Illiquid Plumber

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There’s nothing quite so disgusting as falling out of bed to squeeze in a predawn workout and having the brushing of one’s teeth be greeted by the stench of rotting something. That offending olfactory jolt is just as efficacious but decidedly less pleasant than a hit of espresso for awaking the senses. An emergency run for the purchase of Drano accomplished nothing. Successive days and applications of said remove-it-now saw only an escalation of the nasal assault. The spreading of our by now unbearable mystery odor made it clear that after hours or no, a professional was needed NOW. The dollar signs we saw twinkling in our intrepid plumber’s eyes added a healthy helping of monetary fear to the desperation already so evident in our own eyes. He naturally adjusted his time value of money accordingly, inquired as to the access point of crawlspace and soon enough extracted a most malodorous dead rat. I’m delighted to report that the deceased and I never crossed paths.

Federal Reserve policymakers are wrestling their own anxieties over a very different already way after-hours sort of plumbing problem as they contemplate keeping their collective word to hike interest rates in 2015. In theory, December is the only option left as policymakers are sure to prefer the first increase in nine years to be accompanied by the explanatory venue, the Chair’s press conference. But December is a tricky month to test the plumbing of the vast global fixed income markets. Looking ahead, March is the next scheduled press conference. As Deutsche Bank’s observant Chief International Economist Torsten Slok points out, March is no better in terms of historic liquidity levels in the bond market than this December.

Any plumber can tell you that strong liquidity is the critical element to maintaining a highly functioning and flowing system. Without strong liquidity in our overnight rates markets, we end users will be left feeling about as frustrated as if we had found ourselves standing in a shower waiting for that first blast, but instead christened with a tepid tap. Few market players fully comprehend (yours truly, among them) how the initial one-quarter-of-a-percentage-point interest rate increase is going to filter through to the overnight market.

A bit of background is essential here. Traditionally, banks lent money to one another in what we refer to as the fed funds market. In the good old days, when interest rates were positive, this process was rote. Federal funds were literally excess reserves that commercial banks deposited at their regional Federal Reserve banks. These funds could be lent unsecured to other banks that had insufficient reserves to meet what regulators require to be held. The rate at which they borrowed these funds overnight was thus referred to as the ‘federal funds rate.” The Federal Open Market Committee traditionally set a target rate for the overnight fed funds rate using its open market operations to control the rate, which is the cost to lend and borrow in the economy. In inflationary times of excessive lending, such as the early 1980s, the fed funds rate approached 20 percent.


The financial crisis changed everything. By December 2008 the traditional role played by the fed funds market was effectively nullified. Endeavoring to stimulate the economy, the Fed lowered fed funds to a de facto zero rate at the conclusion of 2008’s final meeting. And here is where things get interesting. Before that time, the Fed did not pay interest on excess reserves (IOER). Enter a Congressional Act, authorized in 2006, which allowed the Fed to begin paying IOER starting October 2011. As the financial crisis barreled towards the world economy, an emergency act accelerated this start date to October 2008. To be sure, the blank check to pay banks interest on their excess reserves did not pass quietly into the night.


In a Fed October 6, 2008 press release, policymakers justified their moves to, “eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.” In practice though, at a level of 0.25 percent, the Fed was paying banks more than they could earn in other cash alternatives. This opened policymakers to the criticism that they were paying banks to sit on monies that could be used to induce economic growth via lending, the exact opposite of what the economy needed at the time. Policymakers’ stock answer was along the lines of – this is no biggie in the grand scheme of things, we’re merely demonstrating that we have an effective tool to rein in inflation when the time comes. License, in other words, to rev up the printing presses and grow the Fed’s balance sheet, maneuvers critics say invite the future degradation of the value of money. Forget the pros and cons – the proverbial water has long since flowed under this bridge. Since December 2008, the Fed’s balance sheet has swelled from less than $900 billion to $4.5 trillion. The trick is figuring out what to do with the $4.2 trillion mountain of bonds amassed over the years absent the political will to earmark it to rebuild the Main Street economy.

