As Pummeling In GC-Reserve Carry Unwind Continues, All Carry Shifts To FX - Mrs Watanabe Wins After All

Following our expose on the unwind in the repo (O/N GC) - reserve (IOER) carry trade yesterday, the FDIC induced compaction in the "free money" rate arb continues with GC sliding again to a jaw dropping 0.03%. And with this source of free money now shut down for good, and creating all sorts of havoc for short-term rates and further headaches for the Fed as it has one more black swan to deal with in extracting liquidity, all the free money trades have firmly shifted to FX carry, where the Yen is now the recipient of the wrath of every single Mrs Watanabe known to man. If and when Yen repatriation resumes in earnest (considering Japan GDP has to surge following its rebuilding effort as pundits claim), the outcome will be quite hilarious.


Carry basket, which following the surge in the Yen after the earthquake is now at the highest since May 2010!

And for those still confused by this developing dynamic, here is a quick note from BofA's Brian Smedley explaining again how the Fed is now completely cornered (even more than before).

Fed policy complicated by new FDIC regime

One of the main problems highlighted by the FDIC policy change is the unintended consequence that regulatory reform has on monetary policy. The new FDIC assessment regime, while intended to better protect taxpayers from large bank failures in the future, has distorted activity in the short-term rates markets through which the Fed traditionally implements monetary policy. In effect, the FDIC ruling change has to us created “easier” monetary policy and weakened the effect of IOER in sterilizing the excess liquidity created by the Fed’s expanded balance sheet. Unintended market consequences have thus far included some negative Treasury GC repo rate trading; specific Treasury issues trading at deeply negative rates in repo; an increase in failures to deliver certain repo collateral; and near-zero Treasury bill rates, which will likely be exacerbated in coming weeks by a seasonal decline in bill supply.

In another era, the Fed might have looked to counteract the impact of the FDIC change in the name of preserving market functioning and liquidity. But with markets hypersensitive to any signs that the Fed is about to take a turn toward the exit, could it tweak short term rates now without rates exploding higher, potentially causing expectations for the path of policy to become mispriced? After all, the fed effective remains well within the FOMC’s directive of 0-25bp.

Regardless of any near-term considerations, the Fed will need to offset this impact to regain control over short-term interest rates when it comes time to exit. Relative to the exit strategy it might have pursued in the absence of the new FDIC assessment regime, the Fed could eventually be required to drain a larger amount of excess reserves to regain control of the fed effective. Alternatively, and more likely in our view, the Fed could raise the IOER rate to a spread above the fed funds target. For instance, were the fed funds target be raised to 50bp, the Fed could raise IOER to 65bp or so. This would likely bring the fed effective closer in line with the fed funds target and would largely obviate the need for huge reserve drains.

But even this elegant solution is not without its complications: while the FOMC votes on the fed funds target, the IOER rate is determined solely by the Board of Governors. In our view, this could partly explain why some regional bank presidents, perhaps already disgruntled by the concentration of power at the Board throughout the crisis, have argued for a rapid normalization of the balance sheet and a return of the primacy of the fed funds rate in Fed  policymaking.

With the new FDIC regime now in effect and more regulatory changes on the horizon, we must put higher odds on the market becoming confused about the timing and impact of Fed policy in the future. For instance, could the Fed effectively communicate the difference between tightening policy and raising IOER to address potential disruptions in overnight markets? And how will the Fed regain control over short-term rates, which have become less closely  linked to IOER as a result of this change by the FDIC, when the time comes to exit? These questions could leave the economy exposed to more volatile inflation expectations at a time when the Fed needs the market to remain confident that it has both the willingness – and the appropriate tools – to achieve its mandate.


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