Chairman Powell Is Absolutely Right That This Sure Isn't Stimulus

Chairman Powell Is Absolutely Right That This Sure Isn't Stimulus
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Don’t call it QE. Seriously, don’t. It’s not quantitative easing. Even though central bank officials are right now working out the quantities, one thing we know for sure is that it won’t be easing. In a lot of ways, whatever this new-fangled balance sheet expansion turns out to look like, it has the potential to be worse than its predecessors.

Before getting to that we need to take a step back. Several steps back, actually. If only policymakers would, too. We need to examine the role of bank reserves (again, I know).

The very last week in 2006, the Federal Reserve reported on its balance sheet that what remained after adding up all its assets and subtracting every cent of its absorbing factors was $6.867 billion in bank reserves. Less than $10 billion for a system at the time blowing asset bubbles all over the planet. Multi-trillion dollar funding markets on top of tens of trillions in credit.

And for all of it, a pittance in bank reserves.

Liquidity, money supply, elasticity; none of those terms applied to them. The repo market functioned very well, obviously, as did federal funds and unsecured eurodollar interbank relationships. They didn’t need the Fed’s “money” because the private and global banking network supplied what was needed, when it was needed, how it was needed.

That last dimension may be the most important one, and also the least understandable and relatable.

It means that what passes for “liquidity” and even money itself can take on different formats. Does a reserve “currency” supply the medium for exchange when the medium demanded is very different from currency? It’s not stacks of cash, meaning Federal Reserve Notes, that get boarded on an airplane and moved from one physical location to another. There are no pallets of gold bullion accompanied by an army of armed guards being shipped all over the planet.

There’s no need.

If Bank A in Singapore wants to settle with Bank B in Liechtenstein via a currency and basis swap in lieu of real money and currency, then any system that will allow such settlement will end up taking over. And that’s just what happened a very long time ago, all the way back in the fifties and sixties.

And that is why there were no bank reserves. They just weren’t needed. The global system didn’t require the Fed to create a virtual clearinghouse certificate, which is all bank reserves can be on their best day, because it supplied its own various currency types in overabundance.  

When it stopped supplying its own liquidity, that’s when the central bank stepped in. Tried to, anyway. A monetary response to a monetary crisis, except what the central bank was offering wasn’t money. At least not in the way the system required. It was the wrong kind of clearinghouse certificate.

But that’s not how the history of 2008 has been written. You’ve been told instead that the Fed printed base money through quantitative easing. It bought assets from banks, expanding the balance on its asset side, and therefore leaving a much larger remainder on the other side of its balance sheet. Those bank reserves. Trillions of them.

You should already be able to tell the difference. QE wasn’t money printing; it was an asset swap. It took one asset from banks, securities either UST or MBS, and replaced them with these reserves (getting paid a much lower rate, IOER). In some very important ways, the end result was degradation – the very answer to the Fed’s inflation problem.

That’s why despite the creation of more than $1.6 trillion of so-called base money bank reserves to that point an unforeseen second liquidity crisis struck in 2011, a mere two years after the end of the unforeseen first one. Policymakers during this second event were just as dumbstruck as they had been during the previous eruption.

“MR. SACK. Can I add a comment? In terms of your question about reserves, as I noted in the briefing, we are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we’ve seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.”

What authorities took away from that second crisis, eventually, was that $1.6 trillion must not have been enough. It was, for them, always the issue of quantity. That’s why officials opted for two more QE’s the following year in order to create even more. They never considered form or type. Meaning, the quantity of reserves wasn’t the relevant factor. The problem was the bank reserves themselves regardless of the amount.

And that’s where we are again today. After what happened in the middle of September, this repo rumble, our central bankers have decided that once again there must not be enough bank reserves. They now say that’s the reason why banks sat idle while money rates skyrocketed during a seasonal low point everyone and their brother knew was coming.

In order to correct it, the level of bank reserves is going to be increased – but not via QE.

Another term for QE in the central bank lexicon is LSAP, or large scale asset purchase. That’s pretty straightforward as far as how these names usually go; any central bank undertaking it is going to be buying a lot of assets. The part left out of the label is why, or the intent behind the large scale.

A central bank will go big because it wants to stimulate the financial system and therefore the economy. Policymakers really want you and more so your boss at work to believe that it is stimulus, that it is money printing, regardless of whether it is or not. If you believe that, and so does your boss, then it is expected that you will spend, and your boss will hire and invest, more today than either you or they would have otherwise.

Inflation expectations.

What Jay Powell has announced recently is a small scale asset purchase, an SSAP. They are still going to be buying assets like before during the QE’s, but only just “enough” as might be required to make sure September’s repo rumble can’t be repeated. The level of bank reserves will therefore adjust to the magic right number. Implicit in the idea is that authorities know what that is.

In order to emphasize the point to you and your boss, Powell has indicated that whatever this program will be called it won’t be buying US Treasury bonds and notes. No long end securities whatsoever. The reason given so far is that in the public mind the public associates lower long-term interest rates with that stimulus. He doesn’t want that.

But since that will prevent the Fed from buying longer-dated US Treasuries, it has to buy something in order to raise the level of assets so as to raise the amount of bank reserves (still the asset swap) up to that magic number. To solve that problem, the Wall Street Journal reports officials will focus their purchases in the bill market.

“Rather than purchase longer-dated securities, Mr. Powell said officials are now contemplating buying shorter-dated Treasury bills. Officials believe holding long-term securities boosts the economy and financial markets by lowering long-term rates and driving investors into stocks and bonds. They think a portfolio weighted toward shorter-term securities provides less or no stimulus.”

