Liquidity is getting tighter. The decline in Fed repos is simply a reflection of their increased cost. Therefore, we will know when things are really getting bad if repo volumes start to pick up. Finally, if the market expected to get a flush of liquidity towards month end from TGA, this is now less likely to happen.
First drop in overall Fed’s balance sheet since 02/26. And it is a rather large drop, $74Bn.
Third week in a row of declines in bank deposits. Level now is the same as 04/15. The 4-week rolling growth rate is now the lowest since the Fed’s U-turn last September.
TGA continues to climb to record highs despite some disbursements towards Fed’s SPVs as new programs get triggered. It is likely that the level of TGA depends on the amount of SBA loans drawn/forgiven and such TGA can stay above $800Bn, Treasury’s target, for some time.
CB swap lines decline by $92Bn – first large decline as some of them have matured and no additional USD funding required.
Net repos outstanding continue to decline – this has been a feature all of this week as both O/N and term repos have been 0 for USTs. Reason for that is Fed raised the minimum bid on O/N to IOER +5bps and on term to IOER +10bps. This was a surprise, not that it happened (Fed probably made that decision at its April FOMC already), but that it happened ahead of tax receipts day. Commercial banks now must step in to fill in the gap but with their deposits on decline, their flexibility is diminished.
Fed bought $83Bn of mortgages – that’s perhaps to compensate for net selling in the previous 3 weeks.
Extra liquidity is getting withdrawn. That’s it. Market is not in distress yet. For that, we will know it when Fed repo volumes start picking up again and O/N rates shoot up. But for sure, on the margin, there is less liquidity to go around. Markets are not reflecting this yet. Perhaps, waiting for a sign, that all this surplus liquidity has been withdrawn, to react.
Repo volumes are rising in a similar fashion to the beginning of the crisis in February. Liquidity is leaving the system. Last two days, repos (O/N and term) rose above $100Bn. S&P500 topped on February 19 while repo volumes were about half of what we are seeing today. By the time we hit $100Bn in repos (March 3), the index had dropped 10%.
We had about two weeks (March 3-March 22) of repos printing about $128Bn on average per day. S&P 500 bottomed on March 23 as the Fed started stepping in with its various programs. Repos went down below $50Bn on average a day. More importantly liquidity started flooding the system. Reverse repos skyrocketed from $5bn on average per day to $143Bn a day by mid-April! Equities rallied in due course.
April/May, things went back to normal: repo volumes between $0Bn and $50Bn a day and reverse repos averaging about $2-3Bn a day->Goldilocks: liquidity was just about fine. Equities were doing well. Then in the first week of June, repos jumped above $50Bn, and last Friday and today they went above $100Bn. Reverse repos are firmly at $0Bn: they have literally been $0Bn for the last 4 days.
Again, just like in February, liquidity is starting to get drained from the system. By that level of repo volumes in March, equities were already 10% lower from peak. S&P500 is just a couple % below that previous peak, but Nasdaq is above!
I am not sure why the market is here. It could be that, in a perfect Pavlovian way, investors are giving the benefit of the doubt to the Fed that it will announce an increase of its asset purchasing program at this week’s FOMC meeting. If it doesn’t, US equities are a sell.
And don’t be fooled by no YCC or any forward guidance. The Fed needs to step in the UST market big way. YCC on 2-3 year will do nothing. Fed needs to do YCC on at least up to 10yr. As to really address the liquidity leaving the system, Fed needs to at least double its weekly UST purchases.
The response from the two most powerful central banks could not have been more different. ECB is innovative, using fine tuning and precision in tiered rates and targeted lending; Fed is still throwing the kitchen sink at the market by flooding the banking system with liquidity.
ECB is also going more direct partially because the banking system there is in shatters, but also because it makes sense regardless. Plus, the ECB is already taking credit risk by buying corporate bonds. Surely, the next step is literally direct credit lending and massively expanding the ECB counterparty list.
Fed is still stuck in the old model of credit transmission, entirely relying on the banking system. That model died in 2008, in fact, even before that, in the early 2000s, as the first Basel rules came into effect and the shadow banking system flourished.
Post 2008 it became much more common for financial institutions, like PE etc. to get in the credit loan business. Needless to say, this carries a big risk given that they don’t have access to Fed’s balance sheet like the banks.
The US banking system is now flooded with liquidity. If the new repo auctions are fully subscribed, this will double banks’ reserve balances and will bring them to the peak post the 2008 crisis. But do banks need that liquidity? It does not seem so: the first $500Bn repo auction yesterday had just $78Bn of demand. But that liquidity from the Fed is there on demand, plus the central banks swaps lines are open, and as of March 12, none has been drawn. And finally, the foreign reverse repos pool balance at the Fed has not shown any unusual activity (no drawdowns). All this is indicating that USD liquidity is at the moment sufficient, if not superfluous, so, it should have a negative effect on USD, given long USD has been a popular position post 2008.
