Is The Surging SOMA To Excess Reserve Differential Proof That Quantitative Easing Is A Failure?

One of the more peculiar observations we noted in our analysis of the Fed's balance sheet yesterday, was that in the week just ended, reserves held by banks with the Federal Reserve dropped by a very material $64.2 billion even as the Fed ended up buying a net of $4 billion in securities: a $68 billion mismatch between an increase in reserves and Fed asset increases. A quick look at how this mismatch has progressed since the announcement of QE Lite (and QE 2) demonstrates this phenomenon very distinctly: while during the QE Lite phase, net holdings of the Fed were flat, bank reserves, which should have followed suit in fact declined notably, by almost $40 billion. Yet it is during the POMO phase of QE 2 that this difference become glaring. During a period when the Fed added a total of $88 billion (net of MBS paydowns) in securities, reserves increased by only $14 billion. This does not include the cumulative differential since QE Lite. And all this came to a head in the just ended week, when the difference between cumulative asset purchases and reserve changes hit a whopping $138 billion. This is very disturbing for a variety of reasons, the number of which is that, as Jim Bianco points out, banks are rapidly exchange securities with higher reserve requirements for those with lower: the net result is a far slower increase in reserves held with the Fed. It also means that banks ever since QE Lite have been stealthily offloading lower quality fixed income products to the market and replacing these with Treasuries (motivation being unclear but likely having to do with presenting a better capitalized state). If true, this would mean that during the entire orchestrated HY bond rally sine August, those who have been buying are in fact the greatest suckers, and have been buying hundreds of billions worth of lower quality paper from none other than the allegedly smart money banks. Alternatively, what this means, is that instead of opening up capacity for banks to bid up riskier corporates and thus stimulate the economy, banks are forced to gobble up the toxic treasuries, that the Treasury puts upon them each and every week. Should this divergent trend persist, we would be very mindful of obtaining verification of either of these two hypotheses.

Chart 1: Change in Various Open Market Securities held by the Fed since QE Lite

Chart 2: Difference between the cumulative increase in Fed holdings, and bank reserves. The highlighted block is the kicker.

We were so fascinated by this curious divergence that we inquired with our good friend Jim Bianco. Here is his response:

Some Specifics since QE2 was announced on November 3rd

                                                        Nov 3              Dec 15 Change
Fed Tsy Holdings                               839.9              960.8              +120.81
MBS Holdings (paydowns)               1051.04          1020.68               -30.36
   Net                                                                                                +90.48

Balance Sheet                                 2280.752        2374.33              +93.578

Since QE2 the balance sheet has expanded by $93.578 billion.  This largely can be explained by a $120.81 billion rise in Tsy holdings netted against a $30.36 billion paydown in MBS. 

Excess Reserves                               969.418          1024.811        +55.393
Total Reserves                                1036.654          1097.166        +60.512
Required Reserves                               67.233              72.355        +5.122

Even though the balance sheet expanded by $93.578 billion, total reserves have only increased by $60.512 billion.  Required reserves increased by $5.122 billion.  Net the two together and excess reserves are up $55.393 billion.

So, the question is why are total reserves rising so slowly?  Why are they not up by the same amount (or nearly the same amount) as the balance sheet?

The Fed does not break down the dirty guts of total reserves so we have to guess.  Here goes ….

Banks are buying $120 billion of Tsys from the Fed via QE2.  They are not letting their balance sheets expand by this $120 billion so they are selling other securities (or calling/refusing lending) to offset these purchases.  They are not selling $120 billion for a perfect offset but are selling some to partially offset it.

What they are selling has higher reserve requirements than Treasuries.  So sell some securities that requires more reserves and buy more Treasuries than require less reserves and net result is total reserves rises by about 2/3 the amount of the increase in the Fed’s balance sheet.

So thanks Ben, banks are now pulling back even more to make room for your QE2 purchases.

In other words, very much contrary to its purpose, QE is in fact forcing banks to retrench even more, merely to satisfy their Primary Dealer quotient and to provide the guarantee that the Primary Dealer take down is always roughly 50% of every auction. In yet other words, despite subsequent monetization, the bonds bought at auction are already at the very margin of the banks' holdings capacity, and result in far lower eagerness to lend out capital (collateralized with subpar assets - the kind of stuff that drives the economy). This goes against the very core premise of quantitave easing! We would love for Rep. Paul to inquire about this very interesting phenomenon at his earliest convenience.