- The New York Fed announced Thursday a dramatic increase in the size and scope of its overnight repo operations.
- Investors seem to be downplaying or ignoring the writing on the wall: We have a liquidity crisis on our hands.
- Don’t pay attention to what the Fed says, only look at what it does.
The Federal Reserve’s intervention in the financial system reached truly epic proportions Thursday after the central bank’s New York division announced the largest series of repo operations ever.
The announcement came mere days after the Federal Open Market Committee (FOMC) painted a rosy picture of the U.S. economy in its final policy meeting of 2019. But what the Fed says and what it does are two completely different things.
Central bankers are admitting – by their actions, not words – that crisis is brewing in the financial sector.
Repo Operations Go Haywire
The New York Fed announced Thursday it’s planning to inject almost half a trillion dollars into the overnight repo market through the new year, significantly increasing intervention to ensure short-term interest rates are kept in check. The plan includes providing an additional $425 billion in short-term funding to banks in dire need of cash.
As the Financial Times reports, the nuts and bolts of the operations include $120 billion in overnight repo up to Dec. 30 and in early January, alongside $175 billion in longer-term operations.
Central bankers are flooding the market with liquidity to avoid another repeat of September when overnight interest rates shot up to 10%, four times the target of the federal funds rate. At the time, the interventions were sold as ’emergency measures’ to shore up the financial system. Three months later, money printing looks like a permanent fixture to cover up what’s really happening behind the scenes.
The September repo bonanza was significant for at least two reasons: It was the first such intervention by the Fed since the financial crisis and it completely caught markets by surprise. Although the Fed’s policy-setting board had already lowered interest rates before the repo operations started, officials described the cuts as precautionary due to ongoing trade tensions. In reality, repo operations blow the lid on the Fed’s narrative that the economy and financial system are in good shape.
That’s because short-term interest rates are extremely sensitive to funding shortages. The Fed is exchanging freshly printed cash for bonds and mortgage-backed securities because there’s a growing gap between the funding needs of the market and cash currently on hand.
Although the Fed won’t reveal which banks are in dire straits, there has to be at least one that’s in a vulnerable position. Max Keiser of the Keiser Report believes it could be JP Morgan:
QE4 to Become Official
Repo operations don’t get called ‘quantitative easing’ because they involve short-term bonds and refer to “organic growth” of the Fed’s balance sheet. The latter is another way of saying that demand for Fed liabilities is increasing.
The difference, which is largely semantic, will become obsolete very soon when the Fed officially begins the fourth round of quantitative easing. As the central bank clearly demonstrated on Thursday, stress in the overnight repo market is becoming more acute. That means the funding scarcity is going to get worse heading into 2020.
Travis Kling, a former portfolio manager, highlights the extent to which Fed repo has propped up the market since September.
$324bn of money printing (that's def "not QE") and the overnight repo market continues to struggle, as evidenced by $43bn of demand for the $25bn repo facility just last night.
As we move towards year-end, that stress is likely to become even more acute. pic.twitter.com/HouRRHy5DS
— Travis Kling (@Travis_Kling) December 9, 2019
Kling may have fallen “down the crypto rabbit hole,” according to his bio, but even those who are still in the mainstream agree that the liquidity crunch is likely to give rise to QE4 very soon.
Zoltan Pozsar of Credit Suisse recently told clients that the next round of quantitative easing could be a few weeks away. Pozsar wrote (as per CNBC):
If we’re right about funding stresses, the Fed will be doing ‘QE4’ by year-end … Treasury yields can spike into year-end, and the Fed will have to shift from buying bills to buying what’s on sale – coupons.
Fed Chair Jerome Powell insists that the repo operations are unlikely to have macroeconomic implications:
But if the repo market is truly broken, as evidenced by the banking sector’s dependence on daily liquidity injections, there’s a good chance it’ll spill over to the rest of the economy.
James Bianco of Bianco Research says there’s no reason to believe the Fed’s now daily liquidity operations are temporary. In an interview with MarketWatch, Bianco said:
This is now far bigger than anyone thought this was going to be. I think they’re hoping the market will magically fix itself. I don’t see why it would.
The Fed’s stabilizing efforts have boosted liquidity in the financial system, which partly explains the record surge in stocks. There’s a good chance that the repo boost will send short-term yields lower as a result.
Markets don’t have a good grasp of where bond yields are headed, a sign of confusion about the economy and monetary policy. According to a recent poll by The Wall Street Journal, economists see the 10-year Treasury yield fluctuating anywhere from 1% to 3% over the next year. That prediction is not only unactionable, but practically useless.