Although Chair Powell may feel that current monetary policy is in a “good place”, the Fed will still be busy this holiday season monitoring the market in which they use to set the stance of policy: the short-term funding market. As we approach year-end, we want to re-visit the drivers of the September funding saga where borrowing rates in the repo market (secured short-term loans backed by Treasuries) spiked to ~10%. When reviewing the factors that contributed to the dislocation at the end of Q3, it is clear that the problem was caused by not one sole factor alone. While the exacerbating factor may have been idiosyncratic in nature, there are a few important structural challenges in the market which have been underlying contributors to funding dislocations.

Contributing factors:

• Bank Reserve Scarcity:
  • As the Fed has reduced its balance sheet through the process of normalization, the amount of reserves in the overall banking system has declined by over $1 trillion since the end of 2015 and currently stands around $1.4 trillion. Reserves are an efficient way for banks to meet regulatory requirements which have been codified in the post-crisis regime to ensure a high level of protection in the event of an economic downturn and elevated loan losses.  If there are insufficient funds in the banking system, the banking system is more prone to liquidity events.  Currently, while we believe there is not sufficient evidence to say reserves are truly scarce, reserves have declined substantially, thus making the system more susceptible to idiosyncratic liquidity crunches.
• Idiosyncratic Factors:
  • These factors relate to temporary drains on liquidity. For instance, when the Treasury decides to increase its cash holdings through the Treasury General Account (TGA) at the Fed, that additional cash for the Treasury is a drain on reserves for the banking system. In September, the TGA increased by $250B which represented a 15% reduction in total reserves during the month. Increasing participation in the Fed’s foreign bank reverse repo facility has also reduced reserves.  Finally, annual corporate tax payments due in September also drained cash from the system (which is reflected in the TGA balance).
• Distributional Issues:
  • The banks that hold the lion’s share of the excess reserves in the system are the same banks constrained by the current regulatory framework and how that framework treats interbank lending. In the past, the interbank markets would have allowed for efficient distribution of excess reserves to flow from those with extra reserves to those that need them.  Today this is not the case. The regulatory costs associated with the distribution function are prohibitive and capital intensive. Outside of the banking system, the dealer intermediaries are also regulatory constrained, so excess cash from money markets and other pools of liquidity cannot be fully distributed to banks and investors that require it.  In addition, dealer balance sheets are constrained by the growing fiscal deficits.  The growing fiscal deficit results in dealers having to increasingly warehouse Treasuries in order to maintain market liquidity. This increased Treasury inventory comes at the expense of other balance sheet intensive activities (such as repo). Research at the NY Fed has identified the challenges with high concentration of reserves and its ability to cause funding dislocations but has not formally identified a solution as it pertains to regulation[1].
• Regulation:
  • The funding stresses experienced in September had elements of all three factors highlighted above, though the underlying constraint appears to be regulatory.  The various regulatory rules (LCR, SLR, CCAR, GSIB) serve as binding constraints to different parts of the intermediation process which limit distributional efficiencies and allows for idiosyncratic factors to have a disproportionate impact.

The Fed has responded to the stresses in September in a few different ways. We believe some solutions will be more successful than others in addressing the contributing factors listed above.

The Fed’s Response:

• Temporary Repo Programs:
  • The Fed has introduced temporary repo facilities aimed at adding reserves to the system. These temporary repo programs (both overnight and term programs) were effective in stemming the funding volatility in September and have been expanded to address year-end concerns. However, given the limited availability of the repo programs (the participants are limited to primary dealers) as well as the distributional and regulatory issues discussed above, these programs can only go so far in improving liquidity if those who participate in the program aren’t willing to intermediate to others in the financial system that need cash.
• Balance Sheet Expansion:
  • More importantly, the Fed also announced they would be expanding their balance sheet through the purchase of Treasury bills currently at a pace by $60bln per month between October 2019 and Q2 2020. In total, this could add upwards of $300bln to reserves.  These actions go a long way to addressing the Reserve Scarcity issue highlighted above.  However, if the issues in the funding market are distributional and regulatory as we suspect, increasing the Fed’s balance sheet by purchasing securities and adding reserves via Repo with primary dealers will not address the issue of liquidity crunches outside the large banks.
    
    
  • Some have questioned if the Fed’s purchase program constitutes as QE. Given the constraints we highlighted above, we do not believe purchases of cash substitutes are equivalent to the QE experience of 2009-2014 when the Fed conducted large scale asset purchases.  More specifically, since the Fed is buying short-term paper it means they are not removing duration from the system and less likely to influence the portfolio rebalancing channel. This should limit the impact on term premium and thus the knock on impact to risk assets through lower long-term funding rates and a reach for yield. What these bill purchases have done is reduce the downside risk that liquidity becomes a disruptive influence on broader markets.

So where does this leave us as we head into year-end? We think the Fed’s actions have assuaged some concerns about short-term funding but risks still remain.

What to watch in December:

• Contained versus Disruptive?
  • As in years past, funding costs are inevitably going to rise over year-end. The key is to monitor if the funding stresses are contained or become more systemic. Despite the shockingly high print on repo in September, the stresses were relatively well-contained to one corner of the market (the secured short-term funding market) while other markets such as dollar FX lending (as exemplified by the cross currency basis market) and unsecured funding (such as commercial paper rates for foreign banks) were left relatively unscathed. If funding stresses are becoming systemic, it could cause a sharp rise in LIBOR or a spike in dollar funding costs which could result in more meaningful implications for the broader market. However in that case, the Fed would likely step in and get even more aggressive with their response ultimately providing a backstop.

For now, the Fed can relax in the comfort of monetary policy being in a “good place” but they must remain on high alert as it pertains to funding markets during the festive winter season.

[1] https://libertystreeteconomics.newyorkfed.org/2018/07/size-is-not-all-distribution-of-bank-reserves-and-fed-funds-dynamics.html