Introduction and Background

In 1944 forty-four nations gathered in Bretton Woods, New Hampshire to deliberate the new global monetary system at the conclusion of World War II. Although superior ideas were proposed the United States' idea of using the gold-backed U.S. dollar as the world’s reserve currency was adopted. Amid the celebrations of a new post-war monetary system, a few forward thinkers, such as Belgian economist Robert Triffin, rightly characterized the Bretton Woods system as doomed for failure – at some point. Decades after the adoption of the Bretton Woods accord global trade expanded exponentially causing the world’s demand for U.S. dollars to explode. Without U.S. dollars nations found it difficult, if not impossible, to trade with one another. An unintended consequence (perhaps not so unintended by the globalists) was the Federal Reserve becoming the world’s central bank. Now Fed policies either directly or indirectly impacted the economy of every other nation on earth.

As of August 1971, the U.S. dollar is no longer backed by gold but still persists as the world’s reserve currency, with nearly 75% of global trading settled in U.S. dollars. So far, Triffin’s Dilemma has been held at bay, but cracks have been emerging for decades. The dilemma begins with the U.S.’s responsibility to provide the U.S. dollar, in sufficient quantities, as a public good to the rest of the trading world. To do so the U.S. must supply those dollars by purchasing more foreign goods than products that are produced domestically and sold to foreigners – what’s known as a trade deficit. A byproduct of systematic and persistent trade surpluses, created by trading with the U.S., is those trade surplus countries investing excess U.S. dollars into safe and liquid securities issued by the U.S. government. By inducing the foreign purchase of U.S. Treasuries, the U.S.’s reserve currency status has meant it could spend more than it earns and finance such fiscal deficits by issuing more government-backed securities.

Until recently, any concern of the U.S. over-borrowing (Triffen’s Dilemma) was subsumed by foreign government’s need to stockpile U.S. dollar reserves in U.S. government-backed securities such as Treasuries. In this context, U.S. deficits didn’t matter and hence the U.S. was described as possessing an “Exorbitant Privilege”. It was not accountable for operating fiscal and monetary policy based on sound money.

Signs of Change

On September 16th, 2019 the global monetary system signaled it had changed. The change had been in process since 2014, advertising its arrival in small, subtle ways only money market insiders noticed – that is until that Monday. On that day, in the middle of the month, the Fed Funds and the related repo market melted down, requiring immediate attention from the Federal Reserve to avoid an economic catastrophe. The Fed Funds target rate spiked from 2.25% to 5% on average, with some transactions close to 10%.

The Fed Funds market is where banks can conduct short-term funding with other banks on an un-collateralized basis. Participants use their knowledge of other bank's balance sheets and relationships with the bank's key people to perform such lending for a short time period as overnight. The repo market performs the same short-term lending but does so on a collateralized basis. U.S. government securities are pledged to a lender providing overnight liquidity. Together, the Fed Funds and repo markets form the plumbing that makes the financial system run. Without them functioning smoothly investor confidence is lost and markets can go haywire.

On September 17th the Fed injected $105 billion of liquidity into the repo market, although it only covered 25% of the demand - $75 billion into overnight repos and $30 billion into 14-day repos. That move was followed up by another $75 billion and an announcement from the Fed that it would continue to provide liquidity until October 10th. This event marked the first time the Federal Reserve had intervened in markets since the 2008 Global Financial Crisis, and noticeably, only 12 hours after the problem surfaced. More importantly, such Fed intervention doesn’t appear to be a fix.

An indicator of policy failure is the persistently high level of the Effective Federal Funds Rate (“EFFR”) which has exceeded Interest On Excess Reserves (“IOER”) the Fed pays banks on their reserves held above-required levels. Here’s how the St. Louis Fed explains IOER as one of its key monetary policy tools:

"Commercial banks must adhere to regulations, including so-called reserve requirements. That is, banks must hold a certain fraction of their deposits as cash in a Federal Reserve account; these are known as “required reserves.” Banks can choose to hold even more cash in those accounts than what the Federal Reserve requires; these are known as “excess reserves.” In normal times, excess reserves aren’t profitable, as they don’t earn a return. Instead of holding cash as excess reserves, banks could lend those funds and earn interest. However, after the 2008 recession, the Federal Reserve started paying interest on excess reserves (IOER). By altering the incentives for commercial banks to extend loans or hold excess reserves, the Fed is able to use the IOER as an additional monetary policy tool."

