Promises Of More QE Are No Longer Sufficient: Desperate Banks Demand Reserves, Get First Fed Repo In 4 Years
While endless jawboning and threats of more free (and even paid for those close to the discount window) money can do miracles for markets, if only for a day or two, by spooking every new incremental layer of shorts into covering, there is one problem with this strategy: the "flow" pathway is about to run out of purchasing power. Recall that Goldman finally admitted that when it comes to monetary policy, it really is all about the flow, just as we have been claiming for years. What does this mean - simple: the Fed needs to constantly infuse the financial system with new, unsterilized reserves in order to provide bank traders with the dry powder needed to ramp risk higher. Logically, this makes intuitive sense: if talking the market up was all that was needed, Ben would simply say he would like to see the Dow at 36,000 and leave it at that. That's great, but unless the Fed is the one doing the actual buying, those who wish to take advantage of the Fed's jawboning need to have access to reserves, which via Shadow banking conduits, i.e., repos, can be converted to fungible cash, which can then be used to ramp up ES, SPY and other risk aggregates (just like JPM was doing by selling IG9 and becoming the market in that axe). As it turns out, today we may have just hit the limit on how much banks can do without an actual injection of new reserves by the Fed. Read: a new unsterilized QE program.
First, here is a reminder of what has been going on in the secular amount of excess reserves as indicated by the Fed.
The total amount of reserves is dropping rapidly which is to be expected: as the Fed's balance sheet contracts due to maturing FX swaps, and numerous other asset reductions, this means that liability side has to contract in parallel which then means that bank reserve levels are not only flat, they are declining. Obviously, absent "reserves" i.e., electronic fungible money created by the Fed, which courtesy of Shadow Banking can be promptly transformed into cash, banks can not buy. Period.
But not only that: there is some speculation that banks have over the past several years used reserves as a stealthy plug to fill capital shortfall at firms whose asset side is being rapidly depleted by non-performing loans and other detractors from cash flow formation. In other words forget buying assets and generating an ROE: banks need reserves to preserve their viability, or else.
All of this came to a head today.
What happened today? Well, first, here is what happened yesterday. The WSJ explains:
Starting Friday, the Federal Reserve Bank of New York will implement a series of "small value" repo operations to test its capability to temporarily boost bank reserve levels.
And there you have it: following several years of reverse repos, or liquidity extracting exercises by way of temporary reserve sequestation, the Fed has finally launched the opposite: or outright repos, or liquidity providing exercises. Which also means that at least one bank was in dire need of new reserves, all posturing by the Fed to the contrary notwithstanding. Because there simply is no reason for the Fed to launch a repo operation out of the blue following 30 "test" Reverse Repos conducted since December 2009.
The WSJ continues:
In a statement Thursday, the New York Fed said the operations are a "matter of prudent advance planning" and "have been designed to have no material impact on the availability of reserves or on market rates."
What is more, it said, "these operations do not represent a change in the stance of monetary policy, and no inference should be drawn about the timing of any change in the stance of monetary policy in the future."
Operations by the Fed involving what are known as repurchase agreements, or repos, act to temporarily add bank reserves to the system by essentially borrowing bonds for a fixed period of time. Once a cornerstone of the day-to-day efforts to achieve the monetary-policy objectives set by the Federal Open Market Committee, the tool has fallen by the wayside as the central bank has moved to pursue massive purchases of bonds. The New York Fed noted that the last time it put in place a repo operation was on Dec. 30, 2008.
December 30, 2008 as a reminder, is when the financial world was collapsing, but was before the March 2009 announcement of the fully expanded QE1, which saw $300 billion in Treasurys and more MBS purchased by the Fed. As the table below shows, in the interim between December 2008 and today, the only operations the Fed conducted were Reverse Repo, which are designed to extract excess liquidity from the system, and telegraph as much.
And today: the first repo since December 2008, for a total of $210 million.
That that the Fed finally broke the mold and did a full blown Repo today speaks volumes about what is going on. Namely that banks are crying uncle and that any additional sustained rise in stocks will need a reserve infusion from either the Fed or the ECB. Everything else is merely noise. However, as the NFP report today indicated, one can kiss expectations for a LSAP-based, or unsterilized, QE in September goodbye. And as Draghi yesterday proved, absent Spain admitting it is fully broke, there will be no new bond buying via SMP or any other mechanism (ignoring for a second that the SMP as a rescue mechanism is completely worthless as the previous two instances of SMP bond buying proved).
The other problem of course is that Spain now will absolutely NOT demand a bailout as its 2 year cost of debt has plunged as the market expects it do just that and demand a rescue, in the process covering its 2 year shorts and pricing itself out of the one conclusion that makes the action logical. But why would Spain demand a bailout now that it can again finance itself at the short-end of the curve cheaply.And so the market is forced to short the 2 year again to push Spain's hand, which leads to more jawboning and repeating the rinse cycle all over again, and so on, in a massively circular argument which shows just how idiotic the conversation between the market and broke politicians is. Yes, welcome to the new normal cause and effect, where attempts to frontrun politicians are always and without exception self-destructive. This is yet another thing the market will realize eventually.
But the biggest issue is that as today's first Repo operation in 4 years proved, at least one bank needs at least $1 in excess reserves. That this is happening with $1.6 trillion in reserves already in circulation shows just how critical and how reliant on flow the US banks are.
And now check to Ben and Draghi to figure out a way to once again refill bank reserves.