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Draghi and the Dominos The Fed Refuses to Take the ECB’s Bait

This week’s Quill was co-authored by Danielle and Bond Strategist George Goncalves.

Have you ever met “someone you’re immediately attracted to who seems at once both exotic and approachable”? That’s how Rita Coolidge described meeting an eight-note refrain in her Hollywood home one afternoon in 1970. The instrument being played by her famous drum-mer boyfriend Jim Gordon was the piano. As “haunting” as the music was, it was lacking. As they played and replayed the refrain, a second progression began to build within Coolidge, a “countermelody that ‘an-swered’ and resolved the tension of Jim’s chords and built to a dramatic crescendo.” Soon enough, the couple was in London, where she played the piece for Eric Clapton hoping he would cover the demo. Though she was none the wiser, Coolidge’s hopes were realized even as Gordon walked away with full credits.

September 18, 2019

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If you’ve never ripped down a highway at breakneck speed, threatening to burst an ear drum blasting “Layla” at full volume, you’ve yet to live. But as brilliant as Clapton’s song is, it’s Coolidge and Gordon’s climatic coda that makes it the masterpiece it is. Sadly, there were multiple witnesses to both the inspired moment when Coolidge was struck by the countermelody and her auditioning the song for Clapton. As fellow Derek and the Domi-nos’ band member said of Coolidge, “Her boyfriend ripped her off.” Not having the funds or the clout to fight Clapton and his high-powered manager, Coolidge eventually found peace knowing it was Gordon’s daughter who received the songwriting royalties. As for Gordon himself, the undiagnosed schizophrenic, who allegedly beat Coolidge while tour-ing with Joe Cocker, he attacked and killed his mother with a hammer and butcher knife on June 3, 1981. He will likely be incarcerated to his dying day.

If only we could plea insanity on behalf of delusional central bankers. Instead, we have to sit back and take our lumps. There wasn’t even shock at the resumption of the currency war, one in which the Federal Reserve is refusing to engage…for now. It seems we will have to wait for the books to close. When they do, it’s likely European Central Bank (ECB) President Mario Draghi will go down in history as one of the most notoriously destructive leaders of all time.

Unlike insanity, inept monetary policy is a contagious disease, one that stock market in-vestors hope to contract. Aside from the massive runup in the S&P 500, what’s the first thing you note about the following graph? The first word that comes to my mind is “shal-low.” The depth of central banks’ capacity to normalize rates has fallen in the post-crisis era that’s featured quantitative easing (QE). In endeavoring to prevent the business cycle from cycling, the cyclicality of monetary policy has also been snuffed out.

The More Stocks Rise, the Less Central Banks Can Normalize

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U.S. Equity Indices, S&P, 500, Index, Price Return, Close, USD Percentage of Major Global Central Banks Easing Policy

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What’s unclear is whether the Federal Reserve, and by extension the universe of central banks, can succeed. Can Jerome Powell pull off his “mid-cycle adjustment”? Will Septem-ber’s rate cut be the last? Answering these questions requires he check off two boxes:

þ No U.S. recession

þ No dollar liquidity crisis

These two conditions are not unrelated. An overabundance of liquidity has propped up the global economy via the debt creation channel. That’s no secret. What’s become in-creasingly apparent is that global liquidity must remain conspicuous in its presence to maintain the visage of economic growth.

The challenge presented by an ever-increasing reliance on liquidity is that the flow can-not dissipate. If it does, any little hiccup can morph into a financial markets event that then bleeds directly into the real economy. It’s symbiosis in the worst possible way. The heightened reliance on liquidity has also rendered economies that much more vulnerable to violent swings. As you can see, the odds of a surprise negative GDP print have risen markedly over the past few decades which have featured an increased encroachment of monetary policy to support financial markets.

Lower for Longer Increases Economic Volatility

Challenging the Fed’s wish to stand pat is the nebulous factor of uncertainty. According to the Business Roundtable, CEOs’ outlook on the economy has fallen for six consecutive quarters through September. The trade war and slowing global growth in particular are taking a toll on planned investment, hiring and sales expectations.

Chief executives’ C-suite counterparts, chief financial officers (CFOs) are similarly down-beat on their outlook. Duke University’s CFO optimism index fell to a three-year low in the third quarter with 55% of those surveyed saying they’d become more pessimistic compared to a scant 12% with a brighter viewpoint. Capital spending plans have been pared back to less than 1%, the lowest level since December 2009. The most notable de-velopment is that economic uncertainty is now CFOs’ top concern, exceeding what we’ve heard throughout the cycle with regards to difficulty hiring sufficiently skilled workers.

