Tag: excess reserves on deposit

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Serious plumbing problems at the Fed

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!

S&P 500 and Fed Assets

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.

Excess Reserves on Deposit and Fed Assets

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.”

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Fed easing continues

Quantitative easing (QE3) ended in the second half of 2014 after the Fed announced it would taper asset purchases in December 2013. The graph below shows that total assets leveled off at $4.5 trillion and have been maintained at that level since.

Fed Total Assets and Excess Reserves on Deposit

But the graph also shows that the Fed continues to drip-feed the financial system by running down excess reserves on deposit from a high of $2.7 trillion in August 2014 to $2.25 trillion in August 2016.

Commercial banks are required to hold certain reserves at the Fed but in times of financial stress will deposit excess reserves at the Fed, when trust in the interbank market breaks down. The Fed commenced paying interest on reserves in October 2008 and increased the rate to 0.50% in December 2015. This has encouraged banks to retain excess reserves at the Fed where they earn a risk-free rate of 0.50%.

Fed Total Assets and Excess Reserves on Deposit

By raising or lowering the rate payable on excess reserves the Fed can attract or discourage deposits, tightening or easing the availability of funds in the interbank market. Banks have withdrawn $450 billion in excess reserves over two years, which suggests that they can achieve more attractive risk-reward ratios elsewhere. The Fed has not responded, indicating that they are happy for this back-door easing to continue.

Only when the red and blue lines in the first graph converge will the Fed have commenced monetary tightening. That still appears some way off.

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QE: The end is nigh?

I have read a number of predictions recently as to how stocks will collapse into a bear market when quantitative easing ends. The red line on the graph below shows how the Fed expanded its balance sheet by $3.5 trillion between 2008 and 2014, injecting new money into the system through acquisition of Treasuries and other government-backed securities.

Fed Assets and Excess Reserves on Deposit

Many are not aware that $2.7 trillion of that flowed straight back to the Fed, deposited by banks as excess reserves. So the net flow of new money into the system was actually a lot lower: around $0.8 trillion.

The Fed has indicated they will end bond purchases in October 2014, which means that the red line will level off at close to $4.5 trillion. If excess reserve deposits continue to grow, that would cause a net outflow of money from the system. But that is highly unlikely. Excess Reserves have been growing at a slower rate than Fed Assets for the last three quarters, as the graph of Fed Assets minus Excess Reserves shows. If that trend continues, there will be a net injection of money even though asset purchases have halted.

Fed Assets and Excess Reserves on Deposit

Interest paid on excess reserves is a powerful weapon in the hands of the FOMC. The Fed can accelerate the flow of money into the market by reducing the interest rate, forcing banks to withdraw funds on deposit in search of better returns outside the Fed. Alternatively, raising interest paid above the current 0.25% p.a. on excess reserves would have the opposite effect, attracting more deposits and slowing the flow of money into the market.

The Fed is likely to use these tools to maintain a positive flow into the market until the labor market has healed. As Janet Yellen said at Jackson Hole:

“It likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends.”

That’s Fedspeak for “Read my lips: there will be no interest rate hikes.”

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