With the current Emerging Market rout growing stronger by the day as the dollar surges, crushing carry trades left and right and sending EM currencies plunging, in the process validating the June warning from RBI governor Urjit Patel who warned the Fed that continued liquidity extraction in the form of balance sheet shrinkage will only make contagion worse, there has been a growing debate just when the Fed will be forced to halt its quantitative tightening.
Yesterday, none other than former NY Fed strategist and current Credit Suisse analyst Zoltan Pozsar, acknowledged by many as the authority on repo market dynamics, shadow liquidity and Fed balance sheet strategy, warned that the U.S. central bank may soon have to make a choice between activating an overnight facility for repurchase agreements or halting its balance-sheet reduction earlier than many market participants expect. And, as Bloomberg reported, Pozsar said that policy makers are unlikely to pursue the option of a new facility until alternatives have been exhausted, meaning a premature end to the taper is the most likely outcome. Meanwhile, both Morgan Stanley and Royal Bank of Canada analysts said last month the balance-sheet runoff could end as early as 2019, while Goldman Sachs strategists in May said they’re assuming an end around April 2020.
“A rethink of the Fed’s operating regime will be necessary,” Pozsar wrote. "We are transitioning from an environment where reserves are excess to an environment where collateral is excess. The Fed’s monetary toolkit has to adapt."
The dilemma facing the Fed is how to keep the overnight fed funds rate within its target band as it tries to normalize policy. The task has been complicated, as Bloomberg adds, by the Treasury's need to finance the growing federal budget deficit and a deluge of bill issuance that’s helped push higher a whole swath of short-term funding rates, including the effective fed funds rate and forced the Fed to decouple the IOER from the upper band of its fed funds rate corridor.
But Pozsar believes that reductions in this rate won’t push overnight rates lower and there are “more effective and less disruptive ways of dealing with the glut of bills.”
So what is the alternative? Pozsar argues that bank reserves, while still in the trillions, aren’t overly abundant and thus there isn’t a lot of room for the Fed to shrink its balance sheet. To validate his point, Poszar shows the lack of use of the Fed’s overnight reverse repurchase facility, which "tells us that every penny of reserves is bid and that balance sheet taper from here will cut right into the system’s liquidity bone."
Which, of course, is problematic: if the US financial system is facing a liquidity shortage when Fed Reserves held at banks is just under $2 trillion...
... then there is very little space for further rate hikes without a "disruptive market event" emerging.
Meanwhile core US inflation running at 2.4%, is now well above the Fed's target, and with tariffs threatening to push prices even higher, the Fed suddenly finds itself in a very unpleasant situation: how to tighten further without crashing the market.
The only option, as the above considerations suggest, is for the Fed to keep hiking rates in hopes of keeping inflation in check even as it gradually brings its balance sheet shrinkage. But what happens next? Well, according to BMO analyst Ian Lyngen, the Fed may have no choice but to begin expanding its balance sheet some time in the next year.
In a note to clients sent overnight, Lyngen writes that continued balance sheet shrinkage has only negative and little to no positive consequences, to wit:
We typically try not to venture too far into the deep end of the academic policy pool, but we donned our floaties to take a look at a speech the New York Fed’s Simon Potter given earlier this month entitled “Confidence in the Implementation of U.S. Monetary Policy Normalization” which we think is informative about how far the Fed will run down excess reserves in the system. Because the volatility in reserves is drastically higher than it was pre-crisis, and the Fed doesn’t control all the factors, it seems reasonable that they would want to avoid risking the reserve volatility feeding through into overnight rate swings. We struggle to think of any macroeconomic benefit resulting from a world with dramatically higher volatility in overnight interest rates – or even running the risk of entering that world – and can only assume that the Fed would prefer to avoid that outcome as well.
So what is the alternative? Same as Pozsar, Lyngen believes that it wouldn’t be "prudent risk management for the Fed to run a serious risk of hitting a non-linear kink point in the reserves demand curve, so would expect them to cease balance sheet roll-off with a sizable buffer."
This would "imply a 2019 end-date to the balance sheet run-off program; markedly earlier than market appreciates." And the punchline: QE4 is now on deck.
In fact, relatively soon afterwards the Fed may need to begin expanding its balance sheet once again to maintain sizable excess reserves in the system.
The implication for markets?
This should be incrementally bullish for Treasuries, and relieve some of the pressure on the market resulting from the recent record setting Treasury issuance. Furthermore, we get the sense we may be reading more about this in coming weeks as this year’s Jackson Hole topic is “Changing Market Structure and Implications for Monetary Policy”.
Of course, it's not just repo considerations that would be relevant: with Trump facing reelecation in 2020, the one thing the president would want to avoid at all costs is a sharp drop in the stock market. And what better way to avoid that than to bring back the best friend of BTFDers everywhere: QE in general, and daily POMO in particular; expect to see some tweets from Trump on the topic in the coming months if not weeks.