Combine the perspectives of CEOs and CFOs and you quickly conclude that the stage is being set for more layoffs in the months to come. We’ve yet to see the last of downward re-

Source: National Statistics Agencies, CIBC Note: Based on Given Potential Growth Rate and Normal Standard Deviation

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visions to nonfarm payrolls, something lenders have already figured out. Yes, we’ve seen a pop in housing. But is this a case of too little, too late? As QI friend David Rosenberg tweeted out, “Finally, mortgage rate declines worked their magic. For some perspective, residential construction has contracted in each of the past six quarters, the first time since 2008-2009.”

Look at this next chart and make the call. Are lenders who have tightened standards de-spite falling mortgage rates likely to take it on faith that Powell’s assertion that his second quarter-point rate cut is going to spur appreciably higher levels of major household pur-chases? Those in the business of making loans to consumers are spooked for some reason, concerns the Fed obviously does not share.

Lenders Tighten Standards Despite Falling Interest Rates

The truth is lenders have a perfect prism into the “chaos” afflicting the overnight lend-ing market, as one market observer described it to Bloomberg. We know that we are not veering into a Lehman moment. But that can’t allay the reflexive reaction to the inexplica-bility of the spikes in overnight rates. The financial crisis was catalyzed by a seizing up in liquidity that could not be fully explained when the first shudders reverberated through the markets.

At his post-FOMC press conference, Powell put a brave face on the ability of the New York Fed’s Open Market Trading Desk (the “Desk”) to address the spikes in the rates in the repurchase, or “repo” market. Peel back every rational explanation for the unseasonal moves and you arrive at an inherent distrust among market players. They are dictating that emergency interventions be carried out by the Fed.

Ahead of Wednesday’s FOMC statement, the uber-bullish Brian Reynolds of Reynolds Strategy made the following observation in a note to clients: “The tone of their wording will have near-term significance because money market investors, as evidenced by 1-year forward Libor, are expecting about 125 basis points worth of cuts over the next year. We remind people this is only the 6th time in history that money market investors have been this strident about the need for cuts, and they have never been wrong about that need in those previous instances.”

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In Reynolds’ view, the Fed’s sating the short-rate market’s demands will manifest in the feedstock that maintains the credit boom that’s facilitated the longest expansion in U.S. history. The stock market would agree with his assessment. The moment Powell acqui-esced to reporters’ badgering him on the issue of QE still being on the table, stocks re-versed off their lows of the day and roared all the way back to close in the green.

History sides with the stock market’s conclusion. Global manufacturing activity has his-torically bottomed following a critical mass of central bankers shifting to an easing stance. Of course, “easing” in the post-era necessarily encompasses QE. That’s the rub of pushing out on the unconventional monetary policy spectrum. You can’t backtrack, which the ECB and the Bank of Japan have both demonstrated. That said, you can’t achieve critical mass without the Fed leading the charge of central banks loosening policy.

A Critical Mass of Easing Rescues the Global Economy

The stock market is giving Powell the benefit of the doubt. The overnight lending market is revolting. Market participants have begun to wise up to the fact that Powell bet on the wrong horse by backing the appointment of John Williams as president of the NY Fed, a move I openly questioned the minute Williams’ promotion to Vice Chairman of the FOMC was announced. How on earth can you entrust the operations of the financial system to an academic who boasted that he was the sole District president who didn’t have a Bloomberg terminal on his desk?

The sharp bitterness Powell can taste may persist for the rest of his life. Not only did Wil-liams oust the architect of QE, Simon Potter, he’s openly advocated for more aggressive easing than Powell. The upshot is short-rate market participants smell blood in the water. They know the Desk is effectively led by someone who has no interest in, nor knowledge of, the intricacies of the overnight lending market. The disruptors know they’re in control of the situation which implies they can eventually force the Fed into the QE corner. This is where George’s expertise and firm grasp of the plumbing of the financial system come in handy. For it is QE that got us to where we are in the first place.

Over the past decade QE has altered markets in countless ways. From a public policy per-spective, one of the aims was to shift sentiment with the aim of rekindling animal spirits. From the actual implementation process, QE purchases of long-dated duration assets (Trea-

Source: Topdown Charts, Thomson Reuters Datastream

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suries) and spread products (mortgage bonds) have motivated portfolio rebalancing away from safe assets into credit and other risk assets (stocks and corporate bonds). The kicker was that QE left the banking system long excess reserves which helped banks meet tight-ened regulatory and liquidity requirements imposed in the aftermath of the financial crisis.

