By John Mauldin
In September of this year, something still unexplained happened in the “repo” short-term financing market. Liquidity dried up, interest rates spiked, and the Fed stepped in to save the day.
Story over? No. The Fed has had to keep saving the day, every day, since then.
We Hear Different Theories
The most frightening one is that the repo market itself is actually fine, but a bank is wobbly and the billions in daily liquidity are preventing its collapse.
Who might it be? I have been told, by well-connected sources, that it could be a mid-sized Japanese bank. I was dubious because it would be hard to keep such a thing hidden for months.
But then this week, Bloomberg reported some Japanese banks, badly hurt by the BOJ’s negative rate policy, have turned to riskier debt to survive. So, perhaps it’s fair to wonder.
Whatever the cause, the situation doesn’t seem to be improving.
Something Wicked Is Going On
On Dec. 12 a New York Fed statement said its trading desk would increase its repo operations around year end “to ensure that the supply of reserves remains ample and to mitigate the risk of money market pressures.”
Notice at the link how the NY Fed describes its plans. The desk will offer “at least” $150 billion here and “at least” $75 billion there. That’s not how debt normally works.
Lenders give borrowers a credit limit, not a credit guarantee plus an implied promise of more. The US doesn’t (yet) have negative rates, but the Fed is giving banks negative credit limits. In a very precise violation of Bagehot’s Dictum.
We have also just finished a decade of the loosest monetary policy in American history, the partial tightening cycle notwithstanding. Something is very wrong if banks still don’t have enough reserves to keep markets liquid.
Part of it may be that regulations outside the Fed’s control prevent banks from using their reserves as needed. But that doesn’t explain why it suddenly became a problem in September, necessitating radical action that continues today.
Here’s the official line, from the minutes of the unscheduled Oct. 4 meeting at which the FOMC approved the operation.
Staff analysis and market commentary suggested that many factors contributed to the funding stresses that emerged in mid-September. In particular, financial institutions’ internal risk limits and balance sheet costs may have slowed the distribution of liquidity across the system at a time when reserves had dropped sharply and Treasury issuance was elevated.
So the Fed blames “internal risk limits and balance sheet costs” at banks. What are these risks and costs it was unwilling to accept, and why?
We still don’t know. There are lots of theories. Some even make sense.
QE4 Has Begun
Whatever the reason, it was severe enough to make the committee agree to both repo operations and the purchase of $20 billion a month in Treasury securities and another $20 billion in agencies.
It insists the latter isn’t QE, but it sure walks and quacks like a QE duck. So, I and many others call it QE4.
As we learned with previous QE rounds, exiting is hard. Remember that 2013 “Taper Tantrum?” Ben Bernanke’s mild hint that asset purchases might not continue forever infuriated a liquidity-addicted Wall Street.
The Fed needed a couple more years to start draining the pool and then did so in the stupidest possible way by both raising rates and selling assets at the same time.
Having said that, I have to note the Fed has few good choices. As mistakes compound over time, it must pick the least-bad alternative. But with each such decision, the future options grow even worse. So eventually instead of picking the least-bad, they will have to pick the least-disastrous one. That point is drawing closer.