Fed Funds Is Loudly Declaring the Fed's Total Cluelessness
That’s certainly not the way this was supposed to go. Federal Reserve Chairman Jay Powell had been planning a nice, quiet rate cut number two. He needed to make his point in as clear a way as possible; which is, the US economy needs a little insurance even though it really doesn’t need any. Everything is fine, but just in case it’s not.
The last thing anyone at the FOMC wanted was for the central bank to be publicly humiliated on the very day of the announcement. It’s a pretty basic thing in one sense, in that all central banking relies on a simple principle. Interpretation is where it gets complex. What a money rate means, that’s the debate. What a money rate does, there’s never supposed to be any question.
I’ve been writing about federal funds for more than a year, which, as I’ve noted along the way, has already been a red flag, a seemingly constant series of them. Federal funds is nothing, a wasteland of long ago faded glory. It is the sparest of spare liquidity. Therefore, if there is ever anything interesting about it, your ears should immediately perk up.
The more immediate trouble began on Monday. As far as most people are concerned, this repo rumble erupted out of the blue. Repurchase agreements and collateral are foreign concepts even though they are the backbone of the global system – precisely because everyone has been taught and conditioned to pay attention only to fed funds.
But as the repo rate (GC, or general collateral using US Treasuries) surged to nearly 3% (according to DTCC) on Monday, it spilled over into that market. The effective rate, EFF, was pulled upward by the rumble. The Fed’s New York branch said Tuesday morning that EFF had been 2.25% Monday afternoon.
By the time that number came out, the FOMC had already sprung into action. Not only was the first day of the regular policy meeting about to open in Washington, in New York the Open Market Desk had been directed to conduct an overnight repo operation. Not because of the repo market, mind you, only because of the fed funds rate.
Monetary policy works, officials believe, by what it signals to you and me. A big part of that signal is that the fed funds rate is conveying only what monetary policymakers want it to convey. In order for that to happen, the fed funds rate has to obey monetary commands.
In the current case, that means EFF is never meant to move outside of its target range. On Monday, that target range was 2% on the bottom to 2.25% on the high side. When FRBNY calculated EFF and found it right at 2.25%, the Fed had to do something in order to make sure it didn’t go any higher. If it did, it would break the range and declare, very publicly, something unusual was going on, the antithesis of monetary theory.
The overnight repo operation was a liquidity auction. The 24 current primary dealers were allowed to borrow funds (reserves) from the Fed, up to $75 billion total, upon eligible posted collateral (UST’s, MBS, and agency paper). Tuesday morning, the dealers bid for $53.15 billion. Wednesday and Thursday, more than $80 billion.
And it had very little effect. The repo rate skyrocketed further on Tuesday despite the first unscheduled OMO, ending up just a tick above 6%! Worse for the FOMC, the fed funds market was stretched to extreme proportions by the action. The upper end of the federal funds market had been pushed as high as 4% on Tuesday, an outrageous 190 bps above IOER.
As a result, the effective fed funds rate, the one rate upon which all monetary policy projection stands, broke out of its target range for the first time since 2008. On Wednesday morning, FRBNY put it at 2.30% for Tuesday, just in time to spoil Powell’s nothing-to-see-here rate cut.
GC and EFF, ceilings, floors, IOER, repos and reverse repos. What are we really talking about?
Former Fed Chairman Bernanke called it transmission. It’s really just a simple question: where are the dealers?
We have to always keep in mind the basics; starting with EFF and federal funds. The fed funds “rate”, EFF, is not universal. It is instead a weighted average of real transactions that take place at many different rates, some high, some low, but mostly falling around the calculated number.
So, monetary policy is supposed to work by targeting a range for EFF which then targets where the critical mass of those real-world funding transactions should take place. Should.
Outside of picking that target range, the Fed influences all those messy transactions by giving money market participants alternate money opportunities. One of them is something called the reverse repo rate (RRP) and before this week it had been set equal to the bottom of the policy target range (more on this later). Another is the infamous IOER; the crisis era joke that US officials somehow made a centerpiece of their post-crisis framework.
Depository institutions have the option of holding reserves with the Fed and getting paid that interest rate. But they also have other options available, including lending in repo and, yes, federal funds. If the Fed is giving you only 2.10% IOER and repo is 3% if not 6%, why not put some of those reserves to work in repo and pocket what is essentially a risk-free arbitrage?
