Major Window Dressing Exercises and a Dead Federal Funds Market

Many of our readers are probably aware of the quarterly spike in reverse repos, which has previously been amply documented and discussed elsewhere. The Fed has introduced these overnight reverse repos two years ago, and has made them accessible to a wide range of counterparties (altogether 163 at last count), including banks, primary dealers, mutual funds, brokers and GSEs. In these transactions the counterparties are essentially depositing cash with the Fed overnight in exchange for treasury securities.

 

defying gravityPhoto via izismile.com

 

The Fed’s counterparties receive interest rather than having to pay interest (currently 25 basis points) when borrowing treasuries in these transactions. By setting the rate it pays at a higher level than the rate on short term t-bills, the Fed encourages participation. The reason for introducing the facility was that the Fed wanted to test various “exit” procedures from its extraordinary monetary accommodation.

 

SingThe flow of money and securities in repo markets, from a 2013 IMF working paper by Manmohan Singh

 

Reverse repos will temporarily withdraw liquidity from the financial system, which will ceteris paribus tend to put upward pressure on short term market interest rates. Here is what has happened since the facility was introduced:

 

reverse reposOn December 31, overnight reverse repo transactions with the Fed spiked to a record $475 billion. The green line is the general collateral repo rate (more on this further below) – click to enlarge.

 

At the same time, the repos are supposed to relieve shortages of high quality collateral, which have reportedly become a problem as the Fed’s QE programs have lowered the amount of treasury bonds available for trading and swapping. Originally capped at a maximum of $300 billion, the RR facility has been expanded to a maximum of $2 trillion after the rate hike of December 16, which seemingly underscores its primary function as a tool to remove excess liquidity.

We have so far not commented on the occasional spikes in repo transactions. It seemed obvious that they were connected to some sort of window-dressing exercise, given their regular month-end and quarter-end timing, but we never gave the topic much thought (except for concluding that no effect on the money supply was to be expected).

Something slightly curious happened at the end of the fourth quarter though. Apart from overnight reverse repo transactions reaching a record high, the federal funds rate apparently nosedived from 35 basis points to just 12 basis points on December 31, way below the Fed’s target range, while the general collateral repo rate concurrently spiked to a multi-year high:

short term ratesEffective FF rate and GCF repo rate – click to enlarge.

 

We have taken the above charts from an article by Jared Blikre, who reported on these events shortly after they happened last Thursday. According to Blikre, the especially large divergence between the two interest rates shown above on December 31 was unexpected and could be a sign of underlying stresses in the credit markets. However, we are actually not so sure about that inference.

When looking at the FF rate data published by the NY Fed, we could find no indication of an effective FF rate for December 31. Assuming that he found the FF rate indication somewhere else and that it is correct, it would still not necessarily mean much. As Lee Adler has recently pointed out, trading volumes in the federal funds market have collapsed, as all the large banks are sitting on enormous amounts of excess reserves.

Why would anyone need to borrow reserves? In fact, since 2008, federal funds trades outstanding have shrunk by nearly 90% (considering that the banks haven’t been particularly constrained by reserve requirements prior to the 2008 crisis either, this is a remarkable decline). We would guess that this dead market will simply tend to be even deader on December 31.

 

Underlying Problems in Credit Land?

Similarly, the surge in the tri-party repo rate may merely be indicative of a short term lack of liquidity due to year-end, but this is definitely connected to the surge in reverse repos. The big surge in reverse repos to a new record high tells us that the removal of the previous $300 billion cap has intensified the above-mentioned window-dressing activity. We don’t think the movement in FF and repo rates reported at year end is as such saying that there is a problem, but Blikre – after briefly discussing the problems of junk bond fund Third Avenue – adds a comment which we by and large agree with (and which incidentally explains the larger than usual upward pressure on the general collateral repo rate):

 

It is possible that mutual funds loaded with distressed debt could use another repo market, the tri-party repo market, to offload their underperforming assets in exchange for cash. This cash could then be used to temporarily buy high quality collateral from the Fed through a reverse repo. At year-end, their balance sheets would appear to be composed of higher quality assets with a higher quality counterparty than would otherwise be the case.

Data is scant with regard to the tri-party repo market, but the size of the year-end Fed auction tells the story. A healthy financial system should not need $475 billion in high quality collateral from a zero-risk entity, such as the Fed—unless there are problems with portfolio composition and counterparty risk bubbling beneath the surface.”

 

(emphasis added)

This is actually a very good point. One has to wonder why such huge window dressing is held to be needed on reporting days if everything is just fine and dandy. This is especially so in light of the well-known lingering liquidity issues in the corporate bond market that have resulted from post GFC regulations such as the Dodd-Frank Act (as an aside: it is amazing that the regulations supposed to hold future banking crises at bay are named after two Congressmen who for years paved the way for ever looser mortgage lending rules governing the GSEs and did their utmost to stop all attempts to rein these institutions in. This has almost Orwellian qualities. A hat tip to the Daily Bell for pointing this out).

