Finally, with quarter-end upon us, the Fed has managed to apply a makeshift tourniquet to funding markets. But, that’s not to say they’ve cauterized the wound. Ultimately, there’s one way out – and that’s where the market appears determined to drive us: large-scale asset purchases (which, of course, is what QE was all about – but we can’t call it that). After all, nomenclature is really just semantics.
If it looks like a duck and it quacks like a duck… well, it doesn’t really matter what the Fed says – it’s probably gonna trade darn like a duck, too.
From repos to POMOs & from LSAPs to QE, here’s what every trader needs to know.
An ugly duckling
Volatility in funding markets has, to a certain extent, normalized…
…though, this has come at the expense of the Fed becoming the market’s second largest money fund repo counterparty.
Of these, the largest, FICC – the Fixed Income Clearing Corp – is a clearinghouse that has a range of both buy- and sell-side firms who operate as “sponsored members”. It was designated a “systemically important nonbank financial market utility” in 2012.
So, while no further operations have been added (as of this writing) beyond the middle of October, clearly markets anticipate that the problem remains far from solved: any short-term fix is merely delaying the inevitable.
To wit, that’s because the Fed’s Open Market Operations (OMOs) are still not getting to those that need that term funding.
Water off a duck – liquidity transfers
A refresher: OMOs only transact with the 24 primary dealers. However, there are many others who engage in the repo market. For instance, among the FICC members that trade repo on the FICC platform, there are currently 67 other institutions that are not affiliated with a primary dealer.
http://www.dtcc.com/~/media/Files/Downloads/client-center/FICC/Mem-GOV-by-name.xlsx
https://www.newyorkfed.org/markets/primarydealers#primary-dealers
Therefore, OMOs are only as effective as the liquidity which is passed onto the market from the 24 primary dealers.
Now, if one of those primary dealers (I don’t know… I’ll pick one at random, like “Deutsche Bank”) needs liquidity for itself, then it’s much less likely to on-lend that liquidity to other market participants.
In addition, given balance sheet constraints imposed by G-SIB surcharges, there’s less appetite these days for primary dealers who DON’T need the liquidity to volunteer themselves as liquidity facilitators.
Thus, while this past week’s episode was thankful for the tourniquet applied by ad hoc OMOs, that has by no means cauterized the wound.
That’s because other measures of funding (such as commercial paper issuance – and thereby LIBOR rates) tend to become stretched as well heading into year-end. In particular, the last 2 years have been rather outsized in this regard, due to the nature of G-SIB snapshots at year-end.
Indeed, we can see that the forward looking metrics of this spread have had quite the volatile ride the past 2 weeks in response to the Fed’s OMO announcements. Note, whipsaw in Dec-19 dated LIBOR/OIS.
Furthermore, we can see that 1-day funding over year-end in the Fed Funds market still costs DOUBLE what it did a month ago – despite everything that the Fed has unveiled as potential arsenal against such moves.
In other words, this is hardly a permanent solution.
This is something I’ve touched upon time & again & again.
POMOs take flight
Naturally, that’s where Permanent OMOs (POMOs) or Don’t-Call-It-Q-E comes in.
Notably, the Fed has become increasingly vocal in recent weeks about the impact of reserve draining on recent volatility in repo rates. Clearly, there is a motivation to correct the problem in a more permanent fashion.
Of course, the simplest way to ensure that the issue remains fixed is to grow the level of reserves available in the system again. That means large scale asset purchases (LSAPs).
No doubt, the most challenging aspect of this implementation will be convincing markets at large that this isn’t QE. On the one hand, it’s correct that in past episodes of Quantitative Easing the intent of purchases was indeed to push long-term interest rates & term premia lower. Reserve balances grew naturally on the liability side of the Fed’s balance sheet in response to a larger asset base.
However, as argued by numerous sell-side analysts (essentially providing the Fed with its script in October), this time around purchases would be liability-driven:
“Much like the Permanent Open Market Operations the Fed conducted for most of the pre-crisis era, the Fed will look to merely “top off” reserves to a level which will indisputably be “ample” in line with the Balance Sheet Normalization Principles and Plans released earlier this year.”
Jay Barry (JP Morgan), “This is not the QE you’re looking for…”
That may be, but the act of convincing may be another story – especially since the total size of the purchases needed to “top up” reserve balances would be about the same duration equivalent as the upsized version of that first round of QE back in 2009.
Birds of a feather
Well, that’s $20mm/bp for those keeping score at home.
Furthermore, those purchases being made in the secondary market will soak up nearly all of the Treasury net issuance that’s been projected thru early 2020, on average.
But, remember though (the Fed is sure to remind us several hundred times over the course of this buying), it’s not QE.
Still, an important fact remains. Each 1% increase in the Fed’s balance sheet as a share of GDP has, over the past 15 years, lowered 10-year yields by 5-10bps. That’s a meaningful amount, especially if we’re projecting GDP to slow next year as the business cycle issues a final death rattle.
So, regardless of how many times the Fed may exhort the market to believe it’s “not” QE – the impact on prices of US Treasuries may end up being very much the same.
In other words, if it looks like a duck and it quacks like a duck, it doesn’t matter what the Fed says – it probably trades like a duck, too.
Obviously, much of that depends on what sector of the curve in particular the Fed chooses to target (in this episode it’s highly likely that they’ll target a maturity distribution roughly on par with what the current makeup of outstanding debt follows). But, even in that scenario which would involve a larger bills-buying program, remember that those issues which ultimately rolloff their balance sheet will have to be replaced somehow.
Again, it just means deferring purchases until the time comes when it absolutely cannot be avoided any further.
Or, just until the next crisis.
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