Pottersville
Sept, 22, 2019 – Weekly comment
There was a lot packed into the past week. It started with the jump in oil prices as a result of attacks on Saudi infrastructure, featured a surge in the repo rate catalyzed by a corporate tax date which revealed a shortage of reserves, encompassed the FOMC rate cut, and ended with the announcement of quarter-end term repos by the New York Fed.
Yields, which in the beginning of September had bounced hard off the new lows set in late August, eased last week, with tens falling just over 15 bps to 1.744%. The thirty year bond fell over 18 bps to 2.187%. WTI crude rose 6% (CLX9) and SPX fell half of one percent.
In my note Wednesday morning (pre-FOMC) I said that the Fed had NOT lost control of money markets, citing a speech in April by NY Fed desk SVP Lorie Logan which had foreshadowed the eventual need for balance sheet expansion. Here is a key excerpt:
As the level of reserves declines, the Desk will monitor medium-term forecasts of reserves and other indicators of reserve conditions. At some point, the FOMC will decide that the system has reached a level of reserves consistent with efficient and effective implementation.
Once this determination has been made by the FOMC, the Desk will need to conduct outright purchases of Treasury securities to supply reserves in order to offset the general decline in reserves from trend growth in non-reserve liabilities and ensure that reserves remain ample.21 In this regard, these purchases will have the same purpose as they did prior to the financial crisis—expanding the size of the SOMA portfolio to accommodate growth in currency and other liabilities. However, the size of these purchases will likely be larger in nominal terms because the growth of non-reserve liabilities is larger. For example, in 2018, currency increased by almost $100 billion, as shown back in Figure 3, compared to average increases of $40 billion a year in the early 2000s before the crisis.
She had noted the end of balance sheet run-off in September, but said the FOMC expected “the level of reserves to be somewhat higher than necessary for efficient and effective monetary policy implementation.” On this point, the Fed was taken by surprise, just as they were last October, when balance sheet reduction had ratcheted up to $50 billion per month, which was a partial spark for Q4’s asset conflagration.
Later in the speech she noted that EFFR had risen one basis point above IOER, and talked about the Fed’s close monitoring of repo and reserve balances. Both she and former head of the desk Simon Potter talk about the “flat” and “steep” part of the curve, in terms of how rates adjust to changes in the size of reserves. In a speech on Aug 4, 2018. Potter gave a detailed account of the Fed’s framework for monitoring rates and reserves. He stated,
The target range is an important feature of the FOMC’s public communications, and maintaining federal funds rates within it is therefore taken quite seriously.
In short, the NY Fed’s market desk anticipated issues which might flow from policy and balance sheet changes. The implementation of repo operations last week was a signal that the Fed was on top of the situation. Indeed, the Fed Effective (EFFR) had come down to 190 bps on Thursday, having jumped to 230 earlier in the week. In futures, October Fed Funds traded as low as 98.085 before FOMC and repos, but closed at 98.13 on Friday or 1.87%, 26 bps lower than EFFR in the beginning of Sept. The spread between EDZ9 and FFF0 had risen to 41.5 during the repo rate surge, but came back to end the week at 36.5 (98.000 and 98.365). This spread reflects “turn of year” pressure and is a libor/ois proxy, and while concerns about year-end funding pressures are evident, they may have peaked. For a turn comparison, note that EDH0/FFJ0 spread is only 23.5 bps (98.255 and 98.490).
However, upon further reflection, I am actually less confident that the Fed will weather this storm gracefully. As noted, Logan’s speech was in April. By late May, Simon Potter and Richard Dzina with a combined 50 years of experience at the central bank, left the NY Fed on the same day due to internal management issues with the new NY Fed President John Williams. From an American Banker article:
“I’m very surprised that both of them would do this on the same day with three days’ notice,” said Tom Simons, a senior economist at Jefferies in New York. Simons said Potter’s job, as head of the central bank’s open-market operations, is “arguably more important than being president of the some of the regional Fed banks.”
He said the departures are especially worrying for market participants given the uncertainty hanging over the New York Fed’s plan, in conjunction with the U.S. Treasury, to replace the scandal-tainted London interbank offered rate…
I would say that the head of NY Fed money desk is unequivocally more important than ALL of the regional Fed Presidents besides NY. Ivory tower policy is transmitted to the marketplace by the NY Fed desk. The desk monitors and implements. Contrast that to Williams’ large communications gaffe on July 18 when he indicated the Fed might cut 50 bps. Immediately afterward the NY Fed went to the unusual step of ‘clarifying’ Williams’ remarks, saying they were the outcome of 20 years of academic research. There’s the problem: Academic vs hands-on market experience and constant market contact. The loss of the latter is a huge problem. Some have now concluded that Williams is a communications liability. Morale within the NY Fed is said to be declining. Probably wasn’t helped by Dudley’s going off the reservation with his, ‘Fed should actively pursue policy choices to prevent Trump’s re-election’ Aug 27 op-ed.
On Friday, Potter, at a private speech, said the Fed “may have to expand the central bank’s balance sheet through outright purchases of US Treasury securities, to ensure stable liquidity conditions at the end of the quarter as well as at year-end.” In an organization that prides itself on concensus and independence, there were three dissents at the FOMC as Bullard opined for a 50 bp cut (apparently lobbying to become the next Fed chief) while Rosengren and George called for no cut. Rosengren voiced worries about elevated asset prices and market distortions caused by low rates; valid concerns.
The Fed will likely have to announce, probably at the next FOMC on Oct 30, that QE is back. Former rounds of QE have coincided with stronger equity prices and falling bonds as stimulus was thought to increase inflation expectations and term premium. With stocks near all time highs in an uncertain environment, it’s not at all clear that prices will react in the same way. Brexit lies ahead, Mideast tensions are running high, China cancelled an agriculture field trip to Montana, casting doubt on trade talks. Lagarde takes over the ECB at the end of next month. I have often thought that markets test new central bank chiefs within a year and thus I had forecast difficulties for Lagarde, but maybe the more pressing concern is the NY Fed and confidence in its ability to both participate in policy choices and implement them. Key tells will be risk-asset prices, gold and treasury yields. I think that risks are high that stocks respond poorly over the next month, and that ten year yields re-visit the low of 1.36%.
This week features 2, 5, 7 year auctions in total of $113b raising over $44b in new cash, which will settle at quarter end, Sept 30.
| 9/13/2019 | 9/20/2019 | chg | |
| UST 2Y | 180.0 | 170.4 | -9.6 |
| UST 5Y | 174.9 | 162.5 | -12.4 |
| UST 10Y | 189.6 | 174.4 | -15.2 |
| UST 30Y | 237.0 | 218.7 | -18.3 |
| GERM 2Y | -70.7 | -71.9 | -1.2 |
| GERM 10Y | -44.9 | -52.1 | -7.2 |
| JPN 30Y | 33.5 | 35.3 | 1.8 |
| EURO$ Z9/Z0 | -40.5 | -46.0 | -5.5 |
| EURO$ Z0/Z1 | -6.5 | -8.0 | -1.5 |
| EUR | 111.57 | 110.19 | -1.38 |
| CRUDE (1st cont) | 54.80 | 58.09 | 3.29 |
| SPX | 3007.39 | 2992.07 | -15.32 |
| VIX | 13.74 | 15.32 | 1.58 |
https://www.newyorkfed.org/newsevents/speeches/2019/log190417
https://www.newyorkfed.org/newsevents/speeches/2018/pot180803
