s Zoltan:
In September [the Fed] learned that when excess reserves are shredded through taper and the distribution of excess reserves is flattened through repeated cuts to the IOR rate, the system is left without a lender of next-to-last resort, and without such a lender the repo and FX swap markets can hit an air pocket, and the many entities that fund through those markets can’t get things done: Treasury can’t fund the deficits and pay its bills, dealers can’t fund their Treasury inventories or their clearing accounts to make markets, and the world can’t fund to get the U.S. dollars to pay for goods or to roll their FX hedges. If carry makes the world go ‘round, and reserves make carry possible… …the day we run out of reserves would be the day when the world would stop spinning.
Ok, so that’s bad. We don’t want Treasury to have trouble funding the deficit at a time when it’s exploding and we don’t want the world to cease to be able to access the dollar funding needed to grease the proverbial wheels.
With that in mind, consider what’s actually happened since September, because it’s not what you think. Conceptually, there have been no “excess reserves” injected into the system, Pozsar says. Rather, the Fed has simply stopped Treasury from bleeding banks’ stock of liquid assets. To wit:
The Fed became lender of last resort to dealers as J.P. Morgan ran out of reserves to lend, and the primary financier of the government as $250 of the $275 billion of the reserves that’s been put into the system since September ended up in Treasury’s general account. Thus, all that the Fed’s liquidity operations have done to date is to ensure that the Treasury’s cash needs don’t drain further liquidity from banks’ HQLA portfolios, but it did not inject excess reserves into the banking system ahead of the year-end turn.
That’s no good. Pozsar then runs through a fairly tedious discussion of year-end turns under Basel III. He probably wouldn’t describe it as “tedious”, but in the interest of keeping readers’ eyes on the ball, we’ll skip ahead a bit.
There are no “truly” excess reserves. A Zoltan writes, “the FX swap market had more excess reserves and a better year-end turn in 2018, which made large US banks spend all their excess reserves on Treasuries during 2019”. The visual illustrates the rotation from excess reserves to collateral in banks’ HQLA portfolios (i.e., in their stock of liquid assets).
The biggest US banks (like JPMorgan) threw $350 billion of excess reserves at collateral, but as Pozsar notes, “dealers and banks loaded up on collateral as a trade – a trade they were supposed to be taken out of by eventual coupon purchases by the Fed”. Because the Fed didn’t do that, the year-end turn is approaching with no excess reserves for the first time ever.
Here’s what he says is necessary for the turn to go smoothly (i.e., to ensure the world doesn’t “stop spinning”, as it were):
What we need are balance sheet neutral repo operations, or asset purchases aimed at what dealers bought all year: coupons, not bills – the former to get around foreign banks’ balance sheet constraints around year-end, and the latter to ensure that excess reserves accumulate with large banks like J.P. Morgan.
Much to Zoltan’s chagrin, the Fed isn’t currently engaged in either of those things.
“Repo operations are done through the tri-party system which means they aren’t nettable, which in turn means that once balance sheet constraints start to bind around year-end, foreign dealers will take less liquidity from it to lend it to those in need on the periphery”, he says. Obviously, the provision of liquidity by central banks only works to the extent dealers have the capacity and the willingness to intermediate it. Further, Pozsar calls the Fed’s bill purchases “ill-conceived” because, again, that’s not what banks are choking on. “Banks and dealers don’t own any bills and so don’t have anything to sell to the Fed to boost their excess reserves ahead of year-end”, he says.
That, in a nutshell, is “Part 1.” In “Part 2”, Pozsar moves to discuss the G-SIB snapshot. The problem is summed up as follows (and we’ve been over this previously):
U.S. banks are particularly sensitive to their G-SIB scores this year, as they all moved up to a higher surcharge bucket due to bigger Treasury holdings and a heavier repo footprint: every U.S. bank except Morgan Stanley has an incentive to shrink its score into year-end.
This is exacerbated in 2019 by the equity rally (which pushes up banks’ market cap and inflates the value of stocks held on their books) and the flatter yield curve (which drives up their scores due to their massive Treasury holdings).
Of course, they can’t really do anything about those aggravating factors. They can’t stop stocks from rising and when it comes to Treasurys, Pozsar reminds you that “they can’t not take down more at auctions if there are insufficient bids”. They are, after all, the biggest primary dealers.
But what they can do to mitigate a creep-up in their scores is repo out some of their equities and/or sell some of their Treasurys to raise excess reserves. They can also “clamp down on market making in the FX swap or sponsored repo markets”, Zoltan warns. And that’s where the problem comes in, as it would “add to the vacuum in market making triggered by foreign banks”.
(He also describes a maddening situation whereby attempts to reduce scores by, for example, funding equities via Canadian pension funds, are stymied by a further rise in stock prices into year-end, as the rally just keeps inflating both the banks’ market cap and the value of their equity books. Last year’s massive Q4 selloff thus provided some relief and thereby likely helped smooth the turn, but this year will be different.)
The “best case” scenario, he says, is that banks lend their “scraps” into the market – i.e., paltry sums. The worst case scenario is this:
Collateral upgrades aren’t sufficient and U.S. banks stop making markets in FX swaps and so exacerbate the vacuum triggered by foreign banks. We are on track to realize the worst case scenario, and the market doesn’t price for that.
Here’s a bit more:
[In 2018] lower G-SIB scores allowed large U.S. banks to spend their hoards of excess reserves on more complex trades like FX swaps, and the year-end turn went down as a non-event – in FX swaps, but not repos. Recall that repo printed at 6.5% on December 31st spot. This year may be the opposite. Higher G-SIB scores will favor repos over FX swaps when deploying excess reserves, but given that the Bakken Shale has run dry, repos may still print as bad as last year-end, while FX swaps could end up as the orphaned asset class without an obvious backstop, and that may force banks in some parts of the world to the edge of the proverbial abyss.
That informs Pozsar’s assessment that “year-end in the FX swap market is thus shaping up to be the worst in recent memory”.
In order to ameliorate all of the above (or at least most of it), he suggests the Fed “encourage foreign central banks to use of the FX swap lines [and] start QE4 by switching from buying bills to buying coupons”. Here’s how those two steps would help:
The Fed’s FX swap lines would get around the G-SIB problem directly – if market making in the FX swap market breaks down due to G-SIB-related bottlenecks at large banks, flows get kicked higher up in the hierarchy and central banks become market makers in FX swaps and lend dollars to banks in their jurisdictions at a price of OIS + 50 bps… …so that the world does not stop spinning. QE4 would help through the backdoor: by reversing the mistake of balance sheet taper. QE4 would mean buying back from dealers and banks the Treasuries they were forced to buy during balance sheet taper and giving back the reserves they gave up in the process. QE4 would re-liquefy HQLA portfolios by trading Treasuries for excess reserves… the excess reserves that were always needed to get through to year-ends seamlessly, and which the system’s liquidity profile and U.S. banks G-SIB scores need desperately.
If so, don’t refer them to the Fed, because in Pozsar’s estimation, they are clearly behind the curve on this.
And they’ve got just a few days to fix the situation.