The above graph plots the IOER along with the EFFR, the Fed’s traditional tool for conventional monetary policy. When banks have excess liquidity or reserves, they can choose to lend those reserves to other banks (at FFR) or deposit them at the Fed (and earn the IOER). Banks aren’t willing to lend to each other if the Federal Funds rate is substantially lower than the IOER, and so the two rates move closely together – at least in normal times.

Prior to the end of 2008, the Fed dictated a specific rate it desired for Fed Funds and managed that rate through open market operations – buying and selling of Treasuries. However, in late 2008, the Fed unfurled a new system to control FFR by defining a 25-basis point range within which the Fed wanted EFFR to fall – what’s described as the Corridor System. To manage the EFFR within the policy range the Fed simply turned the dial on the rate it would pay to banks of IOER. The theory held that If the EFFR drifts much below the IOER rate, banks would respond by borrowing in the federal funds market and deposit those reserves at the Fed to earn the higher IOER rate. In this context, IOER is supposed to be a ceiling for FFR. If FFR ventured too far above IOER a near "riskless" arbitrage opportunity would be afforded to the banks. Banks taking advantage of such arbitrage would then provide the needed liquidity requirements of the Fed Funds market.

However, the system hasn’t worked the way the Fed intended it, with FFR overtopping IOER three times in 2018 and then again in March 2019, where it has stayed ever since. The Fed made a few technical adjustments to IOER in 2018 (June, October, December) lowering the rate each time by 5 basis points, but EFFR persisted outside of the range.

Prior to the June 13, 2018, adjustment, the upper limit of the EFFR target range and the IOER rate were indistinguishable because IOER rate was set at the upper limit of the target range. After June 13, 2018, the IOER rate (green line) is below the upper limit of the FFR target range (red line).

What Does It Mean?

The initial message is clear: something is amiss in U.S. money markets. Fed bashers are quick to cite Powell’s Fed lacks an understanding of the modern monetary system and is attempting to control it in ways it does not respond to. Some market watchers state the persistence of EFFR > IOER is an indicator of a lack of liquidity in the U.S. banking system exacerbated by overly tight monetary policy and a fiscal authority demanding too much liquidity. One issue seems clear: the avoidance by banks to take advantage of a nearly risk-free arbitrage between EFFR and IOER is a sign of too little liquidity in the banking system. But what has caused this shortage?

Financial Failure is Sometimes Regulatory Failure

The easiest narrative to formulate for why the banking system lacks liquidity is to blame the legislators. Increasing levels of bank regulation since 2010, including Dodd-Frank, liquidity coverage ratios, the Volcker Rule and Basel III, have forced banks to increase their held reserves. This aggregate of financial legislation has significantly increased bank liquidity requirements (reducing the effective level of excess reserves) and bank’s ability to lend, some analysts say by as much as 25%.

Money manager Jim Bianco recently stated in a podcast interview with Jim Grant,

“EFFR blew up because banks didn’t have the money to make the needed loans. Ten years ago, Dodd-Frank, the Volcker Rule, coverage ratios, and Basel III all were implemented and were meant to restrict banks from participating in the fed funds market unless they had enough reserves and capital. The consequences are that the repo market (and fed funds) today relative to the size of the Treasury market is at a 40-year low. Market failure is so often regulatory failure. In 2007 the repo market was nearly 85% of the UST market. Today its only 22%”.

George Selgin of the Cato Institute and author of “Floored” says the Fed Funds market used to be where banks were supposed to borrow excess reserves from one another. In 2008 the Fed changed course with its corridor system making it attractive for banks to pile up reserves. In the process, it killed the unsecured inter-bank lending system and grew the reserves in the system from billions to trillions of dollars. Selgin points out that not only have regulators encouraged banks to hold more reserves and demand they hold greater high-quality assets (U.S. Treasuries and German Bunds), but 90% of the reserves that do exist in the U.S. banking system are owned by 5 banks. This concentration of reserves in a few banks has prevented the disbursement of existing reserves and has kept the system from working the way the Fed intended.

