Canary On The Repo Desk: How The Fed Is Dangerously Deforming The Money Markets

“We don’t exactly know how it will work” should be stamped upon every message coming from the policymaking apparatus from this point forward, and then retroactively applied to every message in the age of risk and rate repression. Action in short-term money markets has heated up yet again, and that is not a positive statement toward vital function.

To “exit” from monetary policy as corruptive as it has been, the FOMC and its staff believes a European-style policy framework is “needed.” It is not to be an exact replica, mind you, only the general idea borne out under decidedly American conditions and characteristics. The Fed is trying to build a rate corridor where one never existed, and I would contend never should.

Part of the reason is that the federal funds rate applies less and less to anything of any import, more a relic than a policy measure. After 2007, unsecured overnight lending has been far more of a dream than anything of operational concern, thus the vastly increased relative importance of secured wholesale finance, i.e., repo. To get from fed funds targeting to repo is not an easy leap, particularly since we are again introducing the discrepancy of dollars vs. interbank currency (where it is often difficult to discern which one is more money-like at any one point in time).

The reverse repo program was supposed to provide “aid” toward establishing a hard(er) floor for rates. It obviously failed with the persistent spikes in repo fails, which denote effective repo rates at something between 0% and -3% (and closer to the latter than the former). Collateral, that interbank currency, is not getting out of the Fed “silo” (its vast SOMA holdings) to conduct business as needed.

Back in August, some FOMC comments in this direction show just how much they rely on unproven theory:

Officials plan to use the rate of interest the Fed pays on excess reserves deposited at the central bank as the “primary tool used to move the federal funds rate into its target range” while “temporary use” of the overnight reverse repo facility will be employed to “help set a firmer floor,” according to the July FOMC meeting minutes.

“If we can move those three rates in tandem, then I think it will be pretty clear signaling to markets as to where the Fed stands and where short-term interest rates stand,” Bullard said. “We’ve never done this before, so we don’t know exactly how it will work, but I do think that we are in pretty good shape.” [emphasis added]

They already had more than a little whiff of failure in repo fails, so the statement above was already stale at the point it was issued. They can try to convince themselves that repo fails are strictly limited to the size of the short position in UST, but that is largely irrelevant – it matters not why there is demand for collateral, the only focus should be on why the “market” cannot meet said demand. If an imprint of short selling in UST, expecting rates to rise (which I don’t buy as the primary problem in repo right now, at all!), can rattle repo as it has, then that is very a concerning sign for when there is much more demand for collateral under real, true strain; a condition that is inevitable.

As if that needed reinforcement, the quarter-end at the reverse repo “window” has shocked some of these same theorists. Not only were the bids well-past the “ceiling” set in the middle of September, the tendered rates left the issue at zero, 5 bps below the supposed floor – with who knows how much bid as low as -0.2%.

Most of the commentary so far has revolved around the $300 billion cap, which the Wall Street Journal explained back when it was announced:

The daily cap also seems to suggest the Fed is mindful of rising concerns that it is becoming the dominant destination to invest cash short term, displacing private-sector financial firms.

That is certainly a significant issue, but it also highlights the inherent contradiction in the Fed’s operations right now. They don’t want to be the dominant destination, but clearly they are. Which raises perhaps the more important issue, as to why predominantly MMF’s might be bidding -0.2% to “lend” “dollars” to the Fed on a collateralized basis (hint: because someone was speculating that they could get Fed collateral and flip it out at an even more negative rate to someone else who needed the UST that badly; in other words, we almost have the situation where a MMF or some other non-bank is aggressively bidding to “lend” cash at a negative rate to the Federal Reserve in order to “borrow” cash at an even lower negative rate, all done so that some piece of UST collateral can actually become mobilized and useful instead of frustratingly idle as QE has it; why do we have serial bubbles again?). I can no longer think of this as anything but the theater of the absurd.

As another point in that projection, the general collateral rate yesterday was also negative, fully disproving, yet again, the reverse repo as an effective floor. Which brings about reminiscences of the father of all this, the great bubble-maker who turned monetary policy into soft central planning relying more and more on these kinds of esoteric and really deluded operations to maintain just the illusion of control:

One is that I don’t think we know enough about how the private financial system works under these conditions. It’s really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments – which is what we have essentially been talking about – are independent of the level of the riskless rates themselves. The answer, I’m certain, is that they are not independent. But how their dependency functions and how those spreads behaved in earlier periods is something I think we’ll need to know more about. The reason is that I don’t believe, as I said before, that we can construct an effective preemption strategy. Well, we can construct a strategy, but I’m fearful that it would not be very useful.

That was from the June 2003 FOMC transcript, where Alan Greenspan was addressing the possible downside of actually getting to the zero lower bound (“these conditions”). His candor was very much in opposition to his public persona, which was probably due to the time-delay between that discussion and its actual public release. Ben Bernanke, however, was in no shortage of confidence at that meeting, though he too speculated on what sounds an awful lot like the reverse repo problem, “…it [zero bound interest] works through mechanisms that depend on the imperfect substitutability of different assets.”

Getting it all to “unwork” is just as challenging, as he found out somewhat the hard way almost from the start with QE2’s disruption of bill supply. Substitutability was a huge problem and it did not answer as directly as he thought back in 2003 – that was the entire point of Operation Twist, to stop stripping all the bills out of the marketplace.

I said this before and I think it applies very well right now in light of these recent developments, the Fed does not know what it is doing. They don’t. They want you to think they do because that is the entire point of monetary policy to begin with. However, QE’s came with very real costs which they were willing to bear in the tradeoff of a robust economy – good and solid growth fixes many ills, inconsistencies and even downright false equivalences. That never happened, so the pressure is that much greater to maintain the message of credibility, particularly as all these markets depend so much on the “dominant destination”, Greenspan/Bernanke/Yellen.

If the system does not function as intended now, under if not ideal circumstances than certainly far from stressed, how is it going to perform under real strain and duress? Might that be a significant factor that is beginning to wind its way into the larger dollar system, the venue of the global dollar short? This bears repeating, maybe even included after the perpetual warning I asserted above, that liquidity is not what is evident right now, but what is expected when the things are really going wrong. “We don’t know exactly how it will work” is a hell of a liquidity program for that eventuality.


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