All this liquidity, however, may still do nothing to stocks, as seen by their performance into the close yesterday, because balance sheet constraints prevent banks from channelling that liquidity further into the US economy where it is surely needed. From one hand, the Fed is really pushing on a string when it comes to domestic dollar liquidity, but, on the other, it is providing more than plenty abroad.
Risky assets are still a sell on any bounce, and the USD is probably a sell as well, as the Fed will be forced to keep cutting but it is now running a risk of foreign money exiting long established overweight positions in US assets.
Total assets down $30Bn: the biggest weekly decline since May 1, 2019, and down $27Bn from peak on Jan. 1, 2020. All of the decline is on the back of repos, down $43Bn on the week, and 70Bn from peak. At $186Bn, repos were last time here in mid October 2019.
On the liability side, bank reserves declined by $64Bn. But the liquidity dropped more because both the TGA and domestic reverse repos rose by $31Bn and $15Bn respectively. At $412, TGA is at its highest level over the last 12 months. On the other hand, and as expected, FRP continues to decline and at $250Bn is close to the low end of the 12m period. Currency in circulation also dropped for third week in a row, posting the biggest cumulative decline from its peak over the last 12m. The decline in FRP and currency in circulation cushioned the otherwise drop in overall liquidity.
Going forward, there is no doubt that the bulk of the central bank’s increase in balance sheet is behind us for the moment, ceteris paribus. The Fed will continue shifting from repos to T-Bills and probably coupons (especially if it hikes the IOER/repo rate next week). The effect on liquidity will depend on the liabilities mixture, though. Expect TGA to slowly start decreasing ($400Bn has kind of been its upper limit, rarely going above it by much).
FRP has a bit more to go on the downside but I think it will struggle to break $200Bn, probably settle around $215Bn.
That should help liquidity. If the Fed buys more securities than the decline in repos, under that scenario, bank reserves/liquidity go up. If not, it really depends on the net effect of the change in autonomous factors.Â
If you are trading Fixed Income, expect a bit more pressure on the curve to continue flattening. If you are trading equities, none of this matters to you. At the moment, the only thing the equity market cares about is the size of the gamma cushion.
I am late in this debate, at least in writing, because at first, I thought it did not matter; it is all semantics. Last week I read John Authers’ article in Bloomberg in which he referenced a chart from CrossBorder Capital that showed that the Fed had recently injected the greatest liquidity boost ever. That got me really curious, so I did some digging in the Fed’s balance sheet and I concluded, notwithstanding that I am not privy of how CrossBorder Capital defines and measures liquidity, it is unlikely that the Fed’s actions led to the ‘greatest liquidity boost ever’. And then yesterday Dallas Fed President Kaplan said he was worried about the Fed creating asset bubbles. This pushed the ‘old’ narrative that CBs’ liquidity/NIRP/ZIRP is creating a mad search for yield and a rush in risky assets out of the woodwork again on social media. So, that got me thinking that whatever the Fed did since last September, whether it is QE or not, actually matters.
So, just to refresh, since September 2019, the Fed’s balance sheet increased by about $400bn, of which more than half came from repos, the other from mostly T-Bills, with the increase in coupons more than offset by the decline in MBS. On the liability side, there was a similar breakdown: about 50% came from an increase in bank deposits, the other 50% came from an increase in currency in circulation and the TGA account. This 50/50 in both assets and liabilities is important to keep in mind.
Source FRB H.4.1, BeyondOverton
During QE1, the increase in securities held was more than 3x the increase in Fed’s total assets. That was mostly because loans and CBs swaps declined to make up the difference. On the securities side, the Fed bought both coupons and MBS. T-Bills remained the same, while agencies declined. However, 75% of the increase in assets came from a rise in MBS (from $0 to almost $1.2Bn). The Fed had begun to extend loans to some market players even before September 2008, but immediately after Lehman Brothers failed, the Fed extended loans to primary dealers (PD) as well as asset-backed/commercial paper/money market/mutual fund entities to the tune of about $400Bn. These were very temporary loans, pretty much making sure that no other PD or any other significantly important player failed. By the time QE1 finished the loans had gone back to almost pre-Lehman-time sizes. In a similar fashion, the Fed had already put in place CBs swaps even before September 2008, but immediately thereafter, the CB swap line jumped to more than $500Bn, and by the time QE1 finished it had gone to $0. Finally, repos actually decreased during QE1. Bottom line is, as far as Fed’s assets are concerned, September 2019 had absolutely no resemblances at all to September 2008.
Source: FRB H.4.1, BeyondOverton
On the liability side, the differences were also stark. Unlike 2019, during QE1 bank reserves contributed to 95% of the increase. The FRRP account remained pretty much flat for the full duration of QE1, while the TGA account was unchanged but it did exhibit the usual volatility during seasonal funding periods.
