This little monster that feeds beneath the surface of global banking at its core briefly raised one ugly eye out of the water as 2018 turned into 2019. I wrote back then that the interest spike we saw in the kind of overnight interbank lending known as repurchase agreements (repos) was just the foreshock of a financial crisis being created by the Fed’s monetary tightening. I said the Fed’s continued tightening would eventually result in a full-blown recession that would emerge, likely out of the repo market, sometime in the summer. In the very last week of summer, the Repo Crisis raised its head fully out of the water and roared.
When I first wrote of these things at the start of 2019, the Fed had only been up to full-speed tightening for three months, and already it was blowing out the financial system at its core. The stock market had just crashed with the onset of full-speed tightening just as I had said it would. It fell hard enough to where the only index holding just one nostril above the icy water was the S&P 500 at a 19.8% plunge. Even that holdout briefly dipped its last air-hole under water in the middle of the day (i.e., below 20%), but didn’t stay below for the count. All other major indices and most minor ones took the full polar-bear plunge into the deep, dark water by this day in December.
If not for the obvious bullish bias in all reportage everywhere (except alternative media), the market would have been declared a new bear market at that time (based on the market’s own historic standards where a 20% fall is a bear market), and any bull market after that would be a new bull market, not what is now called “the longest bull market on record.” (I mean, with even the S&P going below the surface intraday, why should the S&P tip the balance against the declaration of all other indices, including the Nasdaq that had driven the market for years and the Dow, which has the longest history?) That kind of reportage, however, doesn’t exist any longer.
The Fed, immediately after this long, dark day last December, slammed the brakes on its interest-rate increases andpromised it would stop tightening sooner than it had originally said it would. That was also something I had said for years would quickly become the case when the Fed finally did go into its long-announced tightening regime.
What developed into the worst December in US stock-market history culminated in an extraordinary repo interest spike at the end of the year, which I claimed happened because the Fed’s tightening had already pulled bank reserves down below the depth the Fed’s new fake recovery, as fragile as a Christmas ornament, could withstand. I showed with graphs how the Fed’s tightening was resulting in bank reserves depleting everywhere to a degree that proportionately matched the Fed’s tightening. That depletion was causing banks to stop loaning to each other, leaving a shortage in overnight funding on the biggest reconciling day of the year.
Now we are coming up on that same day of the year for 2019 when all bank accounts and market funds, etc. are brought to their legally mandated balances at year’s end. As we near that critical date again, the man who wrote the Fed’s own Bible on repos has predicted the likelihood of the greatest repo crisis in history at the turn of the year.
Second coming of the Repo Crisis predicted
Two weeks ago, Zoltan Pozsar warned the world and the Fed that catastrophe would bite us all at the end of the year as the culmination of the repo saga that burst out of the deep at the end of last summer. You may never have heard of this Hungarian fellow, but he was long the Fed’s guru on repos. So, when he talks, the Fed DOES listen. (Therefore his warnings may be the one thing that shunts the disaster of which he’s warned.)
Pozsar laid out the foundations for the modern repo system while working at the US Treasury and then at the New York Fed. He also helped guide the Fed in its early response to the Great Financial Crisis (a.ka. The Great Recession). So, he has a good idea of how a financial crisis forms and a good understanding of what the Fed did to create its recovery, and he might, therefore, … might … have a good sense of where the weaknesses in that recovery effort are and in how they could bring destruction again.
Many, even at the Fed, have said no one knows more about repo than Pozsar, who was also a point person for White House officials during the Great Recovery period. Now, I don’t think much of his recovery plan; but it could very well be that he knows its weak points and knows when he sees it breaking up and is not as constrained by position as the Fed is in speaking out about that — since he no longer works for the Fed.
Two week ago, Pozsar laid the Fed bare for its inadequate response to September’s Repo Crisis, which was one of the ugliest ever from day one. In a note titled “Countdown to QE4,” Pozsar explained why all of the Fed’s interventions between September and December failed to put the Repo Crisis to rest.
