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Far Too Little, Far Too Late

A brief caveat: I spent the majority of my career trading the front-end of the interest rates curve. If I sound a little biased towards the fact “they really should have seen this coming”, it’s only because of the countless hours of meetings I’ve had with policymakers who want to take the pulse of the market – urging them to focus on this issue before it was too late. Well, here we are. The pulse is gone. And yeah, all of this does feel like too little too late.

As mentioned previously, breathless media coverage of “Liquidity and the Funding Market” is just one of those thing you don’t want to hear about. When it’s working as it should, it’s generally regarded as one of the more boring markets on the planet. When it’s not… well, here you go.

Let’s put this in context. Here are a few “large” moves that markets have seen over the past few weeks. Notice anything that stands out?

Suffice to say, we’re not supposed to be talking about $ funding markets – the linchpin of the largest & most important (there, I said it) market in the world, US Treasuries – in the same breath as the wreckage wrought in Argentina only a month earlier. We’re definitely not supposed to be saying “the collapse in the Argentine Peso was barely 1/3 of what we just saw in the market that the Fed controls…”

Yet here we are.

The “move” (it feels like we’re supposed to start calling this something quite different, like “TREXIT” – for example) came about because of a series of coincident events, the perfect storm of conditions. What was a perfectly mundane combination of factors quickly spiralled out of control due to much more sinister structural issues. Sound familiar?


One of the consequences of the financial crisis was the creation of significant levels of reserves within the banking system. As assets rolled off the Fed’s balance sheet once QE in its many-colored forms ended, this reduced the total amount of reserves outstanding. This process accelerated as the Fed began tightening.

The problem was that a second consequence of the financial crisis was the mandatory holding of assets for “liquidity coverage” purposes. This was codified by the Basel accords & further solidified by additional Fed mandates. That meant the minimum amount of acceptable reserves was no longer zero (as it had been in the pre-crisis period) but something closer to the $1-1.2 trillion area – or so we thought.

The debate became over that minimum acceptable level of reserves & showed up in talking points by various Fed officials as a question of “reserve scarcity”. The overwhelming response from the Fed, despite all evidence to the contrary, was that there was no problem. This was seen time & again in speeches by Federal Reserve staff who, let’s be real for a minute, definitely knew better but felt that acknowledging a problem was worse than pretending it didn’t exist.

It strains credibility to believe that senior Fed officials like Potter & Logan didn’t see there was a major brewing storm (oh, by the way, Potter’s no longer there…).


And so, the problem that the Fed refused to admit was a problem grew; the papercut endured in 2015-2017 became a festering wound.

What’s by now a famous relationship was well-highlighted. I’ve reproduced the chart below that, by mid 2018, had become a staple of sell-side short-term interest rates research pieces.

Reserves decreasing caused the FF-IOER spread to increase. The fact that the trend line is turning from a fairly horizontal plane in 2015-2017 to an exponential line in 2019 is evidence of the fact that we’ve hit the theoretical minimum limit of acceptable reserves.


By the time we’d reached this asymptote, it was clear that anything the Fed did was going to be too little too late. On top of that, the vast issuance needed to support an unwieldy Federal budget had conspired to drain reserves further. What resulted was very reminiscent of that scene in “Airplane!”

In a very perverse sense, the worst thing that could have happened for this relationship was the fact a debt ceiling deal was hammered out early in the summer. The resulting “deal” meant that the Treasury could ramp up issuance even further.

And if you think that the Fed had difficulty acknowledging the gravity of the problem at hand, just imagine what the brain trust at the US Treasury thought of the situation.


The problem described above was, unfortunately, just the tip of the iceberg. In addition, post crisis regulations had caused the holdings of Treasury collateral at US banks to become bloated – to say the least. Even a small decrease over the past 3 months did little to alter the fact that banks were holding a quarter of a trillion more Treasuries than they had in the past.

Moreover, as the probability of rate cuts by the Federal Reserve grew this year, the market’s perception that the Fed was behind the curve grew even faster.

In the absence of any discernible sign of inflation, the curve assumed a pancake shape – flatter. Foreign investors did what any logical market participant would do & parked their money at the only point in the curve that still offered any yield: a window that was tantamount to an unlimited supply of free money represented by the Foreign RRP pool.


This didn’t happen without warning. Very much to the contrary.

The setup was evident for well over a year – and recent signs that all was not well with the funding market was evident in spreads that targeted the front-end of the curve most notably.

I recall being in a meeting in early 2018 with a senior staffer who was asked about why the Fed wasn’t more alert to the potential dangers being posed by clear & present reserve scarcity. The (not unreasonable) query was returned by a shrug & dismissal that wouldn’t have been out of place coming from The Dude.

Dec-19 FRA/OIS spreads (yes, that’s Libor-OIS of Lehman infamy) were already pointing significantly wider – pointing to trouble that was brewing beneath the surface (see below & yes of course this is roll-adjusted).

