There's No Money To Be Made In Money Anymore

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In the wake of last September’s repo outbreak, the Federal Reserve under Chairman Jay Powell decided his institution needed to do two things simultaneously. The central bank had been caught off-guard by a good deal of criticism that it had been caught off-guard by what happened in money markets. In the era of moneyless monetary policies, where expectations are all that matter to policymakers, they just couldn’t have it.

But what to do? In any natural human setting, anyone would respond to that question by first asking another. What had been the problem?

While that may seem intuitive logic, it doesn’t apply in this context. Powell was presented with a real monetary breakdown, one that forced his major policy tool, federal funds, to very publicly break outside of its allowed range. It stands to reason that how the Fed might react would be dictated by figuring out first what had gone wrong.

Four and a half months later, officials still don’t know. This isn’t to say they haven’t provided some guesses; they have. A lot of them. Suspiciously too many.

If you were to pin down Jay Powell and ask him to explain specifically in detail what had occurred and if he answered you honestly, he would have to say he didn’t know. And that’s incredibly odd in a very profound way not the least bit of which is because the Fed’s been very, very busy since October.

There have been two main elements in the policy reply to repo. The first is temporary auctions of “liquidity”, in the form of overnight or slightly longer-term balances. Primary dealers are allowed to bid for bank reserves, created on the spot by the Fed, collateralized by three classes of securities (meaning dealers have to post collateral whose eligibility is determined by FRBNY; setup the exact same way as the Discount Window once was).

The second piece is where everyone remains focused. Is it QE? Is it not QE? Powell says it isn’t, most people think that it is. In any sane monetary context, the discussion would be moot because it doesn’t make one lick of difference in the place where it is supposed to. It only matters for other reasons.

Technically what the Fed is doing is very simple. By purchasing in this case Treasury bills from primary dealers it raises the background level of bank reserves behind whatever goes on at the front in temporary repo operations.

Thus, their plan is clear. Having no real idea what happened in repo, policymakers decided to raise the level of bank reserves. But, thinking that the increase needed to be large, they couldn’t just do it all at once. If you think people have gone bananas over the current rate of T-bill purchases, imagine the public reaction to having condensed them all into a few short weeks.

Or buying assets other than T-bills alongside.

Which, by the way, the Fed was anticipating. That’s why there are two sides, or steps, to this thing. Officials knew they couldn’t just raise the level to where they wanted it in one fell swoop. So, to calm the situation while the systemic (read: permanent) balance was gradually lifted they also thought it necessary to provide dealers with a marginal source of bank reserves should they be needed in a pinch.

In that way, they could take their time bringing the terminal level of reserves up to whatever threshold officials had in mind because they provided a substantial backstop, the “repo” interventions, along the way.

Upon reaching that threshold, both would cease. The background level of bank reserves would again be “ample”, “abundant” or whatever other term authorities will think up for them next. The short-term operations thus no longer necessary.

What Jay Powell announced this week at his latest press conference was that the FOMC doesn’t think they’re there. Not yet.

“Over the first half of this year we intend to adjust the size and pricing of repo operations as we transition away from their active use in supplying reserves. This process will take place gradually...we expect to continue offering repos at least through April.”

Originally, back in October, it was thought that by the start of 2020 they’d be close to where they needed to be. Now perhaps April. If you don’t know what went wrong in repo, then figuring out the “right” level of bank reserves isn’t going to be easy, is it?

What if the background balance for bank reserves doesn’t actually make much difference? Then, as Jay Powell, you wouldn’t know it since you’ve already decided that a higher baseline for reserves is the only answer you’re willing to consider. And if something else is going wrong in repo markets, then, in every likelihood, that balance will just rise and rise and rise.

Sort of like how there ended up being four QE’s rather than just the one. If quantitative easing had come close to living up to its name, no more than a single shot would’ve been necessary.

And, yes, there were four before now and, yes, it does matter. QE3 was announced in September 2012 as renewed purchases of MBS. QE4 was announced in December of that year targeting Treasury bonds.

