Quantitative Teasing

The Great Financial Tightening has thrown the global monetary system into disarray, prompting large interventions by financial leaders. Markets perceived their response as a pivot, but it was merely a stopgap. Another “hard landing” now awaits us.

Ever since the great financial crisis in 2008, the system has been sculpted not by sound pre-planning of monetary policy, but by a series of experiments created during a myriad of crises. The response to the latest banking panic was just a taster of the Fed’s financial alchemy. Only four years ago in September 2019, the most relevant episode to today’s fiasco hit our screens. The repo market, where parties borrow short-term cash against collateral (usually Treasuries or state-issued mortgage-backed securities) broke down in spectacular fashion.

At the start of 2019, the rate earned for lending in repo, SOFR (the Secured Overnight Indexed Rate), began to rise above the interest rate banks earned on their reserves: IOER (Interest on Excess Reserves) — now called IORB (Interest on Reserve Balances). The banks piled into the repo market, fast becoming prominent lenders in the most systemically important market globally.

Then in September, the private sector sent a large number of corporate tax payments to the American government, sucking liquidity from the banking system into the U.S. Treasury’s coffers. Meanwhile, banks, now major lenders in repo, had to also absorb a large issuance of Treasuries. What could go wrong?

A lot, it seemed. Only a day later, the Fed’s primary interest rate, Federal Funds, suddenly shot above its intended target range. At the same time, SOFR indicated that rates in repo had soared to over a whopping 5%. The Fed saw no other choice but to act swiftly and intervene.

Facing a crisis, while unsure of a genuine cause, the Fed initiated yet another round of quantitative easing (QE), plus a series of overnight and “term” repos (jargon for loans extended over a fixed period of time) to push the Fed Funds rate back within its target range. They succeeded.

The Fed jamming $53 billion into the system caused a rapid decline in money market rates. By simply offering cash to primary dealers — a group of banks and securities firms — at the cheapest price possible, the Fed stemmed the crisis and thwarted further contagion. These actions went on to become the basis for a “temporary” — meaning permanent — tool to prevent recurrences: the Standing Repo Facility, or SRF.

The SRF would join forces with another creation of the Fed: the Reserve Repo Facility (RRP) introduced in 2013, which has gained much attention lately. While the SRF was meant to prevent rates from rising above the Fed’s target range, the RRP would defend the floor by offering an optimal risk-free rate, out-competing lower private sector alternatives.

Markets, however, always find a way to disobey the Fed. Back in late-2015, as a Credit Suisse report illustrated, the market not only drove Treasury yields below the Fed’s target range but into negative territory. The RRP’s floor grew more than “leaky”.

After the floor was breached numerous times, the Fed nevertheless stated it would phase out the RRP after it was “no longer needed” to stop rates from misbehaving. But markets are complex systems. Today, the RRP not only remains in operation but holds over $2.2 trillion in outstanding transactions.

Since the 2019 repo blowup, the Fed had assembled all the tools necessary to keep money markets rates firmly within its target range. From then on, the potential for further mishaps, and fresh alchemy from monetary leaders, lay elsewhere. Then, the bank run hysteria, a mix of miscommunication, inexperience, and excess, emerged out of nowhere. A run on Silicon Valley Bank led to a run on regional banks, which only swift intervention could prevent. It was time for monetary alchemists to fire up the lab once again…

This time, they didn’t disappoint, implementing the biggest stopgap since the COVID market turmoil. Depositors at various banks were directly and indirectly bailed out by numerous agencies, as the narrative turned from “Not Bailouts” to “Not QE” to “Not Easing”. Panic even spread to Europe, with Credit Suisse finally calling it quits, prompting U.S. authorities to provide nations — at least ones in its good books — with an unlimited supply of dollars via swap lines, stifling any contagion.

Even one of the Fed’s less favored tools, the FIMA (Foreign and International Monetary Authorities) repo facility, was tapped to its $60 billion limit by an unknown user. This was presumably the Swiss central bank wanting to stay in stealth mode or the Chinese, who have no access to swap lines.

https://twitter.com/FedGuy12/status/1639008118456852492

On top of all the other interventions by U.S. authorities, the Fed also created one of its most intricate facilities yet: the Bank Term Funding Program, or BTFP — and not to be confused with BTFD. The longstanding theme of the Fed’s “crisis responses” evolving into monetary policy appeared intact.

The BTFP’s purpose was, first, to revive confidence in the banking system by letting the banks and the general public know the Fed had their back. Second, it allowed banks to continue their day-to-day business (.i.e processing deposit outflows) without becoming insolvent. Struggling entities now only needed to pledge, not sell, distressed securities. The Fed accepted any collateral used in its usual open market operations, like Treasuries and MBS, but offered cash equal to the full (par) value, not market value. It’s like rate hikes never happened.