TU/OIS spreads were also under serious duress, indicating the relative cheapness of collateral – despite an all-world rally. This is a dynamic that I expanded on in detail 2 weeks ago, here.


Earlier this month, when rates sold off dramatically (c.f the largest sell-off in the 2-year point in 10+ years), cash parked at the Fed was withdrawn. Dealers scrambled to reduce Treasury holdings. The ECB added to the chaos by incentivizing a dramatic switch by virtue of their tiering proposal & the deluge was on.

I elaborated on these dynamics at length here, here & here.


All that was left was a catalyst for things to get really, really ugly. That came when a timed demolition went off on Monday: corporate tax day, an overseas holiday for one of the largest holders of USTs (Japan) & a large “unplanned expense” for another (KSA), plus a massive settlement day for recently auctioned Treasury collateral. Any one of those could push overnight repo rates higher on their own, even during “normal” conditions. Given the circumstances, all of these factors together generated the explosive power of a hydrogen bomb in funding markets.

Stripping out year-end turns, this was easily the largest 1-day move on record – exceeding the previous highs that were set during the darkest hours of the financial crisis.


It’s somewhat fashionable for sell-side research to dismiss this with a flippant “one-day means nothing, but longer term…”

Well, let’s be clear. One day is not nothing. At these levels.

Collateral that cleared late day at 600bps over means that you lost nearly half a year’s worth of coupon – in 1-day financing.

The Fed’s response today (which left them back in control of the Fed Funds market for, oh, about an hour) amounted to mild surprise – only a slight improvement over the shrug from 2018. They still don’t seem to get it.

Yesterday, volume in the Fed Funds market dried up to its lowest level (ex-month ends) in years.

The levels of that which DID end up clearing were appalling, as evidenced by the percentile breakdown in the Fed’s summary this morning.

Let that sink in. $10bn+ trading (the 75th percentile) in the market that the Fed supposedly has control over at levels that at nearly a FULL HIKE away from where we are now.

And so, yes – you probably know the rest from this morning’s dramatic announcement: the Fed stepped in. They.. uh.. had a little trouble at first.

Ultimately, the job was completed – sopping up $53bn in total. But does the story end here?

Of course not.

You might be wondering what the market thinks of this whole debacle?

Well, we can discern exactly where the market thinks we’re ultimately going to end up from where the September Fed Funds futures contract is trading.


As of this writing, the September Fed Funds futures contract is trading at 97.935 – a rate of 2.065%.

That rate is a simple average of all the EFFR prints throughout the month, including non-business days. We have 16 of those prints already (yellow shading) with 14 left to go.

A cut is already in the price for tomorrow – that’s not up for debate. If you think that the Fed isn’t going to cut because of all this – well, you haven’t been paying attention. And by the way, for the reporters who take Fed probabilities as gospel off the WIRP page on Bloomberg – or the CME website for that matter – respectfully, learn how to do your job.

With a 25bp cut in the price tomorrow, that means the market is extrapolating a level that’s IOER  +9bps for the rest of the month. That would work out to a 2.19% print for EFFR the next two days (followed by 1.94% the remainder of the month).

Bottom line: here’s what the market thinks of the Fed’s temporary solution…

It’s a joke.


IOER+9bps would still, in the absence of Monday’s debacle, put meaningful pressure on the Fed to do something, fast. Unfortunately, cutting IOER by 10bps means that, well, you’re at the very bottom of the policy range.

So, you could keep cutting it further – meaning that IOER would, laughably, be below the low end of the Fed’s target range, just highlighting how little control the Fed has over the only rate it’s supposed to care about.

Or you address reserve scarcity. And the only realistic way to start meaningfully building up reserves again is – you guessed it – more QE.

To put it in terms that the Fed might understand, we turn to the timeless words of a national treasure: Christopher Walken.


By the way, the only thing worse than this affecting all the US Treasuries in circulation would be if, y’know, this ended up affecting all the interest rate derivatives in circulation.

Imagine trillions of additional derivative positions going from being benchmarked against the red bars below – to the white bars. Note the difference in daily swings that’s readily apparent to the naked eye.

Daily change in SOFR (white) vs LIBOR (red), basis points

That’s right, folks. The (anticipated) benchmark reform means that LIBOR rates will be replaced by SOFR – a rate which is directly tied to repo markets. Now, the calculation methodology for that is still under discussion because… well, look at the chart above. The daily fixing for SOFR moves more than 3.5x what LIBOR does. That’s a heck of a lot of volatility. So, they’re working to “smooth” that out by virtue of an in-arrears calculation & a one-time spread adjustment that’s “in the works”, to put it charitably.

I’m sure that will go as smoothly as the crisis management the Fed’s managed for the “reserve scarcity” issue.

References, Sources : Bloomberg, HFR Research, SocGen Hedge Fund Monitor, CME Group.


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