The reason everyone agrees there were only three is because that’s what the Fed decided. Ben Bernanke told the public QE4 was nothing more than an extension of QE3. While this may seem like semantics, an overly pedantic interpretation of “extension”, it goes right to the larger point.

These people can’t ever seem to figure out the “right” level of bank reserves nor how fast they should get to it. And that’s the exact opposite of how we are all taught if anyone in the world knows what they are doing it is central bankers.

When things were falling apart in 2012, unexpectedly, of course, the FOMC voted in September to raise the level of bank reserves by a certain amount per month. When that proved to be insufficient – hardly anyone noticed what the repo rate was doing in October 2012 even after QE3 had begun, Bernanke did – the FOMC was forced to rethink the pace.

And it was declared open ended largely for that reason. To show the world Bernanke’s gang was serious about their bank reserves.

Why wouldn’t Ben Bernanke just call it QE4? Simple. Because admitting there had been four of them would have amounted to letting the curtain pull back just a little too far. Three was bad enough. Four? People might start to get suspicious this bank reserve, bond buying thing didn’t really work. At the very least, it didn’t work the way authorities said it would.

When all you have is a hammer…

All the Federal Reserve has in its toolkit is bank reserves. Oh, they brag and boast about the numerous ways they’ll be able to respond to the “next” recession or crisis – that’s for your benefit, not the monetary system’s. The toolkit hasn’t been used up; they say. Except all those tools are just different ways of raising the level of bank reserves.

Like Europe, they’ll buy corporate bonds. Like Japan, maybe even mutual fund shares and ETF’s; perhaps equities? Instead of MBS, they’ll purchase US Treasuries!

The difference QE4 or QE3 isn’t about the name, or what’s important about buying this asset class or that. It is how many times authorities feel it is necessary, that the economy becomes so unstable and questionable that even central bankers realize it probably needs some kind of serious intervention. How many times the central bank pulls the trigger on the level of bank reserves no matter the means.

Central bankers haven’t come to terms yet with how they aren’t serious. By counting this way, you begin to see the farce.

To that end, if you’ve been paying attention to repo (and believe me I understand if you haven’t been) the knives are out. Fingers are being pointed in all sorts of directions. If the Fed hasn’t figured it out, neither has anyone else (and, on a personal note, I can tell you people in the media and in professional settings have taken notice).

The Fed is rightly blamed for its lethargic, initial hands-off approach. Critics charge it let something that needn’t have gotten out of control becoming a very public embarrassment at a crucial moment. And they are right.

We’ve also heard about calendar facts, corporate taxes meeting quarter-end bottlenecks. Regulations, where one prominent repo watcher went on a lengthy diatribe over G-SIB and the implications of SLR buckets. A healthy dose of FX in that one. Before those, the same guy was absolutely convinced, and he convinced most of the mainstream, there had been too many Treasuries.

Over the last several months, some fault has found its way directed toward DTCC. Something called “sponsored repo.” A relatively new product, it takes tri-party repo to the next level. As with most financial innovations, it is a good idea.

Sponsored repo is a centrally cleared repo mechanism, run by the Depository Trust & Clearing Corporation, where the firm effectively matches lenders and borrowers. Cash lenders are pooled together as sort of insurance in the case where defaults might cascade.

That’s the stated purpose. Its true purpose is to benefit dealers; not that there’s anything wrong with that, and I mean that sincerely. A true repo requires a dealer to be directly involved, thereby taking up precious balance sheet space even if by some other transaction the first repo is netted out in a second one (from the dealer’s standpoint and therefore balance sheet, the first would be a reverse repo and the net a repo).

Sponsored repo via DTCC’s Fixed Income Clearing Corporation (FICC) lets dealers net out these, for lack of a better word, opposing repo trades so that the balance sheet effects when combined can be severely reduced. Collateral is matched with collateral, cash with cash, and in the event of a fail the dealer isn’t completely on the hook for the thing going wrong.

Under ideal circumstances, as described in the textbook, dealers run matched-book operations and so ideally, they shouldn’t be penalized for when that happens. That’s their argument, anyway.