Our central bankers think those things, or think you think those things, even though none of them are actually true. Lower long-term rates especially over long periods of time do not associate with positive economic conditions and developments. They relate instead only to periods of tight money (interest rate fallacy). Such “trivia” as to how things actually work doesn’t matter to policymakers. It’s all expectations here.

As is the focus on bills for other reasons. One other stab at an explanation for what’s going on in repo has been that dealer banks in the US are being stuck holding too many of them. The federal government’s tax reform led to increased deficits which, in the alleged absence of more foreign buyers, means primary dealers are required by law to buy however much more remains at each auction.

Since bills are used as primary collateral in the repo market and positions are funded there, several commentators have speculated (importantly ignoring every last bit of price behavior) that because primary dealers are holding so many T-bills that also must be a primary cause of the repo illiquidity in the first place.

Combined, the system has supposedly been dealing with increased demand for funding due to these “too many” Treasury bills alongside too little supply of money, these “too few” bank reserves. Mid-September was the eventual collision of those two trends.

Looking at it this way, what the Fed has so far announced would appear to tackle both sides of what is definitely an imbalance. The level of bank reserves is about to go up because the number of T-bills in possession of primary dealers will be going down. Demand for funds falls while the supply of “money” rises. Problem solved.

In addition, because, as Jay Powell says, the economy doesn’t need any stimulus, it is doing just fine, none of this is QE. It isn’t stimulus, just another technical adjustment on the road to normalcy. Three birds with one SSAP stone.

What could possibly go wrong?

Over here in reality, the Fed will be simultaneously increasing the level of irrelevant bank reserves, removing top-notch T-bill collateral dealers don’t want to part with, all while not appearing to stimulate an economy quite badly in need of some kind of actual aid.

Strikes one through three?

The real danger is in swapping T-bills for bank reserves. The latter has no place in repo, nor, really, as a replacement for repo. The former, however, are the best of the best, the most pristine of pristine repo collateral.

Treasury bills occupy the slot at the very top of the list. They are all on-the-run meaning they are all dependably liquid and since they are short maturity instruments they don’t exhibit much intraday volatility. They hit all the sweet spots the repo market is looking for as ideal collateral.

And now Jay Powell wants to remove perhaps a lot of them from circulation even though dealers don’t really want to sell what they’ve got. That’s the price speaking, not me. Right now, it costs you more to fund a bill in repo than it rewards you in equivalent yield. With that kind of negative carry, you get rid of it. If you don’t, then it’s because there is some other utility worth paying what is essentially a liquidity premium.

The fact, yes, fact, that they don’t sell them is an undeniable indication that they don’t want to sell them. They aren’t being forced by the law into doing something harmful at their and the system’s expense, they are choosing to absorb the growing cost in order to face up to some other factor within that system.

What other factor?

This gets back to the nature of the private, global liquidity system. Collateral has been a key part because the repo market always has been a key part of its evolution and development. The original missing money of the missing money seventies.

When there were no bank reserves, it wasn’t just the cash side of repo that fed the concept of “liquidity.” There also had to be collateral on the other side that the interbank market would easily and fluidly accept. Liquidity, in this modern sense, is much more complicated than outdated concepts of cash and bank reserves (as far as the banking system goes).

Collateral can, and has, exhibited its own currency-like behavior. The Global Financial Crisis was a perfect example of this: repo fails skyrocketed just before Bear as well as just after Lehman, the very moment the whole system was in the throes of its worst meltdown. What that meant was elasticity, or inelasticity, but of collateral as much as “cash.”

In other words, repo fails said that interbank counterparties would rather keep the best kinds of collateral than get back the cash that they technically lent out. And this was during an actual honest-to-goodness monetary panic. Collateral more than cash. A new way to look at currency elasticity; collateral inelasticity.

There is a definite multiplier effect. During the precrisis era as well as these brief reflationary periods in between post-crisis liquidity problems, collateral supply becomes more elastic as dealer banks take on more risks in lending, expanding, and transforming the list of systemically eligible collateral. To oversimplify, collateral becomes more available at the same stroke of the same bookkeepers’ pen.

It’s often done imprudently. That was certainly the case before 2007, with so many questionable (and functionally illiquid) securities being accepted in repo on terms they never should have been given. There was also a lot of transformation taking place, hiding what might really be at the base of these collateral chains and structures.

And it was something that a few Federal Reserve officials had flagged many years ago because it was still going on. Former Governor Jeremy Stein noted in early 2013 (stick with what he’s saying):

"Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be ‘pristine'-that is, it has to be in the form of Treasury securities. However, the insurance company doesn't have any unencumbered Treasury securities available-all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade. 

"Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does-say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet."

What you take from Mr. Stein’s very vanilla example is that both the hypothetical dealer as well as the hypothetical initiating insurance company are at risk from posting junk as the basis of the transformation. As a result, what becomes most “valuable” because it has the highest utility in all circumstances is that pristine form of collateral; and that is T-bills.

If global money market participants had been expanding collateral perhaps imprudently when they thought things were going well, such as during 2017’s over-hyped globally synchronized growth, for example, what do you think they might have been doing once they realized their error? The more the global condition looks like it was an error, the greater the demand for…not bank reserves. 

A high level of demand for T-bills instead would be right at the top of the list. Not only would that mean unwinding risky collateral chains, it would also mean a high degree of dealer “shyness” on any side of any transaction. As folks say these days, pure risk-off behavior in all money markets.

But now because this prospective imbalance has become a thorny public issue, simply because the public is now aware of it, Jay Powell’s crew proposes to remove even more of the best of the best collateral so that they can give the system back some more bank reserves. Take the one thing out that’s in huge demand because it is useful while in return handing over something that’s of little use.

At least the Chairman Powell is absolutely right about one thing. This sure won’t be stimulus. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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