Fed Cuts Treasury Buying In Half, Money Markets Normalize, And Zoltan Pozsar Asks: Machiavelli Or Bagehot?

The Fed on Friday said it will cut the pace of Treasury purchases in half next week, to $15 billion per day from $30 billion, as market conditions normalize after last month’s theatrics.

The balance sheet ballooned to nearly $6.4 trillion in the latest weekly update.

Purchases now top $2.2 trillion since the onset of panic in early March.

Critics abound when it comes to some of the Fed’s most aggressive crisis-fighting efforts. On the planned purchase of fallen angels and high yield ETFs, some market observers are incredulous to the point of anger, to let their memos and social media postings tell it.

But you should note that the less controversial measures are having their desired effect.

For example, prime money market funds saw nearly $7 billion in inflows in the week through Wednesday, ICI data showed.

That’s two weeks in a row of prime inflows and it’s welcome news. In the six weeks prior, the funds bled more than $151 billion as the commercial paper market froze, rattling confidence and forcing Fed intervention.

Government funds took in around $39 billion last week, less than the previous week, and orders of magnitude lower than the panic flight to “safe” cash which accelerated meaningfully in the second half of March.

The Fed officially launched the 2020 edition of its commercial paper funding facility this week. Of course, the Fed also moved last month to shore up prime funds amid the exodus, with a liquidity facility that allows banks to pledge assets purchased from money market funds as collateral.

Wrightson ICAP’s Lou Crandall says the simple fact that the commercial paper facility exists may have been enough to stabilize the market.

“The weekly Fed data suggested the launch of the CPFF was enough by itself to improve market conditions”, he writes, in a note, citing a recovery in issuance volumes. “The usefulness of backstop facilities, even when they are not actively used, is likely to remain a recurring theme this spring”.

In his latest masterpiece, out earlier this week, the incomparable Zoltan Pozsar (variously described as the “oracle” of funding markets, and the “spider in the middle of the web” ) offered some characteristically incisive color around the pricing of the commercial paper facility and the money market liquidity backstop.

I’ll leave you with a few quick excerpts from Zoltan’s latest. Bear in mind that when it comes to these types of discussions, there is Pozsar, and then there’s everyone else.

Via Zoltan Pozsar

The CPFF’s price at OIS+110 bps for A1/P1 issuers and OIS+200 for A2/P2 issuers is high relative to other programs, most of which are priced at 25 bps flat or OIS+25 bps. The main reason for the pricing gap is that the low-priced facilities — the discount window, the PDCF, the U.S. dollar swap lines and the FIMA repo facility — are all secured, but the CPFF and the MMLF are unsecured, and the Fed is using their price to mitigate the credit risk of buying unsecured bank debt. But there is an easy way to fix this problem: all the Fed would have to do is ask for a bigger first loss buffer from the U.S. Treasury, and lower the price on the facilities in exchange — to say OIS+25 bps for A1/P1 issuers. The fact that the Fed has not done this in recent weeks is telling… …given all the other things the Fed has done, which include launching three new facilities to backstop the credit market, and temporarily exempting reserves and Treasuries from the leverage ratio (SLR). Why does the price of the CPFF remain far above other facilities’?

There are at least two possible answers.

First, maybe the Fed is sending us a Machiavellian message on benchmark rate reform: Libor is going away and SOFR is the future, and if one-sided borrowers like the Treasury or corporate treasurers were reluctant to issue SOFR-linked debt as they were put off by periodic spikes in repo rates in the past, they should reconsider. The Fed has shown a strong willingness and ability to police the SOFR rate through a low-priced repo facility, but it backstopped unsecured markets — which drive Libor — at much wider spreads. Borrowers now have a choice: in times of stress borrow at a low SOFR rate plus a spread or at a high Libor rate plus a spread. SOFR may come out of this crisis with stronger legs.

Second, the answer may have less to do with Machiavelli and more to do with Bagehot: “central banks should lend freely to solvent firms against good collateral at a penalty rate”.

Central banks do their core activities — open market operations and emergency lending — on a collateralized basis: the discount window lends to banks at 25 bps against collateral; the PDCF — the discount window for primary dealers — also lends at 25 bps collateralized; the repo facility lends to primary dealers at the IOR rate against U.S. Treasury collateral; the FIMA repo facility lends to central banks at IOR+25 bps also versus Treasuries; and the dollar swap lines lend to central banks at OIS+25 bps versus local currency collateral.

No one can say that the Fed has not done enough to backstop the core of the system: core assets like Treasuries are backstopped; core institutions like banks and dealers are backstopped; and core funding markets like repos and FX swaps are backstopped too.

Money is hierarchical…

…and during crises, rules are flexible at the core and rigid at the periphery. In this crisis, the penalty rate part of Bagehot’s rule was replaced with “friendly” rates for the core — with Covid-19 there is no moral hazard in lending to the core of the system at low rates.

But ignoring the need for collateral when lending to the periphery is anathema for the Fed, and given the unsecured nature of the CP market, it’s understandable why the price of the CPFF and MMLF facilities are 100 bps higher than the price of collateralized facilities.

Once again, there is a way to get around the Fed’s discomfort around lending unsecured, which is the U.S. Treasury increasing the first loss buffer backing the CPFF and MMLF.

We doubt that U.S. Treasury would say no to such a request and if the Fed hasn’t asked the Treasury for a bigger first loss buffer, that may suggest that the Fed is intent on either delivering the Machiavellian message above or drawing a stark contrast between the terms of lending secured versus unsecured, and lending to the core versus the periphery.

It appears that according to the Fed’s mental map, prime funds are peripheral institutions, commercial paper is a peripheral funding market and Libor is a vestige of the past, and government funds are core institutions, repos and FX swaps are core funding markets and SOFR is the future. Instead of arguing for lower rates on the CPFF and the MMLF, maybe the market should reflect and listen to what the Fed is trying to say with its pricing.