Lately market participants have been clamoring for liquidity in the system, screaming that the financial system is entering a drought. What they’re alluding to is the massive delta that’s followed peak QE3. Back then, excess reserves in the system were north of $2.5 tril-lion. They’ve since been halved. A 50% reduction in anything is a big deal, but for money markets it’s huge and showing up as spikes in repo and other short-term interest rates.

As you can see, the decline in reserves was not strictly a function of the quantitative tight-ening (QT). The Fed’s Treasury holdings are down nearly $375 billion from the peak while their MBS book shrunk by about $275 billion. Note their MBS holdings are poised to decline further as the majority of MBS proceeds are now reinvested into Treasuries. But that still only accounts for half of the declines in the excess reserves from peak to their recent trough. What gives? That would be the Fed’s other liabilities.

Financial System Craves Liquidity

Currency in circulation -- good old paper money which eats into the excess reserves in the system -- has been growing by nearly $90-100 billion a year, an annual rate north of 6%, since the end of QE3. The Treasury also parks its cash at the Fed. Debt ceilings aside, since 2015 the Treasury has aimed to hold between $300-400 billion in cash. If you like, this balance in the country’s effective checking account is akin to the nation’s strategic petroleum reserves, an SPR for U.S. cash. And lastly, foreign central banks are parking almost $200 billion more in cash at the Fed post-QE3. The premium on offer at the Fed above other cash rates is catnip in a negative interest rate world, but also drains reserves from the system.

That brings us to where we are today. A confluence of events has encumbered primary dealer balance-sheets as the liquidity chairs get shuffled around the Titanic’s deck. The

Source: St Louis FRED

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Excess Reserves Fed UST holdings

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2017 tax cut and ongoing increases in deficit spending have flooded the system with hun-dreds of billions of dollars of new Treasuries. That, coupled with the two last straws, QT’s being supersized a year ago and May’s yield curve inversion, pushed dealer holdings of liquid products, including MBS, beyond $250 billion in the fourth quarter (“Stage 1” in next chart). The $300 billion mark was subsequently hit during the earlier part of the summer (“Stage 2”).

Repo Stability Holds the Keys to the Kingdom

Let’s remember that due to regulatory liquidity requirement on banks, and good old fash-ion safekeeping/hoarding of excess liquidity, this Treasury supply deluge was partially piling up at dealers while foreign official buyers parked more cash at the Fed in lieu of buying bonds, the natural substitute. Foreign investors, especially on the private side, were further discouraged from buying Treasuries when their currency-adjusted U.S. rate curves further inverted. They parallel U.S. banks, that benefit from a steep curve, who too were less willing to buy Treasuries when the 3-month/10-year curve inverted.

Treasury auctions have benefitted from the duration grab globally but – yellow flag -- there’s been a decent amount of concession in the form of clearing yields at auctions com-ing in slightly higher than prevailing market rates. Treasury auctions have also seen an increase in domestic buyers, many of which are levered institutions. This dynamic makes the recent repo spikes all the more troubling. The Treasury needs as many willing buyers as possible ponying up at auction to navigate the increased bond supply.

A stable repo rate provides certainty in terms of the carry calculation and ultimately the cost of doing business for dealers, hedge funds and other levered investors. This is why the last few days of repo increases, which according to Bloomberg and the Financial Times, saw overnight repo rates spike to 8%-10%. That is flat out unacceptable and more impor-tantly, unsustainable. The world’s largest bond market is funding near double digits while yielding 2% or less.

Eventually, levered investors need to de-risk. That requires cash buyers, who can buy bonds

Source: NY Fed, Bloomberg, ICAP

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outright, step in and willingly forego buying something else. The wrinkle is the time of the year we are heading into. Market players are fatigued. If repo remains volatile into year-end, the risk is that dealers will need to warehouse more U.S. Treasury risk again.

The bottom line is stable repo allows for a properly functioning Treasury market and ultimately prevents Treasury holdings crowding out of other credit and risk markets. For a market and economy so sensitive to the stock market and financial condition, this drives to the core of why repo and plumbing matter.

So, what can central banks do at this point to either ease further, in an attempt to soft land the economy while at the same time addressing market functionality challenges, or alternatively provide more reserves, which are increasingly extinguished via cyclical factors (Treasury cash rebuild) or structural forces (like currency in circulation)?. A few ideas come to mind.

As we wrote in A Deluge of Dollars, one idea is the launch of a standing repo facility (SRF) which strips the stigma of financial institutions posting Treasuries for cash at the Fed as opposed to using market repo venues. The aim would be to create a strong ceiling on short rates and dampen the volatility seen in recent days. Although the Fed has been studying the SRF for months, they refrained from starting the launch sequence at its most recent FOMC meeting. This could mean they’re not ready or perhaps prefer to stay with the floor system with ample reserves.