In reality, it was only a matter of time before someone thought of a way to get repo on the same balance sheet footing as FX from a dealer’s perspective. The balance sheet perspective. Both are ways to fund in asset markets, with dealers providing the funding. They are not, however, treated at all the same way when it comes to balance sheet accounting and therefore very real costs.

I wrote a few months ago how you can structure an FX funding transaction as essentially the same thing as US$ repo for foreign investors. Dealers absolutely prefer the FX approach.

“But why do dealers want to do it this way rather than straight repo? Because in the FX method of funding there is practically no balance sheet cost to the dealer. Currency swaps and the whole zoo of related derivative contracts are booked as, well, derivative contracts. 

“A repo is loan; therefore, it goes on the balance sheet at par value. FX as a derivative gets booked instead by its market value, which, in almost every form of swap or forward, starts out at zero. It requires no balance sheet space initially, and over time the only way that changes is if the contract value of the swap materially shifts.”

If dealers can, through sponsored repo, offset repo transactions on their books such that the overall level is netted down to something like FX, then that whole process should only increase the funding available in repo, right?

Theoretically, yes, and DTCC’s published numbers on its program suggest that it is rising quickly. But, and here is where September supposedly comes in, they haven’t quite worked out all the kinks. According to some, including that same repo guy, sponsored repo herded everyone into overnight financing.

DTCC claims that term repo is available, it’s just not widely used on its platform. Not in time for September, anyway.

But don’t blame them, either. Regardless of term versus overnight, its program has increased repo capacity and so the net effect, a spokesman argued, must have been, and continues to be, an overall positive one.

Everyone keeps missing the point. FX, repo, sponsored repo, dealers, even bank reserves. Everything comes down to a single factor – balance sheet capacity. It is scarce. In September, for a few days, it became really scarce. Thus, dealers weren’t entering the market even in sponsored repo where it was economical and efficient to do so.

It's why Jay Powell, like Ben Bernanke before him, can’t figure out the “right” level of bank reserves. It isn’t a single target, and on whichever day during the year it depends solely upon bank balance sheet capacities on that day.

If the trend in the latter, for whatever reasons, is downward then there will be more questionable days than not. And the global economy will suffer for it.

Sponsored repo wasn’t trying to fix a problem in repo, it was invented as one possible way to do repo better under this questionable monetary environment of balance sheet, not bank reserve, scarcity. In a strange but very real way, DTCC was actually doing the Fed’s job! To get more (usable) money into the system by trying to squeeze blood (funding) from a stone (balance sheet capacity).

The interest rate in repo markets, as swap markets, or the basis in FX, all of them move based on changes in balance sheet capacity totally unrelated to the Federal Reserve.

What governs balance sheets? Most people don’t give it a second thought but of the very few who do they say regulations. That’s what has made balance sheet capacity so expensive (another way of saying scarce).

While it is true regulations have made it comparatively more costly, banks would climb all over them with their armies of lobbyists, lawyers, and accountants if they thought it worth the trouble.

That’s the difference. Before 2008, they thought it was. They knew it was. Banks raked in the revenue in these money dealing capacities, which is also called FICC (fixed income, currency, commodities). Contrary to popular belief, there were lots of “onerous” regulations in the pre-crisis era, too.

Basel 3 isn’t something new, it was meant to put a lid on global banks the same as Basel 1 and Basel 2. Just updated for all the ways in which those banks had so easily and mercilessly thwarted them (leverage vs. capital).

No, what’s changed is pure finance. Risk versus return. There’s no money to be made in money anymore; the risks too great (the lesson of Bear Stearns), the rewards never enough. Regulations only tip the scale a little further in the way it has already gone. The pendulum has swung too far in the other direction, and, no thanks to the Fed, it isn’t coming back soon enough.

Primary among these obsessive post-crisis risks?  Liquidity. Doesn’t matter the level of bank reserves, we still end up talking about it because the Fed doesn’t know what else to do when confronted by the same problem time and time and time again. The balance sheet problem.

It’s what vexed Ben Bernanke in the fall of 2012, it’s what favors FX, led the system to sponsored repo, and ultimately to both September’s repo rumble as well as the current globally synchronized downturn.

That is how you end up with four, make it five QE’s. 

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

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