By now everybody knows that only a last ditch intervention by the G7 prevented the financial system from imploding three weeks ago, when the Yen carry trades blew up in the face of all those who had been short yen, long high yielding currencies. The result would have been a pervasive trading desk annihilation, possibly on par with that experienced after the Lehman collapse had the world's central banks not stepped in to sell Yen in droves. Yet what fewer know is that when it comes to funding cheap carry-type trades, the FX carry trade is merely one. A possibly far bigger one has been the one established courtesy of the Fed's generous Interest on Overnight Reserves (IOER) rate, which being far higher than General Collateral (GC) Repo, presents banks with Fed deposit access what was a sure way to earn guaranteed money on an interest rate arbitrage spread. For nearly two years banks collected the proverbial pennies in front of the rollercoaster... until last Friday, when the FDIC decided to spoil the party. What happened as a result of the FDIC's decision to establish an assessment rate which spoiled the arb, was a blow out for most institutions playing the IOER-GC carry trade leading to a major disruption in this funding market, possibly far more serious than the FX carry trade unwind, and a plunge in overnight GC repo rates on Monday (see chart) by over 75%! Does this mean banks have lost one key carry funding source? So it would appear. And it only means that the FX carry trade will be that much more a critical source of "risk-free" income for banks... At least until the next major earthquake above the ring of fire. In the meantime, as the Fed scrambles to restore normality to the repo market, will the Fed be forced to do Reverse Repos, which while fixing the carry trade, will withdraw far more liquidity form the market. Which as we all know is grounds for immediate incarceration in a Centrally Planned kleptocracy such as the USSA.
Of course, the only way to restore normality here is for the Fed to jump in and start conducting reverse repos, which will allow the carry trade to be restored for those institutions that are not subject to the assessment. However, by doing that, the Fed would also withdraw major liquidity from the market. The question becomes: is the continued viability of the banks courtesy of free funding worth a few hundred S&P points? Barclays thinks no way, Jose.
We are not so sure: with most banks now operating at massive leverage ratios, we are confident that quite a few will scream bloody murder and demand that the Fed do anything it can do restore repo market funding (aside from merely the noted arb, now that O/N GC rates are at record lows). And that would mean that broad liquidity is about to leave the system far over and above the amount injected by the Fed. The net result would be a very complex calculation involving liquidity coming in versus leaving. Making it doubly confusing, with the Fed gambling with the idea of pulling QE, the double whammy of suddenly being left with major Reverse Repo operations and no incremental liquidity, would result in a major impact to the market.
Will Bernanke pull the plug? It is unclear. However keep an eye on bankers preaching untold death and destruction unless Benny and the Inkjets restore the repo market. If Jamie Dimon gets involved, then Sell Mortimer.