Without getting too far into the reeds, banks today sit on $2.6 trillion in excess reserves. Using round numbers, banks would sacrifice a small appendage to jettison $2 trillion of these weighty reserves. Why is that? Post-crisis regulations require banks to hold a six-percent capital cushion against institutional depositors’ excess reserves. The more capital is encumbered, the less a bank can lend. IF the Fed raises rates, the roar of the tsunami of reserves rushing off bank balance sheets is likely to be very audible to those on Wall Street. In the words of the original navigator of the financial system, former New York Fed and now Credit Suisse’s Zoltan Pozsar, “Gone would be the penalty banks have to pay as they line up at the equivalent of an all-you-can-eat T-bill buffet.”

In the event you are not comatose at this point, things begin to get really complicated. The Fed has created a facility it uses to emulate that T-bill buffet. It has a name but you won’t like it – the Reverse Repo Facility. The explanation may as well come straight from the NY Fed’s website: “A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Desk sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between sales and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.”

Who in their right mind would dream up such a cruel devise? The reality is, the fed funds market has atrophied to such an extent (hard to trade something with a positive interest rates to control market rates when interest rates are zilch) that today there is a pittance of $50 billion in trades executed daily. Contrast this to the last time the Fed raised rates, in June 2006, when trading in fed funds was five times that much – and that was BEFORE the explosive growth in the level of excess reserves in the system.

Critically, the size of the RRP facility, which deals with money market funds (see “counterparty” above) COULD be infinite. In this base case scenario, all of the money flooding off bank balance sheets would find a home in a facility controlled by the Fed – think of the RRP as creating equivalents to Treasury bills, as being a cash alternative. If uncapped, the RRP would be able to absorb cash from money market funds and in doing so tighten monetary policy. Money market funds, on the other hand, would be attracted to the higher rate on offer from the Fed after an increase in interest rates. This would allow them to trade out of what they own today, loads of U.S. Treasury bills, which would be a win-win as so many other types of foreign and domestic investors have an appetite to buy U.S. government paper.

The best part is there is an optical victory for the Fed to go whole hog and slough off all of their excess reserves. The Fed, in turn, could quit paying that old IOER. Today, the fed funds rate is at zero and IOER is 0.25% — actual interest rates exist in a band. For reasons beyond the scope of your patience, when (be optimistic with me, folks!) the Fed raises rates, it will have to also raise the IOER by the same amount – say 0.25% to 0.50%. But the fed won’t have to pay squat if banks get rid of their prohibitively expensive excess reserves, which would please the Fed’s critics to no end. Counterintuitively, banks would be freed up to lend more if they escape their excess reserves’ regulatory shackles.

For now, we know not what fate awaits for the future of the RRP; it’s been capped at a fixed rate since concerns emerged on several fronts. Some policymakers were concerned the RRP would take the banks out of the funding equation, or “disintermediate the banking system.” In truth, banks are anxious to shed their excess reserves given they drag down return on equity and dilute net interest income. The sanctioning of the tremendous growth of the money market fund industry was also frowned upon as they are not regulated by the Fed. But as Pozsar points out, the funds are much more transparent than banks and easier for the Fed’s fellow regulators at the SEC to understand.

Inflation hawks have also raised concerns that the full allotment of the RRP would guarantee the Fed had to maintain a large balance sheet, which they fear to be inflationary. But the Fed can just as easily use the RRP to raise all overnight interest rates; the fed funds rate would necessarily follow its counterparts upwards. It is not inconceivable that the fed funds market be rebuilt as the size of the Fed’s balance sheet begins to shrink. Policymakers have clearly stated that interest rate hikes will be followed by the cessation of reinvestment of principal repayments. The clever folks at the NY Fed would hopefully be able to engineer a baton handoff – as bonds matured and rolled off the balance sheet, the fed funds market would assume a progressively greater role in the overnight rates market.

If all of these contingencies bring to mind a camel threading the eye of a gate, it’s by design. Exit mechanics will not be elegant and clean, nor can they be expected to be in the aftermath of one of the most magnificent experiments in all of central banking history. If you must, look at it this way. Consider a messy exit to be the lesser of two evils. We all know how the book on the alternative ends. Think of how long that much despised dead rat would have fouled the air if that oh so intrepid plumber hadn’t done his job by squeezing into that extremely constricting crawlspace to dispense with the rot.