“While the Fed staved off a potential year-end repo apocalypse, it is too early to break out the ‘mission accomplished’ banner just yet”, TD’s head of global rates strategy Priya Misra writes, in a noted January 9.
If that’s a reference to George W. Bush’s “mission accomplished” banner, we hope the Fed will never unfurl anything of the sort – after all, that turned out to be a premature declaration of success.
Talk of a repo reckoning has fallen by the wayside after capturing the market’s collective imagination and remaining at the forefront of the discussion for the better part of three months following the September short-term funding squeeze. Zoltan Pozsar – whose characteristically extensive note on the problems at the heart of what he warned could be another squeeze, rippled across Wall Street last month – claimed a kind of victory anyway. “If the year-end is less of a problem because of the repo bazooka we got from the Fed, and if the message of my report played a part in getting that bazooka, then that’s a nice way to be proven wrong”, he told Bloomberg.
But just because the world didn’t “stop spinning”, as Pozsar suggested it might, doesn’t obviate the need for vigilance going forward, and with excess reservers (he would claim that’s a misnomer) sitting just below $1.5 trillion at year-end, the Fed is still a long way from “abundant + a buffer”.
“We believe the Fed should maintain a buffer of at least $400bn of reserves (or more) over the minimum required level”, TD’s Misra said this week, noting that because the repo spike occurred in September “when reserves dipped to just $1.26tn, we expect the Fed to maintain at least $1.7tn of reserves going forward”.
After discussing the adjustments broached in the December Fed minutes, Misra reminds you that “repo operations are the Band-Aid while bill purchases are the permanent fix [and] as the Fed gradually adds reserves to the system via bill purchases, we expect the usage of both the term and overnight repo facilities to decrease”. At that point, the Fed may be able to reduce bill purchases too. Repo wind down could come courtesy of a simple decision to reduce what’s on offer and tweak the schedule, or by making the rates less attractive.
But there are some constraints, Misra says, noting that while the mid-March tax settlements are “not as large as other quarterly corporate tax collection dates, March 16 has seen an average of $24bn of tax collections in recent years”. That will collide with more than $50 billion of auction settlements, adding to the pressure. Quarter-end effects just two weeks later could also have an effect.
And then there’s April 15. “The April personal income tax date is the most significant tax collection period of the year”, Misra writes, in the course of reminding you that “tax collections tend to be backloaded, with 83% of the $311bn collected in April 2019 coming out of the market in the second half of April”.
TD does not expect that establishing the long-rumored standing repo facility will be an easy task, let alone put in place expeditiously.
Finally, the bank says the Fed will likely need to keep buying bills until at least June at the full rate of $60bn/month. Primary dealer projections expect purchases to run through June, but see a taper starting in March. That taper may not be feasible – or at least not that early.
What about liquidity issues? Recall that in the December Fed minutes, there was a discussion about pivoting to short-end coupon purchases in the event negative net bill supply occasioned by Fed demand impairs market functioning.
TD notes that net bill supply was negative in December and should be marginally so in January, before turning positive in February and March. In April, bill supply will fall, and the bank sees net supply turning negative to the tune of -$100 billion.
“If liquidity risks in bills were to materialize, the Fed could consider expanding the universe of securities purchased for reserve management purposes to include coupon-bearing Treasuries with a short time to maturity”, Misra says, adding that when those theoretical assets mature, the Fed will have to reinvest the proceeds “across longer dated coupons via auction add-ons, thus increasing the maturity of the SOMA portfolio”. They aren’t likely to see that as particularly desirable, which is why TD reckons the Fed “will move into coupons only when there is a significant scarcity of bills, probably earliest by April”.
Ultimately, the message is that you haven’t heard the end of this discussion just because we made it over the turn without the plumbing clog causing any kind of catastrophe. The Fed is now entrenched in the repo market and the effort to extricate itself from that role will entail carefully managing the eventual taper in bill purchases, so as to ensure that the “permanent” fix is fully implemented prior to ripping off the Band-Aid.
Of course, if you go back and read your Pozsar, you’ll discover that the “oracle” isn’t likely to be satisfied that the measures taken will be sufficient to prevent another “clog” later on down the line. And he’s not alone. Many market observers (and not just short-end rates strategists) expect the Fed to be forced into coupon purchases beyond the short-end (i.e., the resumption of unequivocal, outright QE “proper”) sooner rather than later.