Pozsar noted how, as I had pointed out at the start of 2019, the Fed’s balance-sheet reduction essentially forced major banks to take on a lot of government securities. Because the Fed was not refinancing those securities, and the market was not buying up the Fed’s slack, the Fed’s member banks were getting stuck with them. While they can carry these almost like reserves on their own balance sheets, they are not as liquid as cash. They are used in overnight to trade in exchange for immediate cash. However, if all banks have more of them than they want, then willing trading partners become hard to find. Cash reserves continued dwindling under the Fed’s continued tightening throughout the first seven months of 2019 as treasuries kept piling up in the Fed’s member banks — especially those that are primary bond dealers.
As Pozsar cautions, the core problem at the heart of the repo blockage is that as banks shifted from owning reserves to collateral (mostly Treasuries) … large U.S. banks like J.P. Morgan that are central to year-end flows spent some $350 billion of excess reserves on collateral since the beginning of the Fed’s balance sheet taper, leaving banks (and especially JPMorgan) dangerously low on reserves.
Pozsar posited two weeks ago that …
Dealers and banks loaded up on collateral as a trade – a trade they were supposed to be taken out of by eventual coupon purchases [longer-term treasury purchases] by the Fed. But the Fed never did that, and for the first time we’re heading into a year-end turn without any excess reserves.
In other words, the Fed has maintained that its massive rescue attempts from the Repo Crisis are “not QE” because it is only vacuuming up short-term treasuries in exchange for new reserve money for struggling banks. Its exclusive focus on short-term treasuries allows it to claim its actions are just temporary monetary stabilization and intervening crisis management. It’s a baloney claim because the Fed indefinitely rolls those over, but it’s a claim that Wall Street and politicians have readily accepted. It gives them a shred of an argument to stand on.
Pozsar wrote that approach is exactly why the Fed’s actions aren’t resolving the repo crisis. So, the Fed is going to be shoved off that approach in order to solve the problem. The system is starving for a return to the Fed’s recovery-era balance sheet — for permanently expanded money supply — and the Fed isn’t giving that. The banks are mostly out of short-term treasuries to exchange in repo actions and stuffed with longterm ones the Fed is not offering to buy in its own repo operations. The Fed is creating money supply by endlessly rolling over short-term operations, but the banking system is starving for permanent expanded money supply to maintain the “recovery” that was built on that supply. That’s a problem that I’ve said here for years the Fed and the world would face as soon as the Fed tried reducing its balance sheet on which the whole world was becoming dependent.
What we need for the turn [of the year] to go well are balance sheet neutral repo operations, or asset purchases aimed at what dealers bought all year: coupons [longer-term bonds], not bills – the former to get around foreign banks’ balance sheet constraints around year-end, and the latter to ensure that excess reserves accumulate with large banks like J.P. Morgan.
In other words, it is time for the Fed to quit pretending it isn’t engaged in QE and just give the banks what they really need!
Because banks had more treasuries than free cash, availability of cash to trade temporarily in overnight or term repos (where one bank temporarily exchanges a treasury with another for cash with the promise that the bank offering the treasury will repurchase the treasury the next day or a few days later) was drying up. Banks needed the Fed to permanently suck these treasuries back up and replace them with cash. Rolling them off the Fed’s balance sheet for investors to pick up hadn’t worked as well as expected. Banks couldn’t find enough investors to resell them to and were stuck with them. So, they don’t want to do repos and get even more of them.
The Fed’s quandary, and why it has refused to cave in and do what banks need, is that the Fed is barred from directly financing the US debt, and it maintained throughout all of its QE regimes that it was not doing that on the sole basis that it would eventually roll all of the QE off, making it just a temporary monetary fix to a crisis, not permanent US debt financing. Sucking up all the long-term treasuries that have overstuffed the banks would mean admitting none of that ever worked or ever will (as I have always said would prove to be the case).