Had enough dealers done that, the repo rate, also a weighted average, never would have gotten so far out of line. Same in fed funds. Had dealers taken advantage of the profit opportunity and entered the fed funds market at the upper ends of its range, the weighted average (EFF) would’ve been much lower, likely never breaching the upper bound.
This didn’t happen, even after the Fed entered, to the point that it left EFF outside the policy range. Where are the dealers?
One must only conclude they are constrained by something. But what? According to the mainstream explanation, it’s Donald Trump’s fault. Seriously, that’s what they have been saying since EFF, IOER, and repo first started signaling difficulties all the way back in early 2018. Here’s what I wrote about it in May 2018, just a few days prior to what would prove to be a crucial piece of evidence against the idea:
“The FOMC has come up with another for why IOER may have to be changed. It goes like this: the recent large increase in the federal government’s budget deficit has required primary dealers to carry more treasury bills in inventory (bills are where changes in government borrowing register first); holding more bills means financing more bills, therefore a higher demand for repo funding; the repo rate rises as a consequence; therefore, the federal funds effective rate moves up in concert (secured vs. unsecured).”
When this plausible sounding theory was first introduced, it was much harder to dismiss it on the evidence alone. May 29, however, showed that there was something else going on and in repo of all places.
May 29, 2018, has turned out to be the inflection point. It shows up like that on every chart that matters; swap spreads, inflation expectations, eurodollar futures, even Treasury yields. Strictly speaking, it was an unusual buying binge in global bond markets. Suddenly, very abruptly, US Treasuries (and German bunds) were in huge demand.
It suggested something serious had just broken, the weight of building negative pressures were too much to overcome and the entire baseline had changed. The drop in yields produced by the surge in prices stood out like a sore thumb at a time when everything seemed to be going the right way for once (according to the conventional view).
That already proposed why the alternate theory for fed funds and repo has become so popular. Boom times, roaring stocks, and a Powell Fed more determined to snuff out what it said were widespread inflation pressures. Illiquid markets didn’t fit the profile, therefore EFF must be some technical matter no one should take seriously.
The FOMC sure didn’t. Dismissing it for months, by June 2018 the Committee finally did…something. They made a “technical adjustment” to IOER, moving it down 5 bps from where it had been relative to the fed funds range (upper bound). Not for nothing, the very day that happened the eurodollar futures curve inverted for the first time.
It was the Fed saying nothing to see here, a minor adjustment no one should bother to care about. And eurodollar futures answering back how there was going to be rate cuts in 2019, just as a start.
As we’ve progressed into and through 2019, the repo issue has been completely cleared up. Not in the mainstream, mind you; the financial press and Jay Powell are still talking about fiscal deficits and dealers. One reason they are is that dealers have absolutely loaded up on UST’s, they have backed up the truck and have taken on a record amount (by far). That part is true.
But while that may sound like it proves the point, in reality it thoroughly disproves it. What dealers are doing this year is an extension of what happened on May 29 as well as the inversion in eurodollar futures which followed a mere two weeks later.
It all revolves around a very simple question: are dealers being stuck holding Treasuries, unwillingly forced to finance them in repo and causing all these problems; or, are dealers choosing to hold so many Treasuries, knowing full well the costs of doing so in repo as well as the greater lost opportunity as yields fall further and further?
How do we tell which one is right? Easy. The market has definitively made the determination for us. I wrote in early August, in the immediate aftermath of Powell’s first rate cut (not one-and-done, after all):
“To believe in this convoluted theory, you are asked to believe that primary dealers whose entire job is to find buyers for Treasuries are disrupting repo markets and other funding mechanisms because they can’t find enough buyers for Treasuries during a time when there is otherwise so much demand for Treasuries it has upended the natural order of curves everywhere.”
Take, for example, the 4-week Treasury bill. On Thursday and Friday last week, it yielded (equivalent) only 1.99% on both days. The 2-month bill was 1.97% and 1.98%, respectively. On the surface, it doesn’t seem like a big deal. But remember that the reverse repo rate, the RRP, which is one of the Fed’s money alternatives, had been set at 2% as a floor.
What it means as a floor is financial firms are given another set of options. In this case, T-bills are a money alternative to RRP. As such, there should never be an instance where they would yield less. Why would any firm choose to lend money to the US government by buying a T-bill at 1.99% when they can “lend” to the Federal Reserve also collateralized by a US government security (that’s what reverse repo means) at 2%? The spread may be small, but it is the market saying there is serious demand for the bills, so much it is willing to take a little less in profit to hold them.