New capital regulations for banks may also be playing a role in this context. In other words, perhaps it isn’t just mutual funds that are responsible for the recent surge in these window dressing efforts, but commercial banks. After all, according to Basel III rules and the various national capital adequacy rules modeled after them, sovereign bonds are regarded as completely risk-free, and therefore require a capital buffer of zero. Banks thus have a very strong regulatory incentive to engage in such temporary asset swaps on reporting dates as well.

Either way though one has to conclude that this cannot be indicative of a healthy financial system. Moreover, it appears as though the central bank is actually assisting large financial institutions to engage in what is ultimately a game of deception by offering these reverse repos – which are ostensibly just a monetary policy tool. If mutual funds and banks are indeed off-loading risky assets in the tri-party repo market to unregulated shadow banking entities on reporting dates and are using the cash they receive to replace them with pristine assets borrowed from the Fed precisely on those days, regulators, shareholders, mutual fund investors or anyone else for that matter, will never be in a position to find out what is actually in their portfolios.

In short, it will be impossible to determine or estimate what risks are actually extant. Similar to Jared Blikre, all one can do is engage in guessing games. It could be that many of the assets that are swapped out are actually perfectly fine, except for being subject to inane regulatory restrictions. However, it seems at least as likely, if not more so, that they are actually quite risky – or as Blikre suggests, even distressed and therefore very risky.

 

tri-party repo marketA map of the US tri-party repo market

 

Conclusion

We wouldn’t be overly concerned over sharp moves in short-term interest rates on the final business day of the year, but the fact that reverse repo transactions on reporting days are extremely large and keep growing quite rapidly (the amount reported at year-end was 40% above the previous record high) is actually raising a few questions.

Either the financial regulations introduced since 2008 are so overly restrictive that they impede the functioning of financial markets unless they can be sidestepped to some extent, or there really is a very large amount of risk out there which is deliberately hidden from the prying eyes of other interested parties (our guess would be that it is most likely a combination of both).

The reason why this topic should be of concern is that there clearly are stresses in several corners of the financial universe (most prominently in junk bonds, commodities and various currencies) – and those are just the ones that are currently blindingly obvious. It is almost certain that quite a few as of yet undiscovered time bombs are lingering in the system as well after seven years of ZIRP.

For instance, during the 2008 crisis, people suddenly became familiar with a great many obscure financial instruments that had previously not attracted much attention. Suddenly they became focal points of the crisis as liquidity dried up (such as e.g. CDOs squared, auction rate securities, et al.). Different obscure instruments are likely to receive attention in the next crisis, but they will have one thing in common with those that rose to prominence in 2008: they will all be the kind of instruments that are great to hold during a bubble and are impossible to sell once it bursts.

 

Charts and tables by: Yahoo Finance, IMF, Zerohedge

 

 
 

Emigrate While You Can... Learn More

 
 

 

Dear Readers! We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in. We are very grateful for your support! As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

2 Responses to “Money Market Distortions at Year-End”

  • HardMoney:

    I believe repo collateral is shown off balance sheet – for banks anyway and not sure why it would be any different for funds.

    Thus, the transactions above would not help dress the BS. I think.

  • Kreditanstalt:

    These reverse repos have “extend-and-pretend” as their purpose…though only God knows why the investors in the participating funds and institutions put up with this obvious bookkeeping fakery.

    How can we have any idea of the real state of a portfolio if the dirty stuff can be freely shuffled off temporarily to other parties? We increasingly know less and less about the true financial positions of these entities because of such short-term accounting tricks. We can only, as you have stated, make the reasonable deduction that something is probably going wrong under the surface…

