Fed Funds R.I.P. Drain No More

Following the Great War, indoor plumbing became without a doubt a Godsend for much of the world. However, few innovative leaps, including even the wonders of indoor plumbing, have ever been entirely free of at least a few drawbacks. Think of electricity and its dependence on any number of variables from lightbulbs to Mother Nature. Or the inevitability of those scratches that marred our favorite vinyl, or later CDs, rendering them unfit for the human ear. And, oh, the sparks that flew the first time we married metal with that fantastic new convenience, the microwave. The greatest innovative leap of our lifetimes started out easily enough with the personal computer. But even that technological disruptor has proven it too can be disastrously disruptive with nasty viruses, bugs and glitches working 24/7 to wreak havoc on our universal connectivity.

As for the wonders of indoor plumbing, its vulnerability rendered it anything but wondrous as it invited that inevitable bane to be borne, known worldwide as the dreaded backup. While no doubt it was a huge relief to no longer have to tiptoe into the night on an outhouse run or tow water to and fro for this and that, plumbing didn’t turn out to be exactly turn-key and stress-free. Anxieties soon arose from the prospect of that first call to the pricey plumber. Even in the 1920s, their service charge and hourly rate were bound to have given pause to the humble housewife. The beauty of the profitable plumber pariah was the subsequent innovation that followed, that of Drano, which was thankfully introduced in 1923.

Over that same 100 years, give or take a few, the financial system has also suffered its own bouts of clogged pipes though the culprits have tended to be a wee bit trickier to dislodge than gelatinous grease and hardened hairballs. Recall that in October 1979, Fed Chairman Paul Volcker formally announced that the monetary base would be the new and improved target to better control the price of credit. When overnight credit is priced perfectly, the funding spigots stay open just enough to keep credit flowing, but not flooding the financial system.

Volcker’s pivot away from the fed funds rate, however, proved more Pandora than panacea. And so three years later, in October 1982, policymakers re-adopted the targeting of the federal funds rate where policy technically remains to this day. An Econ 101 refresher: the fed funds (FF) rate is the interest rate at which depository institutions lend reserve balances to one another on an uncollateralized basis in the overnight market.

Fast forward to the here and now and all is well for the rate setting masters of the universe save one niggling detail: for all intents and purposes, the fed funds market no longer exists. Relatively new regulations have simply made redundant the FF market as it once was and no longer is.

As intrepid readers of these weeklies, you should certainly be aware of one Zoltan Pozsar and his 20 years of groundbreaking work. Today, the thorough brilliance of his work has catapulted him to the rank of world’s preeminent professional plumber, at least as far as the global financial system is concerned.

Pozsar’s ascendance began as many things do, innocuously enough when one day early in his career he was tasked with a particular objective — to contextualize the importance of collateralized mortgage obligations and special investment vehicles within an obviously inflating housing bubble.

Conjure up an image of Russell Crowe in A Beautiful Mind, without the schizophrenia. Now you have a good idea of the ‘aha’ moment Pozsar experienced as he began to connect the dots between the various working pieces that had for years held together the housing market. His peers at the New York Fed knew it was no secret that subprime securitization had opened up housing availability to millions of Americans. But the extent to which toxic mortgages could infect the entire global financial system had not been readily apparent until Pozsar fully diagrammed the plumbing on a three-by-four-foot map. Google it for your edification. You’ll be the wiser for it.

Since leaving the Fed, Pozsar has been conspicuously prolific in his productivity. While at the IMF, he managed to remap the post-crisis financial system (it now resembles a one-foot-thick atlas). He then moved on to Credit Suisse where he is today, educating financial market participants on the vastly changed regulatory regime that has, by the way, eradicated the fed funds market.

Pozsar opens his latest Global Money Notes piece by redefining understatement given the impetus to invent a new monetary mouse trap, so to speak: “2016 is shaping up to be an important year for the Federal Reserve.” Before the year comes to a close, the Fed will not only specify the intended size of its balance sheet but also the securities to be stored on it over the long haul. Spoiler alert: there’s no shrinkage in the offing.

At the nexus of the Fed’s perennially large balance sheet are two seemingly complex terms: the Liquidity Coverage Ratio (LCR) and High-Quality Liquid Assets (HQLA). Hopefully your eyes didn’t roll into the back of your head after being hit with not one, but two, acronyms because these particulars are, well, important for understanding what’s to become the new normal of U.S. central banking.

The Third Basel Accord, or Basel III as it’s become less than affectionately known among banks, was handed down by the Bank for International Settlements (the global central bank to central banks) in 2009. The intent was to reduce the risks in the banking system in the aftermath of a crisis that revealed banks were anything but safe and sound. It should come as no surprise that the subject of reserve requirements was smack in regulators’ crosshairs. By the end of 2019, if all goes according to plan, when Basel III is scheduled to be fully implemented, the capital reserves that banks worldwide must hold against losses will have trebled.

Enter the LCR, which is effectively a global reserve requirement mandated by Basel III. For U.S.-based banks, the focus is on the ‘L’ in the LCR, as in liquid. Regulators prefer reserves over bonds to meet minimum capital requirements. From stage right then enters HQLA, which is the Fed’s baby and emphasizes that the quality of liquid assets held be high, as in pristine. The combination of these two regulations translates into banks having to hold loads more in reserves than they once did and that those reserves be of the highest quality.

“In the post Basel III world order, base liquidity (reserves) will inevitably have to replace market-based liquidity,” Pozsar explains. “This in turn means there are no excess reserves – every penny is needed by banks for LCR compliance. And this also means that the Fed has only limited ability to shrink its portfolio.”

Where does the fed funds rate fit into the picture? As mentioned above – it doesn’t.

Banks would never choose to hold their liquidity buffers in unsecured interbank markets as they would be penalized (the fed funds market is unsecured). Rather, they will be compelled to use the secured repo markets, backed by Treasury collateral, or by accumulating reserves directly at the Fed.

“Excess reserves are not sloshing but rather sitting at the Fed,” Pozsar continues. “They sit passive and inert because banks must hold these reserves as HQLA to meet LCR requirements. You have to fund what you hold and since HQLA cannot be encumbered, you can only fund them unsecured. And banks always attempt to fund assets with positive carry.”

That last part refers to the fact that banks get paid interest by the Fed for reserves they have parked there

Does all of this mean that the Fed will be forced to shirk its role as directive general of the price of credit? Of course not. But the fact is, it can’t just leave the fed funds rate swinging in the wind; the FF has yet to be replaced as the means by which to price a full array of contracts in the financial markets. Lest ye worry, a committee mandated with replacing said FF rate has been actively pursuing an ideal replacement thereof since January of last year. Of course it has an important name! It is none other than the Alternative Reference Rate Committee.

Presumably this esteemed group is working furiously to devise a new overnight bank funding rate (last acronym, promise – OBFR), which Pozsar says is a “necessity, not a choice” given the disappearance of the FF market. The new OBFR will not be interbank, as is the case with the FF rate, but rather a customer-to-bank target rate that’s a global dollar target rate rather than just an onshore dollar funding rate. It will be as if the Fed was targeting LIBOR today.

“What this means for the Fed’s reaction function isn’t clear,” Pozsar concludes. “But our instinct tells us that we will deal with a Fed inherently more sensitive to global financial conditions, inherently more sensitive to global growth and inherently more dovish than in the past…”

Far be it from yours truly to worry. Still, it’s hard to take comfort in the knowledge that the Drano we’ve all come to know, though maybe not love, is now off the market. Less comforting yet is the fact that the plumber among financial market plumbers managed to end his forecast for the future with an ellipsis. He may as well as have ended with, “Better the devil you know…”