Indeed, instead of buying coupon bonds as Dealers have been quietly demanding behind close doors, a process which would allow them to sterilize their massive Treasury holdings, the Fed announced in October it would only buy T-Bills [short-term treasuries] in order to not freak out the market that it is officially launching QE 4 (as a reminder, the only semantic distinction between whether the Fed is doing QE or not doing QE is whether it is soaking up duration; the Fed’s argument is that since Bills don’t have duration, it’s not QE. However once Powell starts buying 2Y, 3Y, 5Y and so on Treasuriess, the facade cracks and the Fed will have no more defense that what it is doing is precisely QE 4)
… or, as I am calling it, QE4ever because that is really what it is going to turn out to be as we are now seeing in Pozsar’s argument that the banks need to return permanently to the Fed’s expanded balance sheet in the form of cash in their reserves, or markets developed on that liquidity will starve for cash.
How bad is the Repocalypse?
Pozsar pointed out that, because the Fed was not doing what the banks needed, the end of 2019 would likely be a catastrophe.
Central bank liquidity is useless unless primary dealers have balance sheet to pass it on, and that they’ve been passing it on since September does not mean they will at year-end … …and Murphy’s law applies in money markets too…. In summary, year-end balance sheet constrains will preclude primary dealers from bidding for reserves from the Fed through the repo facility or through repos from money funds. The slope of money market curves suggest that excess reserves won’t build up at banks, and so U.S. banks will not be able to fill the market making vacuum left by foreign banks.
The flash of a repo warning at last year’s turn and then September’s full emergence of the Repo Crisis will all be nothing compared to the full revelation of the Repocalypse that will form at the turn of this year if the Fed does not seriously address this problem.
After noting other serious stresses building up in the banking system toward year end, Pozsar stated that the US banking system will have mere “scraps” left to lend out in repos at the end of the year. And that is after the Fed has already created about $350 billion in new money in the system via its own endlessly rolling-over repos and via its new “not QE” wherein it is buying up short-term treasuries in exchange for newly created reserve cash.
These flows will be scraps of excess reserves … and that’s the best case scenario. The worst case scenario is that collateral upgrades aren’t sufficient and U.S. banks stop making markets in FX swaps and so exacerbate the vacuum triggered by foreign banks. We are on track to realize the worst case scenario, and the market doesn’t price for that.… Repos may still print as bad as last year-end, while FX swaps could end up as the orphaned asset class without an obvious backstop, and that may force banks in some parts of the world to the edge of the proverbial abyss.
Pozsar believes this could create serious problems for some major hedge funds as well, which may not find the kind of balance-sheet rebalancing they need at the end of the year.
The overnight repo problems might stem from the reluctance of the four largest U.S. banks to lend to some of the largest hedge funds. The four banks are being forced to fund a massive surge in U.S. Treasury issuance and therefore [they have] reallocated funding from the hedge funds to the U.S. Treasury. Per the Financial Times…: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” – was a key factor behind the [recent repo] chaos, said Claudio Borio, Head of the monetary and economic department at the BIS [Bank for International Settlements].
Massively levered hedge funds may be in for a shock in the coming days, as bank sponsors are woefully low on the reserves that the hedge funds need to perpetuate their RV [relative value] trades (and leverage) into the new year.
As a short explanation, various kinds of funds are required by their own statements to investors on how they are managed to maintain specified relative values of equities to securities to cash in their holdings. As markets change, these have to be rebalanced and brought in line at the end of the year, which may require large cash moves through the banking system in addition to other kinds of trades or swaps.
Given that … excess reserves are gone, the FX swap market, unlike last year-end, may end up without a lender of next-to-last resort, and so it will likely trade at implied rates far worse than anything that we’ve seen in recent year-end turns….
