Will SOFR Be the Death of Jay Powell?
March 21, 2022 | Last week, Federal Reserve Board Chairman Jerome Powell said that he was pleased with FOMC’s balance sheet discussion, Ian Katz of CapitalAlpha Partners reports. “We made excellent progress toward agreeing on the parameters of a plan to shrink the balance sheet,” he said. Powell then went on to say that the framework for shrinking the balance sheet is going to look “very familiar to people who are familiar with the last time we did this. But it will be faster than the last time, and of course it’s much sooner in the cycle than the last time.”
Powell’s comments ought to be troubling to readers of The Institutional Risk Analyst on several levels, but mostly because they suggest that the Fed has not learned from past mistakes. The chart below shows the S&P 500 vs the Fed’s almost $9 trillion system open market account (SOMA).
Both Powell and other Fed officials reflect a level of confidence in the process for reducing the size of the central bank’s balance sheet that belies the failures of April 2020, September 2019 and December of 2018. In each case, a lack of appreciation of the magnitude of the failure of public policy remains a major blind spot for the Fed. One of the single biggest errors in judgement by the Fed was the decision, together with the Bank of England, to kill the LIBOR market.
The general point is that Dodd-Frank and particularly the Volcker Rule has made dealers reluctant to deploy capital, especially dealers inside large banks. As a result, in times of market stress, the major dealers and warehouse lenders led by JPMorgan (JPM) have folded their arms and refused to provide additional liquidity to meet market demand. Into this already constrained market for liquidity, the Fed has introduced another variable: kill LIBOR.
Instead of asking Congress to fix the liquidity problem, the politically cowed members of the Fed’s Board of Governors have instead created a standing repurchase facility (SRF) to correct earlier policy errors led by the Volcker Rule and the Liquidity Coverage Ratio (LCR). The SRF will, in theory, enable the Fed to provide liquidity directly to the markets, reflecting a significant departure in terms of market structure that was not authorized by Congress.
The Fed’s forward and reverse repurchase facilities represent an additional nationalization of the US money markets, this atop the confiscation of the market for overnight funds (aka “Fed funds). This once private marketplace has been transformed into a policy instrument by unelected economists, rendering the US markets more and more a copy of the authoritarian states of Continental Europe.
David Andolfatto and Jane E Ihrig of the Federal Reserve Bank of St Louis made the very practical case for a SRF in 2019. Having started quantitative easing after the 2008 market correction, the FOMC eventually found “fine tuning” monetary policy impossible with a now $9 trillion balance sheet. Powell and his predecessor, Janet Yellen, have stretched the “necessary and proper” clause of the US Constitution to the breaking point when it comes to interpreting the intent of Congress.
The authors noted that due to the constraints of Basel and Dodd-Frank, large banks understandably prefer cash reserves held at the Fed to Treasury securities, which bear market risk and require higher capital allocations. They noted an earlier discussion by the Fed of New York that large banks might need the ability to liquefy up to three quarters of a trillion in Treasury paper during times of stress.
The authors concluded in 2019 before the Fed’s September liquidity snafu:
“Even though balance sheet normalization is well underway, we think it is never too late to introduce a repo facility. The FOMC would learn over time whether the facility is working to reduce the demand for reserves. The FOMC could do so, for example, by permitting reserves to run off organically with the growth of currency in circulation while remaining confident that interest rate control would be maintained through the repo facility.”
Taken to its bureaucratic extreme, SFR would reduce the amount of reserves held by banks to some minimal amount since banks could get actual cash for Treasury obligations upon demand. Combined with a floor underneath interest rates in the form of the Reverse Repurchase Facility, the two new appendages of the central bank would essentially corner the market in short-term interest rates, forcibly if need be. But the SFR also suggests that if the markets ever turn away from the US Treasury, the Fed will be the buyer of last resort.
Having the Fed push the largest banks out of the way in the market for overnight funding brings the US into alignment with Europe, where the central banks are the center of a largely state-sponsored market for secured finance. In plain terms, the Fed is killing the private bond markets in the US to control volatility and thereby make life more convenient for Fed bureaucrats. The SFR also serves another, unstated purpose, namely to keep the market for Treasury debt open.
In this decidedly anti-market and also anti-democratic formulation, US investors have been reduced to the role of the residents of Locker C18 at Grand Central Terminal. Don't worry, the "Men in Black" from the Fed will save the world. Chairman Powell is obviously Will “Jay” Smith, while Tommy Lee Jones is played by former “Chair” and now Treasury boss Janet Yellen. Note who is in charge.
Unfortunately, happy endings only occur in Hollywood, while in the real world agencies like the Federal Reserve Board make it up as they go through time. This is hardly a formulation that adherents to the free enterprise model of American political economy would recognize. Like the European Central Bank or even the Bundesbank in Frankfurt, the Fed now has the front row seat (singular) on the floor of the virtual exchange that is the US bond market.
Keep in mind that during the liquidity hiccups of the past five years, the Fed was busily destroying LIBOR, the chief global rate for funds from overnight to more than a year. The replacement created by the Fed, SOFR, barely trades and does not follow LIBOR, forcing market participants to pad the rate to adjust. SOFR has no term structure and seems to have no correlation to other benchmarks. How is this helpful?
Of note, the Fed has already removed the historical LIBOR data from its servers so that the public cannot compare the two series. Our bet is that the zombie SOFR “market” will likely die a well-deserved but natural death and other private measures such as the Treasury swaps curve or CBOE’s Ameribor will replace it.
Q: What is wrong with the graph below? A: SOFR is a zombie, does not trade, lingering at 0.3%. LIBOR is at 0.9% this morning while Ameribor is 0.58%. How can Chair Jay seriously expect to reduce the Fed’s balance sheet when he has so perfectly screwed up the market for short-term secured finance??
The chart above shows overnight SOFR, 3 month LIBOR and the 3 month Ameribor contract traded by the CBOE. The Fed’s zombie SOFR index does not really trade significantly beyond overnight. Notice that the two new measures SOFR and Ameribor, which lack a significant market follow, are barely moving after the FOMC’s latest policy action. The disruption caused to the secured financial market by the Fed’s ill-considered decision to terminate LIBOR may come back to haunt the US central bank later this year.
The good news is that markets such as Fed funds and the too-be-announced (TBA) market for agency and government mortgage securities trade against the Treasury yield curve. Everything else in the world of asset backed securities, however, has historically traded vs. LIBOR and now trades against, well, nothing. SOFR is not a market or even a benchmark. It is a not quite wet dream created by the Fed’s staff that like most economist musings, has no real substance.
When markets get volatile, the trillions of dollars in ABS that have traded vs LIBOR historically will effectively be cast adrift without a basis for valuation. As one veteran trader reflected in Twitter over the weekend with respect to the above chart: “Something is going to break.”
The point about LIBOR is not merely to illustrate the Fed’s lack of sensitivity to the cost of its policies. The folks at the Fed are really good at destroying markets, but less skilled when it comes to creating new markets, as with SOFR. Being a New Deal (aka “socialist”) institution, the Fed pursues the goal of “full employment” to the exclusion of all other goals – including price stability -- but never bothers to notice or acknowledge when it makes a policy “misjudgment.”
Followers of the Church of Rome take solace in the fact of a loving and forgiving God, but there is one sin that God will not forgive: arrogance. It is time for Congress to help the Fed. In order to introduce better decision making into the Fed’s complex deliberations, we need to make Fed governors more accountable for the consequences of their decisions so as to better align economic policy and the real-world results. That is, should the Fed cause another liquidity crisis as it ends QE and shrinks the balance sheet, then Chairman Powell should immediately resign.