14 Aug 2011

The Fed’s secret QE equivalent

Anyone catch this from the New York Fed on Friday? It’s hugely important:
Beginning tomorrow Monday, August 15, the New York Fed intends to conduct another series of small-scale reverse repurchase (repo) transactions using all eligible collateral types. The first operation will be conducted using only the expanded reverse repo counterparties announced on July 27, 2011. Subsequent operations in this series will be open to all eligible reverse repo counterparties.
Going forward, the Federal Reserve plans to conduct a series of small-scale reverse repurchase transactions about every two months, which will bring the frequency of these operational exercises in line with that of the Term Deposit Facility exercises.
Like the earlier operational readiness exercises, this work is a matter of prudent advance planning by the Federal Reserve. The operations have been designed to have no material impact on the availability of reserves or on market rates. Specifically, the aggregate amount of outstanding reverse repo transactions will be very small relative to the level of excess reserves, and the transactions will be conducted at current market rates. These operations do not represent a change in the stance of monetary policy, and no inference should be drawn about the timing of any change in the stance of monetary policy in the future.
Why so important?
Well. Weren’t we all conditioned to think that reverse-repo operations were meant to be an exit strategy? Weren’t they supposed to be deployed as a way to soak up all those excess reserves?
Why on earth would the Fed be choosing to soak up excess reserves at a time when the panic in the markets has reached highs not seen since 2008, and at a time when most of the market is calling for more liquidity and quantitative easing?
Well, we would argue it’s because the Fed believs the financial system may have crashed through a critically important juncture. Actually perhaps a rabbit hole or a looking glass are more accurate.
QE is no longer the cure. It has now become a poison.
Which would explain why the Fed did not announce more QE at the last FOMC meeting, despite rampant calls for the opposite.
It’s now very possible that the majority of the FOMC voting committee believes more QE could plunge the system into a desperate capital preservation frenzy, resulting in nothing else than self-imposed and voluntary capital destruction.
That the system is so broken, it doesn’t matter how much liquidity the Fed creates because it won’t be able to get any further than the immediate banking community. And that’s because banks still can’t find enough credit worthy people to lend to. That the majority of loans still have a greater default risk than the banks are prepared to weather. That loans equal capital deterioration. And only loans to the most credit worthy people (of which there are not enough) are worthwhile.
If banks do indeed perceive that capital deterioration risk from lending is much greater than a self-imposed haircut on the most liquid and safe security, they’re prepared to take that haircut — especially in a world with no alternative — because it guarantees some sort of remaining capital preservation. The haircut, of course, is the negative interest rate.
If that is the case, the worse thing the Fed could do is more asset purchases. It would only take out more supply of quality collateral out of the market, heightening the pressure to take a self-imposed haircut just in order to get your hands on the security. A fact echoed by the number of above par bids at this week’s 30-year Treasury auction.
As we’ve already noted, Ben Bernanke discussed that the Great Depression was arguably catlaysed by a move towards voluntary capital destruction via a frenzied fight for the remaining quality collateral.
Back then, the Fed also deployed so-called quantitative easing to flood the system with liquidity. It only made the situation worse.
That is why this time round Bernanke’s liquidity injection came alongside two very important new measures. Interest on excess reserves — designed to keep a floor on rates and stop them plunging into negative territory — and SOMA limits. So that the Fed could never fully wipe out Treasury supply in the market.
Of course, two of those key anti-deflationary measures were partly compromised this year. The first was interest on excess reserves, via the April introduction of a FDIC fee. This negated much of the incentive to keep your deposits at a nominal interest rate at the Fed. It actually made it costly.
The second was the debt ceiling debacle, which clearly made the subject of adding additional supply via fresh issuance from the Treasury a more than taboo subject.
Faced with no incentive to hold cash on reserve at the Fed, and more cash than God to invest, money flooded into the money markets and short-term bills. This caused pressure on repo rates, which caused pressure on money market funds. Money market funds opted to hold demand deposits at a zero rate than risk breaking the buck through bill investments.
It was this that was responsible for the second biggest US M2 rise in history:
But this was always arguably unlikely to be inflationary. The buck stopped with money market funds. What’s more, the banks were back at point A. Holding large excess reserves at the Fed that weren’t making them any money.
Bank of New York Mellon’s decision to charge for deposits thus reflected a critcially  important development. It meant money market funds would have to either suffer capital destruction or move elsewhere.
Elsewhere was back into the bill and money markets. A move which only intensified the free fall of short-term yields and once again posed the threat of negative yields and repo rates. It was a no-escape scenario from capital destruction. Or what we dubbed the 2011 deposit crisis.
So the Fed’s decision to start reverse repo specifically to money market funds is specifically about giving them somewhere to invest their cash at a positive interest rate.
And that, to end this sorry story, is why the decision to increase reverse-repos is not a tightening measure but actually a very clear move to put back some sort of floor on rates, or as the New York Fed put it “The operations have been designed to have no material impact on the availability of reserves or on market rates.”


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