This is not the first time we’ve seen this, either. In fact, you can go back to the early months of 2017 long before EFF, IOER, and Trump’s-tax-reform-is-to-blame and you will see many days and weeks of the same thing – bill rates dropping below the RRP “floor.” The most egregious was June 23, 2017, when the 4-week rate priced a stunning 24 bps underneath.
What that said in early 2017 was that there was a collateral shortage. Yep, repo is the reason for heightened demand for securities compared to the Fed’s money alternatives. An ongoing one, yes, since in many ways this remains the big problem leftover from the 2008 crisis. But in the specific context of 2017 and that reflationary period, those bill rates showed the shortage had become more acute.
But if that was so, and it was, why didn’t it derail everything back then? This is again where we leave evidence and fall into interpretation (only to come back to evidence again in 2019). What was likely to have happened was the global eurodollar banking system responded to the shortage of Treasuries in 2017 by manufacturing collateral.
It was “globally synchronized growth”, after all, and many really believed that worldwide recovery was at hand. Therefore, much, much lower risks because meaningful economic growth reduces the chances of something serious going wrong. On that premise, it isn’t hard to imagine at least some global banks plunging back into the world of securities lending betting on the positive economic scenario.
You want to speculate on junk corporates issued by some company in Brazil? You can’t go to the repo market to fund that position because the repo market won’t take it. But you might be able to go to one of these more optimistic dealer banks and “borrow” some Treasuries putting up your junk as collateral for the transformation. The more willing the dealers, the more this goes on (and the cheaper it gets).
It’s the same sort of thing AIG did in the precrisis era which eventually led to its bailout (it wasn’t credit default swaps which nearly brought the company down, it was securities lending of just this type). In other words, banks engaging in these transactions know what the true downside looks like. They must not have believed there was much downside given, again, “globally synchronized growth.”
But what if that proved to be nothing more than a bumper sticker slogan? Now you begin to see the early months of 2018 very differently. If you are a dealer bank who had been involved in especially Eurobond tranformations throughout 2017 as a bypass of the Treasury shortage, then you scale back if not stop the transformations and bring the system back to…the Treasury shortage.
Not only that, if you are a dealer who was engaged in this kind of risky (really, stupid) behavior throughout 2017, binging on transformation of Argentine, Brazilian, Chinese junk, you are going to set about cleaning up your act in early 2018 as it looks like things are starting to go the wrong way. The further 2018 went on, the more wrong, the cleaner your act.
Nobody wants to be the next AIG. Cleaning up your act means taking on less risk, doing less monetary things.
The rising dollar beginning in April 2018 was the global marketplace signaling this was going on. Therefore, May 29 followed in close succession (a collateral event). Eurodollar futures a few weeks after that (pricing for the consequences). Then full-blown yield curve implosion another five months further down the road (widespread acceptance of this as the new base case), all while Powell was still hiking rates and congratulating himself on the unflinchingly strong economy.
With all that long in the past, overtaken by more serious conditions, what does the Fed do this week? Overnight repo operations which had very little if any effect, a fourth adjustment to IOER, and a first one for the RRP. After having the bill market embarrass their “floor” time and again, the FOMC voted Wednesday to just move the floor.
In other words, no serious attempt to gain a sense of what is actually going wrong. In one sense, it’s because they don’t still believe there is much that is wrong (some things will never change). Not only is Powell sticking with his story about dealers stuck with inventory, policymakers and Economists don’t understand bonds anyway, he told the assembled press on Wednesday this week’s funding pressures:
“They have no implications for the economy or the stance of monetary policy.”
Are you sure though, Jay? If we’ve wanted to know where the dealers are in all this, it is clear after this week they are preoccupied by something else such that there is very little the central bank can do about it when they refuse to come to market. That seems substantial.
When we first started talking and writing about fed funds and IOER it was all epic boom, unemployment rate, and a surefire inflationary breakout. Rate hikes and more, heading into normalcy for the first time in a decade.
As those same pressures have only escalated despite the denials, ridiculous explanations, and plethora of claimed technical factors and constant stream of technical adjustments, it has been nothing but rate cuts, growing concerns and economic questions, and so much that resembles again all the bad things about the last twelve years.
Something sure changed between then and now, and it was because the one thing that didn’t was how we are still talking about fed funds. The Fed needs fed funds to signal only what it wants. Instead, fed funds is very clearly declaring how they really have no idea what they are doing.