Bianco refers to this as “unintended consequences of central control legislatures attempting to exert power over the almighty market” at the inopportune time of U.S. deficits growing at ever and ever faster rates,

“Why do we need $1.3 Trillion in excess reserves and why is that inadequate? Prior to the GFC rules from above, that would have been plenty. But given these regulations, it’s no longer excessive. In short, the increase in U.S. deficits has caused the new Treasury issuance market to run away from U.S. funding markets. Collateral (U.S. Treasuries issued as a result of U.S. fiscal deficits) is not going to go down. The U.S. is currently running budget deficits of around 4.5% of GDP, the largest ever during a non-war, non-recessionary period. There’s a need to increase reserves which is another way of saying Quantitative Easing, which will increase the Fed’s balance sheet”.

A manifestation of such new legislation is the rise of the Federal Funds Rate above that of Interest on Excess Reserves and is a sign of a simple mismatch of supply and demand for Treasuries. Excess reserves have become required reserves in a system of banks shifting cash into Treasury purchases to pick up 200 basis points in yield, but not into the repo market taking Treasuries as collateral where banks could pick up even more yield. If you believe in the power of self-interested profiteers comprising our financial markets then you may wonder, what is going on?

Another issue related to insufficient reserves was recently highlighted by Santiago Capital’s Brent Johnson. He points out that many of the reserves sitting with the Federal Reserve are owned by foreign central banks within what is called the Foreign Repo Pool. The FRP is a short-term, liquid, U.S. dollar investment option for the account holders and supports daily cash management needs to clear and settle securities. These financial services are offered by the Federal Reserve Bank of New York to roughly 250 central banks, governments, and international official institutions. Most of the assets in these accounts are U.S. Treasuries and agency securities. Mr. Johnson estimates that 30-40% of stated excess reserves are owned by foreign institutions who are not inclined to let go of them any time soon. These foreign central banks are hoarding their U.S. dollar reserves to fund their own ongoing dollar funding issues related to operations and trade through the Federal Reserve’s Funds Transfer System, otherwise known as Fedwire. Mr. Johnson cites this fact to debunk the idea that the repo spike was simply a U.S.-centric issue.

Bottlenecks: Unforeseen Needs for Liquidity

A widely repeated narrative attempting to explain the repo market’s lack of liquidity has been the bank’s unexpected need for cash. It's widely known that liquidity ebbs and flows throughout the year, with naturally occurring bottoms at the end of every quarter. These periodic liquidity bottlenecks are caused by company’s quarterly tax payments, efforts by banks to clean up their balance sheets before quarter-end reporting, payments due to the Treasury from the latest bond auctions, and the U.S. governments need to replenish its cash account for operational funding. But these dates for liquidity drawdowns were known by the banks and the amounts shouldn’t have surprised anyone. To compensate, the narrative added Saudi Arabia’s need for cash to repair its oil fields recently attacked by Middle Eastern foes. In the end, this narrative is weak, and at best, these cash needs were merely a part of the overall story.

The Business Cycle Has Become a Series of Mini Liquidity Cycles

Juliette Declerq of JDI Research recently stated that the ongoing U.S. dollar shortage is an old story blaming the repo funding spike and the corresponding liquidity crisis on the Fed’s misunderstanding of what really drives economic activity. Declercq says,

“On one side there is the price of money. If its too high growth will be choked. On the other side is the quantity of money. This is not something that central bankers understand because business cycles used to be driven by employment cycles and the price of money rather than liquidity waves. However, through balance sheet expansion central bankers have turned the ongoing business cycle into a series of mini-liquidity cycles.”

The main problem with liquidity cycles is that liquidity is easy to inject, but hard to remove without significant consequences on global activity. A recent global slowdown is her empirical evidence.

Declercq is part of a growing crowd calling for the Fed to immediately address the U.S. dollar shortage by instituting some form of liquidity provisions. On the list of alternatives is the Fed’s proposed Standing Repo Facility, which some describe as QE Lite. The Standing Repo Facility is separate and apart from the Fed’s traditional discount window and uses Treasuries as collateral. For qualifying banks, it would be a way to circumvent the market and go directly to the Fed for its liquidity needs. In other words, the Fed would become a market maker in the repo market.

