Treasury Minutes Suggest Fed to Remove $1 Trillion in Excess Reserves by March 2010

This morning, Treasury released the quarterly Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association, which is

[A]n advisory committee governed by federal statute that meets quarterly with the Treasury Department. The Borrowing Committee’s membership is comprised of senior representatives from investment funds and banks. The Borrowing Committee presents their observations to the Treasury Department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues. The Securities Industry and Financial Markets Association does not participate in the deliberations of the Borrowing Committee.

Though the Committee had some interesting things to say about 30 Year TIPS and inflation expectations, we will focus on the statements of one member’s presentation regarding the Federal Reserve’s exit strategy (with respect to the >$1 trillion in excess reserves held by banks on its balance sheet).  We are not told just who the presenter is, but the Committee members comprise the most highly influential firms on Wall Street, including representatives from JP Morgan (Chairman), Goldman Sachs (Vice Chairman), Soros Fund Management, and Pimco. From the minutes:

The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve's exit strategy and the implications for the Treasury's borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities.  It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield.  Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more.  According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages displays this reach for yield.  A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.  [This is a shot off the bow to HY and, especially, CRE—more on this in another post.]

Here’s where it gets interesting:

The presenting member then looked at the likely sequence of the Federal Reserve's exit strategy.  The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates.  It was suggested that the most likely sequence would be the [1] draining of excess reserves from the banking system, [2] the cessation of the mortgage-backed securities purchase program, and [3] only then raising the Fed funds target rate.

Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.

 
The Fed’s $1.25 trillion Agency MBS buyback program is set to expire at the end of March, 2010, according to the last FOMC Announcement from September 23, 2009.  The point of the “several members” is valid, because why would the Fed drain reserves, only to continue adding them as a result of MBS purchases?  The presenting member points out that the Fed can avoid adding reserves after they are first drained through a revival of Treasury’s Supplementary Financing Program (SFP).

By way of background, the SFP is a special account maintained by Treasury at the Fed and is financed by cash management bills.  Says Treasury on September 17, 2008, “Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Once the Fed gained the ability to pay interest on excess reserves in October 2008, Treasury announced that SFP would be gradually wound down as it was no longer necessary to sterilize the Fed’s balance sheet.  [As an aside, no where does the presenter mention the ability of the Fed to pay interest on excess reserves, a fact of which it is highly unlikely he would be ignorant.  Given the Fed’s recent statements regarding the use of other tools to manage excess reserves, we infer that the Fed does not view this as a viable option for managing excess reserves–perhaps because it is too costly, or too impotent a strategy.]

The big picture point, however, is that at least according to the presenting member (that we presume to be Fed-connected), the Fed currently envisions draining the >$1 trillion in excess reserves currently on its balance sheet by next March.  This is close to criminally insane, as the Fed has been deflationary with respect to M2 money supply since April 2009 and draining reserves would only further deflate the general economy.  If credit is hard to come by now, it will be immensely more so should these actions come to pass.

The mechanics of the draining are then discussed as follows:

The presenting member then addressed the options for draining reserves from the banking system.  The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off.  One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery.  A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use.  Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market.  [Keeping up the public’s appetite for debt is the Fed’s de facto third mandate.]

According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear.  If it is to undertake these reverse repos, the selection of counterparty is important.  Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts.  In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member.  Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries - in the absence of loan demand. [Whether it’s the “absence of loan demand” or absence of banks willing to loan is a point for another post.]

Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.

At this point, we must consider the possibility that the presenter is acting on behalf of the primary dealers and issuing a thinly veiled threat against the Fed and its deflationary policies.  QE has certainly been a profitable endeavor for them and the (recent) cessation of Treasury QE puts the primary dealers on the hook for any extra supply.  We hope we’ve simply read too much into this or that the presenting member at the TBAC minutes simply does not know what he’s talking about.  However, if the Fed is truly contemplating a drain of all excess reserves in such a short period of time, with the view of tightening shortly thereafter, we implore it to reconsider.

Comments

[EB]

Excess reserves are supposed to be unused capital held at the Fed.  The threat to the Fed is that they could be deployed at any time and become inflationary.  By tapping (for instance) the money market funds with reverse repos, the Fed sells the MMF's Treasurys at a loss, which pre-emptively drains liquidity from the system so that even if the excess reserves are deployed, they will not be inflationary.  As the MMF's are a key source of funding for the already hampered credit markets, a $1 trillion drain would have almost unthinkable consequences.  That's why it could simply be someone shooting their mouth off.

