Fed activities in repo markets are growing. They have already expanded their balance sheet by $335 billion since the beginning of September and the party is just getting started. Former Fed repo expert Zoltan Pozsar, now at Credit Suisse, warns that major banks are heavily overweight in US Treasuries and underweight in excess reserve deposits at the Fed. The result is likely to be a major liquidity squeeze over the December year-end, with the Fed balance sheet expected to expand to more than $4.5 trillion by mid-January – a total injection of close to $750 billion in little more than 3 months!
Pozsar is critical of the Fed’s strategy, warning that purchases of short-term T-bills (done to avoid flattening the yield curve) will not solve the problem as the banks need to sell longer-term Treasuries in order to improve liquidity. Current operations have failed to lift excess reserves on deposit at the Fed.
The result, according to Pozsar, is that the Fed may be forced to commence QE4 — purchasing longer-term Treasuries despite its reluctance to do so. The alternative could be far worse:
“….the dismal liquidity situation within the US commercial bank sector is so dire, that the shortage of reserves will start a cascade of liquidations beginning in the FX swap market, progressing to Treasurys, and culminating in stocks… and a full-blown market crash.”
Underlying the repo crisis are the usual suspects, according to Zero Hedge:
….massively levered hedge funds engaging in Treasury relative value trades (think of these as a modern twist on the LTCM trade)
“High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” was a key factor behind the chaos according to Claudio Borio at the BIS.
The BIS’s finding was novel, and surprising, as it highlighted the “growing clout of hedge funds in the repo market” echoing something we pointed out one year ago: hedge funds such as Millennium, Citadel and Point 72 are not only active in the repo market, they are also the most heavily leveraged multi-strat funds in the world, taking something like $20-$30 billion and levering it up to $200 billion. They achieve said leverage using repo.
As baseball icon Yogi Berra said:
“It’s like deja-vu, all over again.”