While it took the equity markets over 24 hours to wake up to the realization that the first Fed tightening in 9 years is actually just that, and that not only monetary conditions will progressively get more constrictive especially if the Fed is intent on 4 more hikes in 2016, but that P/E multiples will contract by at least 3% according to a still optimistic Goldman Sachs, something far more interesting happened in repo markets, where the consensus expectation was that the Fed's rate would be accompanied by a major liquidity drain via reverse repos.
Recall that two weeks ago [11]we cited repo-market expert E.D. Skyrm who calculated that moving general collateral higher by 25bps would require the Fed draining up to $800 billion in liquidity: "In 2013 on my website, I calculated that QE2 moved Repo rates, on average, 2.7 basis points for every $100B in QE. So, one very rough estimate moved GC 8 basis points and the other 2.7 basis points per hundred billion. In order to move GC 25 basis points higher, in a very rough estimate, the Fed needs to drain between $310B and $800B in liquidity."
Then on Wednesday morning [12]Citigroup opined that the liquidity drain could be substantially greater: "There will be a separate document from the NY Fed with details around the operational aspects of the liftoff. Of primary interest will be the size of the overnight reverse repo facility that the Fed will put in place to pull short rates higher. We don’t think it will be unlimited, but a size large enough that will keep short rates from falling below the 25bp floor – and the size could be as high as $1tn."
So what happened?
As we reported a little after 1:15pm on Thursday [13]when the details of the Fed's first post-hike reverse repo operation were revealed, something very strange and unexpected happened: not only did the Fed not drain $1 trillion, or $800 billion, or even $310 billion, the Fed did not drain any incremental liquidity at all!
[14]
In fact, the $105 billion accepted in the Reverse Repo operation was just $3 billion more than the op conducted the day before, the last ZIRP operation.
[15]
How is this possible, and how could the Fed substantially tighten financial conditions without draining any liquidity?
The answer: having read the work of most repo analysts over the past 48 hours, the truth is that nobody really knows, however for perhaps the most curious attempt at an explanation we go back to Wedbush's repo-expert E.D. Skyrm, who is just as stumped but has proposed an entertaining version of what happened: market by decree. To wit:
The Fed didn't really drain any liquidity yesterday. They moved the IOER up to .50%, moved the RRP rate up to .25%, and the RRP volume
came in at $105 billion, only $3 billion more than the day before. Where was the draining? But interest rates moved up anyway to reflect the
tightening, without any fundamental change. Basically, the Fed decreed a rate tightening and the market moved rates higher.
Markets work in interesting ways sometimes. Why should the GC rate trade at .41% yesterday when it traded at .21% the week before? In
the Repo market, rates are often set by where traders believe rates should be. Then, rates move higher or lower with imbalances between
supply and demand throughout the day. Naturally, there are substitution effects as Repo rates change in relation to other market rates, but
fundamentals don't necessarily dictate why Repo rates trade at .40% compared to .45%.
I wonder how many economic interest rate models include "by decree" as a factor?
That is one of the better financial questions we have heard in a long time, and here is another: do assets trade "by decree" or merely reflecting the wishes of the Fed's trading desk which together with its arms-length HFT intermediaries such as Citadel, has become the dominant marginal price setter across all asset classes.
A logical question is if the Fed is indeed focused on tightening easy financial conditions (ref: the recent implosion of the junk bond bubble) then the market - with its complete liquidity preference indifference to a the 25 bps hike - just dared Yellen to hike again, and again, until finally hundreds of billions if not trillions in excess liquidity are drained.
Finally, if repo rates move "by decree", what about Treasury markets, or commodities, or stocks? And what happens when the Fed can no longer move markets "by decree"?
For now, however, the Fed's "plumb protection team" is happy.