QE2 was much more straightforward than QE1. The Fed’s assets increased only on the back of coupon purchases (around $600Bn), while the Fed continued to decrease its MBS and loans portfolio. On the liability side, bank reserves continued to contribute about 95% of the increase. The rest was currency in circulation. Bottom line here again, really no resemblance to 2019.
QE3 was similar in the sense that Fed’s reserves increased 100% on the back of securities purchases (around $1.6Tn), but this time split equally between coupons and MBS. On the liability side, at 80% of total, bank reserves contributed slightly less towards the overall increase. The rest was split between currency in circulation and reverse repos. During QE3, unlike QE1 and QE2, less of the Fed’s balance sheet increase went towards higher liquidity (bank reserves), but still nothing like in 2019. For one reason or another, the market was willing to give some of the liquidity back to the Fed in the form of reverse repos even before the Fed started tapering (reverse repos were prominent after QE3 when the Fed stopped growing its balance sheet but before it actually started tapering it).
No, you can’t call whatever the Fed has been doing so far, starting in September 2019, QE. There are simply no comparisons with any of the previous QEs: The largest increases on the Fed’s balance sheet in 2019 was T-Bills and repos; the Fed never bought T-Bills or engaged in repos in any of the previous QEs – the asset mix was totally different. On the liability side, while in the QEs almost all of the increase went directly into bank liquidity, in 2019 only 50% did. FRRP was more or less unchanged, at around $100Bn between QE1 start and the end of QE3 – by September 2019 it had tripled! TGA averaged around $60Bn before the end of QE3; thereafter the average increased 4x!
As to the second issue of how much of the Fed’s liquidity injection since the crisis has boost asset prices? Not much.
According to the Fed’s own flow of funds data, real money has been a net seller of equities and buyer of risk-free assets since the 2008 financial crisis. If there is a rush into risky assets, it is not obvious from the data. There is also this argument that the Fed’s consistent boost of liquidity, combined with low interest rates, provides the proverbial put for prices and, therefore, the search for yield can be implemented by selling vol/gamma. This could indeed be the case. The problem is that I have not seen any data which shows exactly what the $ notional (in cash equities) equivalent of that vol selling flow is.
Moreover, given that both ECB and BOJ have engaged in even bigger balance sheet expansions, plus their interest rates are negative, the case could be made for a similar exercise in Europe and Japan. However, both European and Japanese equity markets have been languishing for years, underperforming US equity markets. Finally, even if this indeed were the case, the more likely explanation for the reasons people would be selling vol is the relentless bid from corporates engaging in share buybacks. This would also explain the underperformance of equity markets abroad relative to US ones despite higher CBs’ liquidity boosts there.
But how much liquidity did the Fed provide since the 2008 financial crisis?
Source: FRB H.4.1, BeyondOverton
Equities bottomed in March 2009. Fed’s assets increased by about $2Tn thereafter. But only 37% of that increase went to bank reserves. 40% went towards the natural increase of currency in circulation, 14% went to TGA and 9% went to the FRRP (drawing liquidity out). It is slightly better if one does the comparison since QE1, but even there, at most, 50% went directly to bank reserves.
Finally, one has to take into account that banks’ reserves needs have also substantially increased since the 2008 financial crisis on the back of Basel III requirements. According to the Fed itself, the aggregate lowest comfortable level of reserve balances in the banking system ranges from $600Bn to just under $900Bn. At $1.6Tn currently, there is not much excess liquidity left in the system. In fact, banks Fed deposits were already at around $800bn in March 2009. Given that most of the regulations were implemented thereafter, one could claim that no additional liquidity was really added to the banking system since.
According to John Authers at Bloomberg, data from CrossBorder Capital, going back to January 1969, shows that we have been recently experiencing Fed’s greatest liquidity boost ever. I have no reason to doubt CrossBorder Capital or their proprietary model of measuring liquidity. But there are many ways of defining, as well as measuring, liquidity. So, I decided to simply look at what exactly the Fed has done since it started expanding its balance sheet in September last year.
Source: FRB H41, beyondoverton
Fed has indeed been doing more than $100Bn worth of repo operations on a daily basis recently, but those operations are only temporary, i.e. they can not be taken cumulatively in ascertaining the effect on liquidity. In fact, the Fed’s balance sheet has increased by $380Bn, and only 55% of which came from O/N and term repo operations ($211Bn). The other 45% came from asset purchases. On the asset purchases, the Fed bought mostly T-Bills ($182Bn), some coupons ($55Bn) while letting its MBS portfolio slowly mature (-$81Bn).