You may end up as a forced seller of Treasuries. Our overarching point is that a dealer is a hedge fund’s enabler, not its friend … and dealers that co-exist with large bank operating subsidiaries have an incentive to introduce imbalances [in] the repo market to boost the value of their banks’ excess reserves, and dealers that have the balance sheet to take liquidity from the Fed’s repo operations will not necessarily do repos with RV hedge funds if FX swaps offer a much better value.
Our big picture conclusion is that… the safe asset – U.S. Treasuries – … will go on sale… Treasury yields will spike. The FX swap market could be the trigger of forced sales of Treasuries around year-end, and these funding market stresses will likely pull away capital and hence balance sheet from equity long-short strategies which could spill over into a broader equity selloff… during a Treasury selloff – that’s not the right kind of risk parity Christmas.
In other words, the greater risk, according to Pozsar, is that all of this spills over into stocks, too, crashing all markets.
Year-end in the FX swap market is thus shaping up to be the worst in recent memory, and the markets are not pricing any of this. Prices don’t seem to discount the facts thatexcess reserves are gone and the Fed’s operations still have not added any…. Something will have to give and the turn has to get very bad before something gives.
In Pozsar’s view, the Fed could best avert this by giving up its charade that it is not doing QE and launching directly into QE4 before the year’s end.
The Fed’s response
All of this could turn out like the Y2K bug that didn’t bite precisely because everybody responded to the warnings as needed. The Fed listened to Pozsar … sort of … because when Pozsar speaks about repo, the Fed listens. Still, its response remained constrained by its need to maintain the charade that it is not doing QE4ever and, thus, monetizing the US debt. It did something big, but did not do exactly what he said where he said it needed to happen.
In his December statements, Powell noted that interest rate targets will be on hold throughout the coming year (doing nothing to help with Pozar’s noted problems but helping the stock market feel relaxed for the Santa Clause rally). Pressed at the Fed’s presser on Zoltan Poszar’s repo doomsday scenario, Powell stated in the usual Fed tone of calm assurance that all is going smoothly, but the Fed is open to purchasing coupon-bearing treasuries (i.e. longer-term treasuries) if need be. (Still not actually doing it to resolve Polzer’s immediate concern ahead of crisis.) In fact, Powell tried to keep things as short-term on the longterm end as possible:
We’re not at this place, but if it does become appropriate for us to purchase other short-term coupon securities, then we would be prepared to do that if the need arises.
With reporters questioning him on Pozsar’s warnings, Powell noted the Fed will adapt if needed. That still left my own longterm question wide open as to whether or not the Fed would ever fully get done what it needs to do in time — something I’ve claimed it would not do.
With Pozsar’s push, the Fed may have finally proved me wrong on that … maybe … by saying it will leap into that if necessary. In other words, it may, at the very last minute do what is really needed just in the nick of time, thanks only to Pozsar’s staunch forewarning.
Powell also said the Fed would adjust its repo operations as required, something it has been endlessly adjusting upward, as I said back in September the Fed would have to do … which still does not resolve Pozsar’s concerns in the manner he prescribed. The stated purpose, of course, would not be to boost bank reserves forever; rather, “the purpose is to ensure monetary policy decisions are transmitted to the fed funds rate.”
Still, not much hope there that the Fed gets it. In the very least, the Fed is constrained from showing it gets it by saying it is engaged in full-fledged QE … forever. Just tweaks of the existing plan into the year end.
So, the repo market continued to suck up all the Fed would throw at it, oversubscribing the next Fed repo offering.
And then …
Two days later, the Fed perhaps saw the light … almost. It expanded (again) its term repo operations to create vast money supply across the New Year turn. The Fed promised it would saturate markets with half a trillion dollars in total repo operations before the year turned! Half a trillion!
You cannot tell me now that the Repocalypse is not the little monster that roared, as I wrote a month ago.
The Fed exceeded anyone’s expectations (except maybe Pozsar’s) and announced it would offer its two-week term operations twice a week for a total of four operations that would be in place to span the year’s turn, and it would (once again) expand its overnight operations (this time to $150 billion), and on December 30th, it would offer a special $75 billion operation that would not mature until January 2nd.
