As Zero Hedge accurately predicted, on Thursday there will be no $25 billion 56 Day Cash Management Bill auction, as part of the just announced roll down of the Fed's SFP (or SFB as it is known elsewhere) program, which will bring down holdings of associated debt at the Treasury from $250 billion to just $5 billion in 8 weeks. Previously we predicted that the impact of this activity will be nothing short of a doubling of POMO but did not discuss the impact on bank excess reserves. Over the weekend, Barclay's Joseph Abate analyzed the impact of the termination of SFP as well as the ongoing QE2, and came to the conclusion that excess reserves, which at last check had been just about $1 trillion (well below where they should be based on recent asset purchases, another topic we have discussed) are about to surge by a massive $700 billion over the next 5 months! What this means is the market will simply factor in even a greater impossibility for the Fed to tighten liquidity when the moment comes (which we believe will be pretty much never) forcing those evil speculators to push all commodities to even greater record highs (yes, rice included), forcing us to get even more bullish on the continuation of the recent round of global food-price hike driven revolutions.
From Jo Abate:
The Treasury announced Thursday morning that it would let the SFB program wind down gradually beginning next week. The program was created in 2008 as a means for the Federal Reserve to drain bank reserves with the help of the US Treasury. Under the program, the Treasury sells 2m bills and deposits the cash raised in its account at the Federal Reserve. In this way, cash moves from the bill purchasers’ bank accounts (more specifically, their banks’ reserve accounts) to the Treasury balance at the central bank. The program has locked up $200bn for almost two years.
Since these bills count as marketable debt, they add to the US Treasury’s running total under the debt ceiling. With the Treasury fast approaching the ceiling, it needs to create room under its remaining capacity in order to keep its coupon auctions regular. Allowing the SFB program to expire is the first step in what we expect to be a series of moves the Treasury will make as Congress debates spending and delays raising the ceiling.
The Treasury will allow the SFB program to roll off gradually – each week, $25bn of these bills will be retired without replacement, so that the program should end by March 30. The Treasury has decided to leave a token $5bn in SFBs outstanding at that point – largely as a placeholder, presumably so that it can bring the program back in the future.
At the moment, of course, the Fed is far from draining reserves. Its asset purchase program will increase reserve balances this spring. We look for bank reserve balances to climb to $1.4trn by the end of March – up from $1.084trn as of Wednesday – with half of the increase coming from the expiration of the SFBs and the rest from the Fed’s Treasury purchases. This forecast assumes few additional surprises in the Fed’s balance sheet between now and then. But the Treasury’s cash balance can be pretty volatile on a weekly basis, as tax and spending flows typically cause significant volatility. That said, with reserve balances likely to reach $1.4trn by the end of March, we look for the effective Fed funds rate to fall by 2-3bp – to around 14-15bp.
The conclusion demonstrates why the traditional Fed liquidity tightening mechanisms will soon be completely useless.
We believe that the Fed’s current tools (reverse repos and term deposits) might be able to soak up $700bn in bank reserves. But with reserve balances likely to reach $1.7trn by the time the Fed is ready to begin draining the pool, an extra tool such as the SFB program might prove useful.
We wonder what happens to already unmanageable liquidity concerns after QE3 is announced, some time in June...