May 21, 2021 | Back in 2019, we published a post in The Institutional Risk Analyst called “Nationalizing the Federal Funds Market,” that talked about the increasingly overt actions of the Federal Open Market Committee in the market for short-term funding. Then as now, we view the actions of the FOMC as slowly destroying the private money markets in the US and preparing to very visibly push the big banks out of the transmission chain of monetary policy.
One reader of The IRA asked yesterday:
“Brother maybe you can help me understand: reverse repo 351BN 5th largest ever. What is going on? Any thoughts? No rush but I haven't heard anyone talking about this. I don’t get with all the excess why banks need to be doing this. Haven’t seen it since march 2020.”
Now that is the right question. As we told Keith McCullough at Hedgeye recently, the Fed’s primary concern is not employment or inflation, but rather keeping the market for Treasury securities functioning. In this we agree entirely with our friend Ralph Delguidice, who has believed for several years now that the Fed is preparing to take direct control over the market for Treasury securities. He wrote in a recent missive for Pavilion Global Markets:
“Before the Fed can even think about thinking about raising rates or tapering the pace of QE, they have a suite of urgent repairs to make to the wholesale financial infrastructure supporting the US capital markets. In the year-end 2020 report to Congress, the Financial Services Oversight Council (FSOC) highlighted several specific areas of ongoing systemic concern. The first—and by far most pressing— is the problem in the Repo markets, AKA ‘The Usual Suspects,’ which failed disastrously in the fall of 2019.”
Ralph and many other colleagues who trade the short-term money markets in the US have long identified a basic structural problem that has existed since the passage of Dodd-Frank in 2010 and also the many changes to the Basle bank capital framework. What problem? That the big banks sometimes step back from the money markets and deny liquidity to nonbank clients. For the Fed the worry is not the small nonbanks, but the resulting market volatility as they scramble for liquidity.
In 2019 and 2020, for example, there were periods when the FOMC was adding liquidity to the markets, but the top wholesale banks led by JPMorganChase (NYSE:JPM) essentially folded their arms and went no bid. This refusal on the part of the large banks to participate cost many smaller participants months’ worth of profits due to a sudden, unanticipated lack of liquidity. Some firms almost failed, including several large mortgage lenders.
Thus we come back to the reader question: Why did the Fed feel the need to absorb $351 billion in cash yesterday via reverse repurchase (RRP) transactions when the banks are seemingly awash in cash? Is there a shortage of collateral? Maybe Treasury Secretary Janet Yellen needs to issue some T-bills?
A: The cash liquidity inside the banks is actually retarding lending activity, as evidenced by the fact that bank lending continues to fall along with bank assets. The largest banks are desperately trying to shed short-term liquidity as rapidly as possible even as loan portfolios shrink.
If you’ve been following the conversation on Twitter, Delguidice has outlined three basic changes that are coming to the US money markets, changes that have implications for banks, cryptos and anything else that interacts with the world of dollar liquidity.
First, the FOMC is going to make permanent the RRPs, essentially accepting the proposal by the Federal Reserve Bank of St Louis to create a standing repo facility for banks and nonbanks alike. This means that funds, REITs and especially smaller dealers are going to be able to go direct to the Fed of New York and finance collateral, breaking the monopoly control of the big primary dealer banks. H/T to George Selgin at Cato Institute.
Second, and this change is already in process, “swing pricing” for money market funds and corporate bond funds will allow the Fed and the Financial Stability Oversight Council (FSOC) to manage liquidity. For investors, this means that the Fed and FSOC will be able to suspend immediate cash redemptions on money market and corporate bond funds in time of liquidity stress. The message here is simple: “We’ll get back to you.”
By imposing a global “time out” for conventional funds, the FOMC no longer need provide liquidity support for funds. During 2019 and 2020, during times of liquidity contagion, the Fed essentially had to provide liquidity to MMFs and corporate funds in order to avoid a market break. Now the onus shifts onto investors. The winners here are the exchange traded funds (ETFs), which have shown superior performance during periods of market stress, and independent dealers.
Third and most significantly for the large banks, the Fed and FSOC are going to push for central clearing of all Treasury securities, killing the predominantly bilateral market for US debt and also eviscerating the monopoly of the primary dealers on financing collateral.
“This gives the Fed direct control over leverage,” Delguidice tells The IRA. “Today, 80% of the bond market trades bilateral. The Fed has decided rightly that the market for Treasury debt is too important to leave up to the whim and caprice of the large primary dealers. Many of these banks will get out of providing repo financing once the Fed steps into the market.”
In the world of asset financing, having the Fed always ready to provide liquidity to counterparties with Treasury or agency collateral will smooth volatility and make a repeat of year-end 2018 or April 2020 less likely. Many smaller dealers, nonbank lenders and REITs would welcome such a change.
Yet these developments also mark a major, historical change in how the US money markets operate and particularly the central role of the money center banks, a quaint but increasingly dangerous point of failure in the vast market for US government debt. Think of the post-COVID period in US history as marking the end of the old Anglo model of finance.
Having JPM decide it does not care to add liquidity to the markets in times of stress is a policy challenge to the FOMC that cannot be tolerated if the Us central bank ever hopes to taper QE, much less raise the target rate for federal funds. But the changes outlined by Delguidice and also echoed by many market traders, changes that we agree are inevitable if not immediate, will present a huge challenge to the major US banks as time goes on.
We’ll be outlining the impact of those issues on banks and nonbanks in greater detail in a future comment for the Premium Service of The Institutional Risk Analyst.