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The Institutional Risk Analyst

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Repo Market, Liquidity & QE 4

New York | We spent a good bit of time in Washington last week, listening to very smart people talk about housing reform. Little of what we heard makes sense in market terms, but that does not seem to bother anyone in Washington. To read our latest comment in National Mortgage News about the Trump Administration’s plans for reforming the Federal Housing Administration, click the image below.

The strange thing about the Washington conversation regarding housing reform is that nobody seems to understand how the FHA and the GSEs actually function in the secondary mortgage market. For example, the Trump Administration actually thinks they can gut the FHA program for low- and middle-income households with no knock of effect for the US economy or secondary market participants.

Then there is the absurd discussion about privatizing the GSEs. Private capital is irrelevant to the future of Fannie Mae and Freddie Mac, but credit spreads are crucial. If the GSEs cannot offer execution that is attractive to private lenders seeking to sell loans to investors, then they will fail. If they cannot access unsecured funding near current yields, then the GSEs will die. No amount of private capital will change this reality.

The spread of GSE debt over US Treasury yields determines whether Fannie Mae and Freddie Mac are competitive with the big banks and the FHA. That’s it. The GSEs fund their operations, including advances on defaulted loans and even the payments to bond holders, in the unsecured debt market. If after re-privatization the cost of funds for Fannie Mae and Freddie Mac goes up significantly, then the GSEs will die. The execution for the GSEs as issuers of debt in the bond market is all that matters. But nobody in Washington knows or cares about such details.

Meanwhile in New York, the Federal Open Market Committee has now completely reversed its 2018 policy goals, ending increases in the target for fed funds (FF) and ceasing shrinkage of the Fed’s balance sheet – and indirectly bank deposits. The FOMC has dropped the target for FF and is now adding reserves back into the system in a short-term version of “quantitative easing.” Let’s call it by name: “QE4.”

The short-term repo operations announced last week by the FOMC through early November likely will be made permanent a la TALF and other post crisis liquidity facilities. The entire narrative for monetary policy that existed a year ago has been abandoned, leaving some to wonder if the FOMC should continue to use FF as a policy tool. Question: If the FOMC cannot effectively defend the target range for FF, then what is the purpose of this policy approach?

Since Q4 2018, the FOMC has faced a deteriorating market situation when it comes to liquidity, this as debt issuance by the US Treasury has risen significantly and once plentiful excess reserves were drained from the system via “quantitative tightening” or QT. The movement of FFs did not suggest any problem, however, until a combination of a shrinking Fed balance sheet, soaring Treasury borrowing and rules for large bank liquidity caused a funding squeeze last month.

Looking at the GCF repo index compiled by the DTCC, the increase in interest rates prior to the end of 2018 and in September 2019 look strikingly similar. In each case, liquidity was suddenly lacking in the fed funds market and rates spiked across the repo market for Treasury and agency collateral. As the chart below shows, RMBS repo between dealers traded over 6% in September – twice the effective coupon on the underlying securities.

It does not take a lot of volatility of this magnitude to convince investors to back away from Treasury and agency debt as an asset class. Is anyone on the FOMC listening? Here we though that the Federal Reserve Board wanted to protect Treasury's access to the debt markets! Maybe not. Suffice to say that if the FOMC cannot defend the upper bound of its FF target range, then year-end 2019 will be another mess.

On Thursday of this week, we’ll be participating in a discussion sponsored by the Global Interdependence Center to review the liquidity situation in the market for fed funds. Join The IRA's Christopher Whalen, Robert Eisenbeis, Vice Chairman and Chief Monetary Economist at Cumberland Advisors and William Kennedy, Chief Investment Officer of Fieldpoint Private, for an important conversation. Click the image below to register for the virtual event.


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