Other market watchers are calling for a simple return to the Fed’s balance sheet expansion, or QE Regular. Balance sheet expansion is the purchase by the Fed of bank assets, which creates bank reserves and potentially relieving many liquidity pressures without Fed Funds-like counter-party risks.

Disappearing Foreign Investors and Brewing U.S. Fiscal Crisis

Far more important than liquidity bottlenecks were two macro events both involving foreign investors. First, the third quarter of 2014 marked the beginning of global central banks behaving as net sellers of U.S. Treasuries as a response to the high value of the U.S. dollar, the U.S.’s self-sufficiency with oil, along with secular current account deterioration among creditor nations such as China, Germany, and South Korea. This led to a shift in the financing of U.S. government deficits to the global private sector which began to crowd out global Eurodollar markets - evidenced by LIBOR rising. The U.S. responded by regulating banks and money market funds into purchasing more Treasury issuance.

Second, four years later, and after increasing regulatory scrutiny, U.S. banks began to shrink their swaps books significantly, causing the cost of currency hedging to rise. FX hedge costs turned foreign investor's net yields on Treasuries negative for the first time in history. While it’s true that Foreign investors could choose to purchase Treasuries unhedged and earn 1.75% while domestic issues yielded negative, having the high valued dollar make a 5-10% retracement would be career-ending. Today FX hedged Treasuries are yielding approximately -100 basis points for Japanese investors and -125 basis points for European investors. Luke Gromen, of research group Forest For The Trees, describes this scenario as “foreign private investors were effectively being paid not to buy or rollover Treasury positions, and this weakened their bid for new issuance”.

The net result was the near disappearance of foreign buyers of new Treasury issues. This meant the ever-increasing burden of absorbing U.S. fiscal deficits was left to the U.S. private investor, specifically the 24 Primary Dealers. Beginning in the fourth quarter of 2018 Primary Dealers were purchasing Treasuries at a rate of $600 billion annually, and this continued into 1Q19. $200 billion of those purchases came from three Primary Dealers. On March 19th, 2019 the lack of foreign investors for U.S. Treasuries manifested itself in FFR overtopping IOER for the fourth time. Every trading day since FFR has remained above IOER. In the next 90 days, the Fed cut IOER twice and FFR twice, but the inverted relationship remained. As Mr. Gromen points out,

“this was a reflection of the accelerating crowding out of the U.S. private sector that began in 3Q14. And what happened on September 16th was a reflection of an incipient U.S. fiscal crisis”.

In other words, skyrocketing U.S. fiscal deficits are crowding out the U.S. banking system, and FFR > IOER is a sign of a lack of U.S. bank balance sheet capacity to fund U.S. government deficits.

Mr. Gromen predicts,

“Federal Reserve rate cuts in July and September will most likely be followed by more rate cuts and a return to growing the Fed’s balance sheet – better known as Quantitative Easing. These moves are less about the economy and more about U.S. money markets demanding help from the Fed to finance U.S. deficits. FFR > IOER is a sign of a lack of sufficient U.S. private sector balance sheet capacity. This U.S. fiscal problem is causing a global shortage of U.S. dollars.”

Deficit spending is best used to jump-start a moribund economy and grow GDP. When GDP growth rates exceed interest cost on the debt it means growth. However, today’s fiscal deficits are growing faster than GDP when the economy is positive, which indicates over-indebtedness and low marginal returns on each additional dollar of debt. U.S. deficits, in the face of slower GDP growth, are being funded strictly by new Treasury issuance. This is adding growing pressure to the global monetary system and is not likely to end well. For the first time in 70 years U.S. deficits matter again!

Preparing for the Real Crisis

But wait…. If primary dealer banks are overwhelmed by the Treasury deluge, why don’t they simply sell their holdings? After all, the global demand for safe-haven assets has never been greater relative to supply.