Markets quickly perceived this as the Fed initiating another round of quantitative easing (QE), the Fed’s mechanism for injecting the most liquidity into the system. In reality, however, it’s far from it. With QE, the Fed buys bonds and issues reserves to pay for them. This was different.

Quantitative Tightening, or QT, is still underway today. The Fed hasn’t bought bonds outright and is (at least) trying to lower the size of the balance sheet. The sudden pop in assets reflects an attempt to paper over cracks while the Fed keeps tightening. This is not QT but Quantitative Teasing.

In the Quantitative Teasing era, the Fed will provide the minimal amount of liquidity and easing possible to quash anything that threatens their ability to maintain a tightening stance and avoid “pivoting” .i.e lowering rates and pausing QT. The BTFP is the ideal tool to achieve this.

In a BTFP transaction, the Fed increases the level of bank reserves in the system and sends them to the struggling bank’s reserve account, while the bank sends securities to the Fed via the Fedwire Securities Service (FSS). But at the end of the loan, the Fed sends the security back and destroys the associated reserves. Like with a normal repo transaction (see below) conducted in the $4 trillion daily private markets, a cash borrower pledges “eligible collateral” to receive funds from a cash lender. Yet at no point does the lender, or in this scenario, the Fed, fully buy the bond. This is the key difference.

As the Bank of England illustrates, central banks conducting repo transactions does boost liquidity but has minimal impact on (and provides no liquidity to) the real economy. Genuine QE, the outright purchases of bonds, boosts real economic activity — though somewhat modestly.

When QE was initially devised, the idea was that the Fed buying bonds would remove duration from the market, subsequently pumping asset prices and forcing consumers to feel richer and consume. In reality, though, QE tended to pump asset prices rather than spur the real economy.

Compared to QE, the BTFP facility will have less of a stimulative impact. The cash the Fed provides to struggling entities will be used to fund “deposit outflows”, where their very own customers withdraw money to other banks or, worse, to money market funds (MMFs).

Small banks are also likely to be deleveraging when taking on BTFP loans, while the big banks (sometimes even the recipients of the small banks’ deposit outflows) will likely tighten lending. Plus, they will be paying a premium (4.79%) to watch their liquidity wane further. In fact, the only big beneficiaries of BTFP will be entities that took advantage of arbitrage opportunities, like borrowing from the BTFP facility, buying callable bonds, profiting from the spread, and exiting the trade at the first sign of trouble, with little repercussions.

Despite the BTFP being Quantitative Teasing, markets perceived the Fed’s response as a full-blown round of QE. When the words “bailout”, “liquidity”, and “easing” appeared on Bloomberg, stocks rallied along with yields — which, funnily enough, tend to rise — not fall as anticipated — during QE.

Just because the Fed’s actions weren’t traditional easing, however, that didn’t prevent a bullish message from being sent to risk assets. After all, it’s not whether you understand QE’s mechanics, it’s what the crowd believes to be true. And the herd deemed another driver much more influential.

The BTFD sent a signal to markets that central banks might not only grow more accommodative but suppress interest rate risk. The notion that the Fed was now willing to backstop (even some) duration was all it took to fuel a short-term meltup. Other assets joined in swiftly.

https://twitter.com/concodanomics/status/1635998075075325953

The bank bailouts were seen as a replay of the Bank of England’s bond market intervention, but with less effectiveness. Those who recognized this dynamic outperformed those who bet solely on the mechanics of the Fed’s actions. This wasn’t a pivot, but it was stimulative regardless.

Money markets, which tend to thrive on lower bond volatility, were once again encouraged to extend funding and credit. Decreased bid and ask spreads increased liquidity for market makers and securities dealers. The effects then rippled into stocks. Lower bond volatility prompted lower stock market volatility, prompting price-insensitive entities (those who don’t care about price) to start buying equities. Multiple entities, meanwhile, were likely caught short. What’s more, the huge ~0.7% decline in Treasury yields caused major rebalancing from bonds into stocks. Retirement funds (like target-date funds) will have been selling bonds and buying equities. Entities like “volatility control” funds, which buy stocks solely because volatility falls, will have joined in too.

Liquidity proxies such as gold and bitcoin have also soared, while the U.S. Dollar (which usually spikes during a panic) has weakened. Even the cross-currency basis, the best dollar stress signal, barely declined, revealing no shortage. A liquidity squeeze is currently absent.

But that’s soon about to change. Liquidity and animal spirits remain on a knife edge, while the sheer power of flows has moved asset prices upwards. A battle between price-insensitive buyers and bearish financial actors has been playing out in full force, but it’s about to conclude.

The Great Financial Tightening, as Concoda calls it, has merely been delayed. Once the might of the U.S. consumer is unleashed, inflation will force the Fed to engineer tighter financial conditions, unless another liquidity crunch doesn’t do it for them. The recent banking panic and the Fed’s response to it reveal a pivot is now fully off the table. Monetary authorities will do everything in their power to maintain order during further tightening without reversing course, and the most likely outcome is a hard landing.