    This can only increase systemic instability.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • LA5H5981sc
President George W. Bush presents the Presidential Medal of Freedom to Federal Reserve Chairman Alan Greenspan, one of 14 recipients of the 2005 Presidential Medal of Freedom, awarded Wednesday, Nov. 9, 2005 in the East Room of the Whiite House.  White House photo by Shealah CraigheadAlan “Bubbles” Greenspan Returns to Gold
      Faking It   Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. […] The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. — Alan Greenspan, 1961   He was in it for the power and the glory... Alan Greenspan gets presidential bling...
  • William SimonEnd of an Era: The Rise and Fall of the Petrodollar System
      The Transition   “The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil rather than dollars or euros. The sooner the better.” Ron Paul   A new oil pipeline is built in the Saudi desert... this one is apparently destined for the Ghawar oil field, one of the oldest fields in Saudi Arabia...
  • Vote Early Zombie at Sharpstown High SchoolWriting on the Wall
      Time to Sell... Maybe BALTIMORE – Yesterday, the S&P 500 hit a new all-time high. And the Dow just hit a new record close as well. If you haven’t sold yet, dear reader, this may be one of the best times ever to do so.   It's still flying... sorta. Meet Bill Bonner's tattered crash flag Image credit: fmh   We welcome new readers with a simple insight: Markets are contrary, pernicious, and downright untrustworthy. Just when the mob begins to bawl most loudly...
  • robot tradersA Fully Automated Stock Market Blow-Off?
      Anecdotal Skepticism vs. Actual Data About one month ago we read that risk parity and volatility targeting funds had record exposure to US equities. It seems unlikely that this has changed – what is likely though is that the exposure of CTAs has in the meantime increased as well, as the recent breakout in the SPX and the Dow Jones Industrial Average to new highs should be delivering the required technical signals.  The bots keep buying... Illustration via...
  • Toscana_Siena3_tango7174The Central Planning Virus Mutates
      Chopper Pilot Descends on Nippon Readers are probably aware of recent events in Japan, the global laboratory for interventionist experiments. The theories of assorted fiscal and monetary cranks have been implemented in spades for more than a quarter of a century in the country, to appropriately catastrophic effect. Amid stubbornly stagnating economic output, Japan has amassed a debt pile so vast since the bursting of its 1980s asset bubble, it beggars the imagination.   A...
  • tokyo whaleDestination Mars
      Asset Price Levitation One of the more preposterous deeds of modern central banking involves creating digital monetary credits from nothing and then using the faux money to purchase stocks.  If you’re unfamiliar with this erudite form of monetary policy this may sound rather fantastical.  But, in certain economies, this is now standard operating procedure.   The “Tokyo Whale” Haruhiko Kuroda explains his asset purchase madness with a few neat little slides. Photo credit:...
  • The-Deep-State-Mike-LofgrenAmerica Has Become a “Parasitocracy”
      Dread and Denial So, let’s return to the discussion you can’t have with your congressman, your mailman, or your barmaid. It’s the important one. It concerns what the Fed is really up to.   Eight years after achieving independence, a State modeled after the British merchant state was established in the US. It took a while for the Deep State to consolidate itself within it, a process that was accelerated greatly in the run-up to and aftermath of WW I. Illustration by Ana...
  • London-City-Scene lo rezFat People for Trump!
      Alphas and Epsilons BALTIMORE – One of the delights of being an American is that it is so easy to feel superior to your fellow countrymen. All you have to do is stand up straight and smile. Or if you really need an ego boost, just go to a local supermarket. Better yet, go to a supermarket with a Trump poster in the parking lot.   The protest vote attractor with the funny hair. Image credit: Liberty Maniacs   Trigger warning: In the following ramble, we make fun of...
  • bristlecone-1000x672Long Term Market Perspectives
      Methuselah Tree When looking for a good theme for this post I pondered for a while and then decided to use a picture of a bristlecone pine, which are widely considered to be the oldest living trees in the world.   Ye olde bristlecone Photo credit: Kosta Konstantinidis   You can find them near the Nevada/California border and if you wind up traveling in the area then I strongly recommend that head over to Bishop and from there head up high up into the White...
  • Juncker, Keqiang, Tusk 2EU Sends Obsolete Industries Mission to China
      “Tough Negotiations” The European press informs us that a delegation of EU Commission minions, including Mr. JC Juncker (who according to a euphemistically worded description by one of his critics at the Commission “seems often befuddled and tired, not really quite present”)  and European Council president Donald Tusk, has made landfall in Beijing. Their mission was to berate prime minister Li Keqiang over alleged “steel dumping” by China and get him to cease and...
  • Purchasing Power of the BuckThe Real Reason the “Rich Get Richer”
      Time the Taskmaster DUBLIN – “Today’s money,” says economist George Gilder, “tries to cheat time. And you can’t do that.” It may not cheat time, but it cheats far easier marks – consumers, investors, and entrepreneurs.   Tempus fugit – every action humans undertake has to take time into account. In the economy, interest rates serve as the signal and regulator of the inter-temporal structure of capital. In an unhampered free market economy, they tell...
  • chart-4-silver-basis and cobasisGold is not Going to $10,000
      One Cannot Trade Based on the Endgame The prices of the  metals were down again this week, -$15 in gold and more substantially -$0.57 in silver. Stories continued to circulate this week, hitting even the mainstream media. Apparently gold is going to be priced at $10,000. Jump on the bandwagon now, while it’s still cheap and a bargain at a mere $1,322!   All aboard... or maybe not? It all depends on what one wants to achieve – there's many a slip 'twixt the cup and the...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com