The new schedule would look like this:
That’s almost half a trillion in aggregate in new money in just revolving “temporary” repo operations in place at the end of the year, and when you add the Fed’s ongoing T-bill purchases, it is a half a trillion injected in December alone!
So, no one can convince me the financial world did not crash at the end of summer when I said it would. The Fed may have jumped in with a response massive enough to avoid the recession that I said this financial catastrophe would cause, but that remains to be seen. Anything that requires such an ongoing and gargantuan response was certainly a leviathan of a problem.
The end of the year isn’t here yet, and the Fed has still avoided precisely following Pozsar’s advice by trying to do something similar to what he sought, but in purely short-term temporary operations because it feels constrained to maintain the charade that none of this has to continue beyond the end of the year … or, at latest, beyond April when its short-term T-bill purchases are scheduled to end with those rolling back off the balance sheet fairly quickly, given their short maturity dates. However, banks may simply not have many short-term treasuries to use when D-day comes.
The Fed has been claiming this “temporary” nonsense since September even though each new round of new money had to be increased in new rollovers a week or two later. It has been an ever-burgeoning temporary set of operations that has not hit the half-trillion mark!
In short, all that the Fed has now committed itself to will look like this when it has been completed:
What a coincidence! It expands the Fed’s balance sheet exactly back to where it was before the Fed started to pretend it could unwind its balance sheet … as I always said the Fed would find it could never do! Oh how fun!
For now the Fed’s actions FINALLY seem to have been enough to calm the raging monster. For the first time in months, the Fed is finding fewer takers for its term repo operations than what it is offering:
So, maybe a recession caused by the full emergence of late summer’s Repocalypse has been averted. Maybe the little monster’s head has been chopped off and there will be no second coming at the turn of the year. Maybe. Or…
On the other hand … the Fed has not gone longer-term, full QE as Pozsar prescribed because it cannot publicly admit it is doing that, so MAYBE all of that won’t work. Maybe banks are not soaking up the bigger repo offerings simply because, as Pozsar stated, they are near the end of their capacity to do ANYTHING with shorter-term treasuries. So, maybe they are not sucking up all that the Fed is extending in repos because they can’t. The Fed isn’t buying what they need to trade!
For now, however, the overnight repo rate is back under control:
All is calm, and not a creature is stirring, not even a mouse!
Pozsar is not convinced:
“If the yearend is less of a problem because of the repo bazooka we got from the Fed, and if the message of my report played a part in getting that bazooka, then that’s a nice way to be proven wrong.” However, he then added ominously that “now we’re getting into a point in the year when balance-sheet problems are going to flare up, and I think the system will get gummed up again.“
Repocalypse may be as quiet as a Christmas mouse again now, but, as we cross over into the roaring twenties, will it, at midnight, become the creature that suddenly roared back out of the deep? The Fed fully failed to see what was needed in September and how bad the problem was, and Pozsar thinks the Fed may still have failed because it is trapped into not admitting it must go full QE and are, therefore, is managing a longterm problem with only short-term solutions that do not resolve the banks’ actual reserve needs.
If the Fed has finally managed to cut the head off the Repocalypse (as the repo charts above seem to indicate), then it may have also nipped my predicted recession in the bud, countering my claim that the Fed would — because of its own blindness and the QE corner it would paint itself into — not do so in time. After all, it has barraged the monster with half a trillion dollars in fire power, equal to the cost of our first year of war in Iraq if I recall. So, maybe what is looking like a 100-day mission has been accomplished!
However, if Repocalypse does make a second coming to roar into the dawning twenties, the recession that I said would be caused by another financial crisis due to the Fed’s tightening may still prove to have first raised its head out of the murky deep in the late summer of 2019 as a problem the Fed failed to slaughter in time.
For the moment, this Christmas the Repocalypse sleeps, so may visions of sugar plums dance in your head.