Comment

Tone deaf Fed will soon slash rates to near zero and relaunch quantitative easing

Fed illo

The US Federal Reserve has once again tightened too much. It continued to sell bonds and unwind quantitative easing (QE) on self-described “autopilot” for at least a year too long.

It brushed aside ever louder pleas for liquidity from traders and market makers working at the coal face of the financial system.

By last week this tightening process had caused usable “excess reserves” (a misnomer) held at the Fed to shrivel to barely more than $300bn, and the operative word is usable. The engine has been running on fumes.

That was the backdrop – if not the trigger – for the seizure in the overnight lending markets. Nor is it over yet. The New York Fed had to inject another $66bn on Monday.

Yes, there were technical reasons for the spike in the key repo rate from 2pc to 10pc but to dwell on details is to lose sight of the wood for the trees. Nikolaos Panigirtzoglou from JP Morgan says there are deeper causes to the money market stress than a dysfunctional repo market.

This is also the view of Simon Potter, the New York Fed’s trade desk chief sacked in May after major policy rift. He says it may take fresh QE to restore stability.

What happened is faintly reminiscent of the credit “heart attack” in August 2007 when three-month US Treasuries began behaving very strangely. Note that Wall Street carried on rising for another two months after that episode before finally rolling over.

Former Fed chairman Ben Bernanke told former colleagues – politely – in early 2017 that they should not even try to reverse QE until interest rates have risen far enough to build a safety buffer for the next recession. In a Brookings paper he said they should allow the economy to “grow into” the Fed’s $4.4 trillion balance sheet. Translation: don’t touch this nitroglycerine.    

The Fed went ahead with quantitative tightening regardless. The result is that excess reserves have fallen from a peak of $2.7 trillion in late 2014 to nearer $1.3 trillion now. JP Morgan said this has cut the ratio of bank reserves to assets from 18pc to 7.9pc, the lowest level since 2009.  This is too little to keep the financial system on an even keel given everything else going on. 

The liquidity squeeze has collided with post-crisis regulations imposed under the infamous Dodd Frank Act – of which will be hearing much more when trouble starts in earnest, since it prevents the Fed from repeating key emergency measures that averted a global depression in 2008. New rules have tied up $1 trillion of the remaining reserves. Brilliant.

It has also collided with moves by the US Treasury to rebuild its depleted account after July’s debt ceiling deal on Capitol Hill, and with a surge in corporate tax payments. The Treasury account has jumped from $112bn to $308bn over four weeks. This pace amounts to a liquidity shock. It was predictable. Don’t the Treasury and the New York Fed talk to each other?

More broadly it is colliding with Donald Trump’s fiscal deficits. Treasury issuance will be $1.2 trillion this year. This is soaking up money.

Another corner of the market known as the foreign repo pool has also gone off the rails. Foreign banks have parked some $520bn at the Fed to lock in yield of 1.8pc available – and too enticing to resist – as a result of the heavily inverted US yield curve. 

Zoltan Poszar from Credit Suisse warned last month that a “super-massive black hole” has been building up in this market. It has led to a glut of collateral. The only way to resolve this is to slash interest rates far enough to “re-steepen” the curve.

“A credit squeeze could soon develop if the Fed doesn’t act to boost reserves and steepen the yield curve out to two years,” said Steve Blitz from TS Lombard. Exactly.

It did not do this at its meeting last week. The Fed's deeply split FOMC rate-setting committee instead did the minimum: it cut by a quarter point and signalled that there would be nothing more coming this year. 

The Fed is sticking to its line that the latest cut is a precautionary action, a “mid-cycle” tweak akin to 1995 and 1998, rather than the start of a full loosening cycle. Lord help us. If this is a mid-cycle moment I will eat my straw hat. 

The Fed is a superb central bank but it has a déformation institutionelle. It tends to reads too much into lagging indicators such as the jobs market and it is tone deaf (though getting better) to the effects of dollar liquidity in a global financial system that has never been more dollarised. That is why it is repeatedly caught off guard at big turning points. 

Its “dot plots” show that five FOMC members wish to raise rates over coming meetings. This is truly heroic at a time when global trade is contracting, global capex has stalled, whole economy profits in the US are in a nose dive, Germany and Japan are sliding into recession, and the global industrial slump is beginning to infect services. 

Let me stick my neck out. Events will force the Fed to slash rates to near zero and relaunch QE on a large scale in relatively short order. 

In the meantime, expect more trouble in the repo markets, higher spreads in CCC junk bonds, and lots more CLO haircuts in the $1.4 trillion leveraged loan bubble. And be careful.

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