[mgarrett84]

Its my prelimary view that,  a move to drain the reserves would go hand in hand with a prompting of the depositors to increase their extension of credit to businesses. 

I believe there are risks that this could cause dislocation to the yield curve and spark moves higher in the money multilplier and velocity.  Which is where we want to be at the end of the day.  Inflation will surely be a byproduct but at that point the FED has a menu of dials to tweek.  

I still need to talk to people about this, to get a fuller understanding.  

[NYPoke]

The issue is that it would reduce the bank's ability/inclination to extend credit/loans.  Being that the last Nobel Prize in Economics confirmed what many of us already believe, that extending credit creates money (supply) not the government printing it, this would be HIGHLY deflationary.

The banks must maintain a certain level of reserves, based to their loaned out amount.  With real estate prices likely to continue to fall & lots of homes still not in foreclosure yet, this isn't going to help.

[mgarrett84]

Agreed. But Excess Reserves if drained could expand money supply (if that capital is routed into credit creation, and/or risk taking.  Velocity could pick up as well.  

[NYPoke]

That would be if they reused the excess.  I think this is mostly an accounting entry, but I'm not an expert.  If they wanted to give the money elsewhere, they would.  If they wanted to encourage Credit Creation, this is the LAST thing they would do.  They would add $1 Trillion, instead, which is what they have been doing for the past year.  It didn't help.

[Anonymous]

Doubtful. The institutions that received the gift of confidence are uberprofitable now with Mark-to-Monkey.

[digalert]

Of course QE has been extremely profitable for them, let's see who's on the committee, GS, JPM, PIMCO and Soros yeah sure that hopey changey thing is working.

[Handle with care]

The article writer seems to have interpreted "draining excess reserves" into "draining ALL excess reserves" which seems a bit of a leap in order to be sensational

[EB]

I considered very carefully whether the presenting member meant the Fed would simply begin the draining process by end of March 2010 or would have finished the process by then.  When he focused attention on the renewed SFP to drain any excess reserves as they are generated by continuation of MBS buybacks, he suggests that all excess reserves will have been absorbed up until that point.  If his point was that reserves were only beginning to be drained, mention of SFP would be a non sequitur.  Of course, this assumes rational actors.  The relevant quote is:

"Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time."

[chet]

That was my reading as well, Handle.

[Cognitive Dissonance]

Yeah, when I drain a boil, I always leave some of the good stuff behind. Puss does the body good. :>)

[Bit Bucket]

I never ever go back to gloat. But how do you like HGSI? I am $184K to the plus side. And you??????????????????????????

I would not have posted this comment but you certainly upped the anny with your wicked witch is dead rant.

Bit Bucket

[MsCreant]

Actually (erase ad hominem attack), he said you would be back, that your type does exactly what you just did here. I hope his trading calls are as good as his call on you.

We are not here to make you money. I was way too polite before. You did not read that link I posted for you that tells you what ZH specifically says regarding making money from info posted here. The whole fucking thing is falling apart, everyone (including you) is being ripped off blind, and raped, and like a child, all you want is to dance and strut over your one success. Well go ahead already... you done yet? When my son was a baby he'd come out of the tub and streak through the house laughing. I'd catch him in a warm towel, dry him off, and laugh with him.

No one is going to catch you love, so why the need to go streaking through the place?

I bet you won't really ask yourself that question at all. You can't cause then you'd cringe to see what you look like. Too much information for you to handle. Just like the economy falling apart, too much info.

I'm glad you made a good call. You will need the money for what is coming. Now stop being a (delete insult).

[Anonymous]

God I wish I was 3 again.

[Takingbets]

+100 The stalking on different threads is laughable.

[nicholsong]

Agreed. Bit Bucket is bilge. Check this out:

OK - serious 7 figure net worth, retired now 52, and if I cannot get health care for my family

where does that leave the little people?

You obviously are an idiot or you have no relevant experience to write this article.

"The little people."  This guy's the perfect example of a Napoleonic turd.

http://www.zerohedge.com/article/heather-graham-health-care-policy#comme...

[MsCreant]

Good research Nicholsong!

Busted Bucket is the new name!!

[BobPaulson]

Seems unlikely that anything radical would come out of there. In a world populated by ass coverers and can kickers, big change only seems to come from spontaneous external forces, not by radical changes in policy.

[Burnbright]

Text... so small

[Danz Gambit]

Ctrl + +/=

[luster]

Ctrl + fixes that.