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.
Photo 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.
The 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:
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:
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.”
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.
A map of the US tri-party repo market
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
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”
Most read in the last 20 days:
- Free Money Leaves Everyone Poorer
Destroying Lives BALTIMORE – A dear reader reminded us of the comment, supposedly made by Groucho Marx: “A free lunch? You can’t afford a free lunch.” Groucho dispensing valuable advice Photo via imdb.com He was responding to last week’s Diary about the national referendum in Switzerland on Saturday. Voters will decide whether to give all Swiss residents a free lunch – a guaranteed annual income of about $30,000 a year [ed note: the initiative was...
- How the Welfare State Dies
Hollande Threatens to Ban Protests Brexit has diverted attention from another little drama playing out in Europe. As of the time of writing, if you Google “Hollande threatens to ban protests” or variations thereof, you will find Russian, South African and even Iranian press reports on the topic. Otherwise, it's basically crickets (sole exception: Politico). Gee, we wonder why? They don't like him anymore: 120.000 protesters recently turned Paris into a war zone. All...
- Free Speech Under Attack
Offending People Left and Right Bill Bonner, whose Diaries we republish here, is well-known for being an equal opportunity offender - meaning that political affiliation, gender, age, or any other defining characteristics won't save worthy targets from getting offended. As far as we are concerned, we generally try not to be unnecessarily rude to people, but occasionally giving offense is not exactly beneath us either. The motto of the equal opportunity...
- Moving Closer to BREXIT
Polls Show Growing Support for a Break with the EU In the UK as elsewhere, the political elites may have underestimated the strength of the trend change in social mood across Europe. The most recent “You-Gov” and ICM pools show a widening lead in favor of a UK exit from the EU as the day of the vote comes closer. Pro-BREXIT campaigners Boris Johnson (ex-mayor of London) and Michael Gove (UK Secretary of Justice) are in a good mood. Photo credit: Paul Grover /...
- A Market Ready to Blow and the Flag of the Conquerors
Bold Prediction MICHAELS, Maryland – The flag in front of our hotel flies at half-mast. The little town of St. Michaels is a tourist and conference destination on the Chesapeake Bay. It is far from Orlando, and even farther from Daesh (a.k.a. ISIL) and the Mideast. St. Michaels, Maryland – the town that fooled the British (they say, today). Photo credit: Fletcher6 Out on the river, a sleek sailboat, with lacquered wood trim, glides by, making hardly a...
- Toward Freedom: Will The UK Write History?
Mutating Promises We are less than one week away from the EU referendum, the moment when the British people will be called upon to make a historic decision – will they vote to “Brexit” or to “Bremain”? Both camps have been going at each other with fierce campaigns to tilt the vote in their direction, but according to the latest polls, with the “Leave” camp’s latest surge still within the margin of error, the outcome is too close to call. The battle lines are...
- Going... Going... Gone! The EU Begins to Splinter
Dark Social Mood Tsunami Washes Ashore Early this morning one might have been forgiven for thinking that Japan had probably just been hit by another tsunami. The Nikkei was down 1,300 points, the yen briefly soared above par. Gold had intermittently gained 100 smackers – if memory serves, the biggest nominal intra-day gain ever recorded (with the possible exception of one or two days in early 1980). Here is a picture of Haruhiko Kuroda in front of his Bloomberg monitor this...
- What Could Possibly Go Wrong?
A Convocation Of Gamblers The Wall Street Journal and BloombergView have just run articles on the shadow banking system in China. This has put me in a nostalgic mood. About 35 years ago when I was living in Japan, I made a side trip to Hong Kong. Asia's Sin City, Macau Photo credit: Nattee Chalermtiragool I took the hydrofoil to Macau one afternoon and the same service back early the next morning. On the morning trip, I am sure that I saw many of the...
- Rule Britannia
A Glorious Day What a glorious day for Britain and anyone among you who continues to believe in the ideas of liberty, freedom, and sovereign democratic rule. The British people have cast their vote and I have never ever felt so relieved about having been wrong. Against all expectations, the leave camp somehow managed to push the referendum across the center line, with 51.9% of voters counted electing to leave the European Union. Waving good-bye to...
- The Real Reason We Have a Welfare State
From Subject to Citizen BALTIMORE – June 5th, the Swiss cast their votes and registered their opinions: “No,” they said. We left off yesterday wondering why something for nothing never works. Not as monetary policy. Not as welfare or foreign aid. Not in commerce. Not never, no how. But something for nothing is what people most want. The future Switzerland just managed to dodge... for now The Swiss voted against awarding all citizens a “universal basic...
- The Problem with Corporate Debt
Taking Off Like a Rocket There are actually two problems with corporate debt. One is that there is too much of it... the other is that a lot of it appears to be going sour. Harvey had a good time in recent years...well, not so much between mid 2014 and early 2016, but happy days are here again! Cartoon by Frank Modell As a brief report at Marketwatch last week (widely ignored as far as we are aware) informs us: “Businesses racked up debt in the...
- A Darwin Award for Capital Allocation
Beyond Human Capacity Distilling down and projecting out the economy’s limitless spectrum of interrelationships is near impossible to do with any regular accuracy. The inputs are too vast. The relationships are too erratic. The economy - complex and ever-changing interrelations. Image credit: Andrea Dionne Quite frankly, keeping tabs on it all is beyond human capacity. This also goes for the federal government. Even with all their data gatherers and...