According to Jeff Snider, of Alhambra Investment Management, Primary Dealer inventories of Treasuries have been rising since the GFC. Snider said the following in a recent podcast interview,

“Even when we had abundant reserves in the banking system and smaller fiscal deficits Primary Dealer inventories were rising. Spikes in repo rates coincide with spikes in UST inventory ever since. The banks are choosing to not sell their inventory, and are thus hoarding UST’s. There’s no law that Primary Dealers must sell their inventory, only that they buy. But what sense does it make to buy 2-year Treasuries yielding 1.8% and financing them with repo at 2.3%? Moreover, it’s not just funding cost, but also the opportunity cost Primary Dealers are giving up to invest at higher yields somewhere else - such as lending into the repo market where banks can earn a 2.3% yield collateralized by government security. However, to do this you must have the capacity and willingness to be on the lending end of repo, which is very different from owning and possessing a government bond. There’s something special about possessing Treasuries.”

And that something is repo collateral. According to Mr. Snider, In the current money market environment, it’s better to hold Treasuries to use as repo collateral than it is to lend to other banks providing Treasuries as collateral. Why? Because, for banks, Treasuries are not investments they are balance sheet tools whose entire purpose is to facilitate weathering a market storm. The cost of holding them is immaterial to banks, even when yields are negative. Holding negative-yielding sovereign bonds is a relative measure of the insurance cost for banks. Global central banks are using U.S. Treasuries, and German Bunds, to manage their own liquidity risk. Banks are willing to pay higher and higher policy premiums because they perceive higher liquidity risk coming. A bank must have repo worthy collateral to weather such a storm. Periods of resolution (financial storms) are very reflexive environments for banks, which means bank balance sheets must be beyond reproach to regulators and other banks alike. This was a lesson learned in 2008 by banks - in the next resolution phase it’s better to have reserves in highly liquid sovereign bonds as opposed to cash. In other words, high-quality sovereign bonds are desired for their liquidity characteristics.

Snider continues with his analysis of bank’s current priorities,

“Bank’s demand for Treasuries stems from the need to deal with priorities. Yes, the U.S. government is the brokest institution ever but dealing with that credit risk is tomorrow’s problem. Today’s problem is being able to resolve the balance sheet, which can only be done through having enough Treasuries to satisfy the repo market when lesser quality collateral becomes illiquid”.

As Snider eloquently lays out, EFFR > IOER is an indicator that there’s a monetary problem, a big problem, that lies beyond the money markets,

“Offshore eurodollar markets need more U.S. dollars and the banks earning IOER don’t want to make that investment. That investment means willingly accepting Euros for U.S. dollars. Liquidity is not being spread around because there’s a monetary issue in the wider system beyond the fed funds market. Primary Dealers are hoarding liquidity because they expect to need it and/or liquidity will be more expensive in the near future. Without sufficient amounts of U.S. dollars in the global banking system, a liquidity event will force the Fed to cut rates and begin QE again and perhaps forever. The near-term problem is a liquidity crisis, and the longer-term problem is U.S. credit risk. The markets must deal with them one at a time”.

As the data indicate September 16th, 2019 was like a safety valve releasing pressure from the system to prevent the plumbing from blowing up. These events were a combination of seasonal bottleneck running up against an underlying constraint, which was impossible to predict and factor. Banks assumed they would have their liquidity needs covered but found out quickly that the Primary Dealers weren’t going to be there for funding, and more importantly, neither was the Fed. The overnight repo actions the Fed did take were misdirected and therefore of little consequence. FFR > IOER is still in play, and more than $900 Billion of funding in the repo market that week cleared the at rates above 5% after the Fed injected $53 Billion. The situation didn’t get much better in the immediate days following. As Mr. Snider observed,

“The only reason conditions stopped being so outrageous was because the bottleneck simply passed. It wasn’t the overnight repo operations restoring order, it was the Fed was just lucky that there wasn’t an actual systemic event along the lines of 2008. This was, however, a dress rehearsal for one”.

Clearly money market participants noticed how chaotic markets became at certain points after September 16th. Reflexively, its likely some concluded that they must hold more Treasuries going forward, only making global dollar shortages worse.

That Primary Dealers are hoarding Treasuries is important, and we should be paying attention. Primary Dealers can see parts of the market we can’t, the parts that indicate bigger issues like counter-party risk, a la 2008. The Primary Dealers know something is amiss and they’re sending us signals that they’re uncomfortable about what they see. Will we heed their call?

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