However, not all of that increase went towards interbank liquidity. In fact, only about 50% of that increase ($198Bn) went towards bank deposits. The TGA account increased by $167Bn; that drained liquidity. Reverse repos decreased by $20Bn (FRP by $17Bn and others by $3Bn), which added liquidity. Finally, $37Bn went towards the natural increase in currency in circulation.
Source: FRB H41, beyondoverton
Fed actually started increasing its T-Bill and UST portfolio already in mid-August, three weeks before the repo spike. Part of that increase went towards MBS maturities. But by the end of August, Fed’s balance sheet had already started growing. By the third week of September, also the combined assets portfolio (T-Bills, USTs, MBS) started growing as well, even though MBS continued to decrease on a net basis.
Source: FRB H41, beyondoverton
Fed’s repo operations started the second week of September. They reached a high of $256Bn in the last week of December. At the moment they are at the same level where they were in the first week of December ($211Bn).
Source: FRB H41, beyondoverton
On the liability side, the TGA account actually bottomed out two weeks before the Fed started buying USTs and T-Bills, while the FRP account topped the week the Fed started the repo operations. Could it be a coincidence? I don’t think so. My guess is that the Fed knew exactly what was going on and took precautions on time (we might find eventually if it did indeed nudge foreigners to start moving funds away from FRP).
Source: FRB H41, beyondoverton
Finally, while currency in circulation naturally increases with time, bank deposits also bottomed out the week the Fed started the repo operations in September, but strangely enough, they topped the first week of December (for the time being).
Source: FRB H41, beyondoverton
So, while the Fed’s liquidity injection since last September was substantial relative to both the decrease in liquidity before that (starting in 2018 when the decrease in the Fed’s balance sheet became consistent) and, to a certain extent, since the end of the 2008 financial crisis, it is difficult to make a claim that this is the greatest liquidity boost ever. The charts below show the 4-week and 3-month moving average percentage change in the Fed’s balance sheet. The 4-week change in September was indeed the largest boost in liquidity since the immediate aftermath of the 2008 financial crisis. The 3-month change though isn’t.
Source: FRB H41, beyondoverton
The Fed pumped more liquidity in the system during the European debt crisis. In the first four months of 2013, not only the growth rate of the Fed’s balance sheet was higher than in the last four months now since September 2019, but also the absolute increase in Fed’s assets and US bank deposits. Moreover, there were no equivalent increases in either the TGA or the FRP accounts.
Final note, if the first week of January is any guide, it might be that a big chunk of the Fed’s balance sheet increase might be behind us, if only for the time being. Fed’s balance sheet decreased by $24Bn, which is the largest absolute decrease since the last week of July 2019, i.e. before the start of the most recent boost in liquidity. I actually do expect the Fed’s balance sheet to keep growing but at a much smaller scale and mostly through asset purchases rather than repos.
Things
the Fed can do to alleviate the potential repo squeeze (apart from the usual
suspects already discussed in great detail by both saleside/buyside research
and in Twittersphere):
1) hike the interest banks pay on TT&L ‘notes’ accounts from EFF-25bps to EFF, or to make it even simpler, equal to IOER. That could encourage funds to move from the TGA account back to TT&L accounts and ‘release’ reserves.
When the Fed started paying IOER, the opportunity cost for the Treasury to keep money on deposit in the banking system (TT&L accounts) rose. The Treasury thus started using the TGA at the Fed.
2) cut the fee on daily uncollateralized overdrafts from the current 50bps, adjust the net debt caps, decrease the penalty daily overdraft fee of 150bps. That could encourage better use of the existing Fed intraday liquidity option.
The Fed made major changes to its daily overdraft operations in 2011 spurred by some inexplicable desire to limit its credit exposure. This was probably on the back of political pressure from the legacy of the 2008 crisis during which the Fed indeed took massive credit risk.
Before 2011, the majority of the Fed’s daily overdrafts were uncollateralized. The new rules discouraged uncollateralized ‘repos’ by raising their fees and introducing collateralized overdrafts for free. After those changes, majority of the overdrafts became collateralized. The problem arose when during the most recent repo squeeze, the mechanics of obtaining collateral became complicated.
In any case, Fed’s action was strange given the fact that only a few months before that, in 2011, it had changed the accounting rules which pretty much ensured that the central bank can not go bankrupt (no negative equity) even in theory.
Should the Fed, actually, be providing free intraday liquidity with no collateral to eligible institutions? I think so. Because:
-that liquidity is needed for transaction (retail 24/7), not consumption or production purposes (Pfister 2018)
-the central bank can create money at zero cost, while the opportunity cost of holding money should be equal to the social cost of creating it (Friedman 1969)
-the central bank would be simply accommodating Basell III regulations
These two solutions are not groundbreaking: the Fed would be either going back to the way things were before 2007 (uncollateralized Fed daily overdrafts), or taking into account new developments (the emergence of IOER).