Alternatively, Powell et al might envision skipping the SRF and do QE instead.

The Fed is already in the process of buying Treasuries with proceeds from MBS bonds roll-ing off its balance sheet. The QE buying apparatus is in place. And yet, the Fed is holding the line on sticking with rate cuts as its preferred form of easing. Launching another asset purchase program and calling it QE, with stocks near their all-time highs and the unem-ployment rate at a half-century low could broadcast panic at a most delicate moment.

If the issue is that liquidity is being locked up, hoarded or extinguished with each passing day, perhaps Fed officials can simply focus on adding reserves as opposed to re-launching QE, which communicates they’re back in the business of credit easing.

Here’s where this gets good. Academics rock at meaningless acronyms. The Fed could cre-ate something called a “Supplementary Reserve Program,” (SRP!) wherein the Fed mod-els the seasonal trends in currency demands, and in turn, monitors and projects the needs of the Treasury General Account (TGA). Cash management of the TGA ebbs and flows with tax payments and at times can be nearly depleted due to debt ceiling constraints. Lastly, the SRP would track the inflows and outflows of foreign central banks engaged in reverse repos with the Fed as a proxy for cash allocations. In practice, they could dovetail on the operation schedule being used to allocate the MBS proceeds and just increase them whenever there’s an offsetting decline in reserves, whatever the source.

Brilliant, no?

That process alone would make most risk-takers view the SRP as a program that slowly increased the size of the Fed’s balance-sheet due to mechanical demands. “It’s not QE, folks!” The catch is markets live and die on fresh easy money, as we’ve demonstrated and written for years. It’s been the primary driver of market returns for the last decade.

If you’d prefer a visual, the rolling annual returns of the S&P 500 had a strong correlation during the introduction and completion of the two major QE programs – QE2 and QE3. Equity returns arguably flat-lined in the years that followed and only got a major boost

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after Trump was elected, a la renewed animal spirits, better growth thanks to tearing down the regulatory apparatus and the promise and eventual delivery of tax cuts.

Fed Incrementalism Won’t Placate Markets

Cushioning the transition further, once Fed officials stopped easing, they didn’t tighten quickly alongside corporate issuance and stock buybacks further fueling equities’ gains of the last three plus years. What we increasingly hear from central bankers is incremental-ism and not the shock and awe of days past. Sadly, even if the Fed introduces a program such as our brilliant SRP, it won’t move the needle for risk assets. Markets got an early glimpse of this after the ECB re-launched QE, but at a paltry monthly rate.

If the repo market stabilizes relatively quickly, as per Powell’s post-FOMC script, further Fed easing actions will be delayed, for now. But for the record, all bets are off if repo stays mired in dysfunctionality until the Fed next meets in October to say nothing of the disarray we know the calendar promises as year-end bears down on us. If disruption continues to rule the trading day, the Fed would likely be forced to make a destabilizing intra-FOMC intervention.

On the optimistic flip side, if repo is tamed in the interim, there’s serious upside risk to the economy and financial markets due to the lagged effects of Fed easing kicking in and the U.S. and China arriving at a trade war truce. Such a scenario would unhinge long-term rates while equities cheer the worst having passed.

This is where a word of caution must be voiced. Premature celebration could be a head-fake setup for markets into year-end as the calendar exacts its revenge with a renewed bout of dollar funding pressure irrespective of any Fed easing.

Let us paint you a picture. Dealers would see further pressure on their holdings of long-term Treasuries while still dealing with a deluge of front-end supply impacting repo. The cash curve would bear-steepen temporarily and then flip into a full-on bull steepener once the Fed realizes they’re forced to expeditiously cut rates again. Meanwhile, swap spreads

Source: St Louis FRED

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10 © Danielle DiMartino Booth | Quill Intelligence | info@quillintelligence.com

would remain under pressure tied to excess supply and heightened repo volatility. There will come a time to be long duration, but there will likely be a better entry point.

It may involve kicking and screaming, but Powell could hold the line, and in doing so provoke a true liquidity event. The better outcome entails a large dose of humility. John Williams is incapable of captaining the NY Fed through these rough waters. But there are plenty of market experts the Fed can discretely tap to guide its way back to fully functional liquidity in overnight markets. The best news is a true market patriot would happily help the country with no expectation of glory. It would be as if Rita Coolidge had knowingly gifted the world the best piano solo ever written.

We openly ask Jay Powell to play the music, rip down the highway, let it loose and do right by his country.