The Fed's Killing Floor

Earlier this week, Ralph Delguidice authored a comment in The Institutional Risk Analyst("Bigger Balance Sheet Bullish? Really?") that discussed the changes coming to the short-term money markets as a result of the FOMC's blink on running off the QE SOMA balance sheet. Below is the rest of the story, in which he explains how the Fed has nationalized the US money markets since 2008.  Big banks are coddled, non-banks are being set up for slaughter in the next liquidity/credit cycle. And unsecured lending by US banks is essentially prohibited under Pax Fed.  

Q: Who gave the Federal Reserve Board the legal authority to make such significant changes in US market structure?  Memo to Senator Pat Toomey (R-PA).  Chris


The Killing Floor
Ralph Delguidice

Lost in the post FOMC avalanche of giddy optimism that the “Powell Put” is real—and proximate—,was by far the most important decision made by the FED after nearly a decade of thinking about how the “normalization” would progress: how the actual operating system of monetary policy would work in a post GFC market that no longer supported unsecured bank lending or “FED-FUNDS.”

In announcing that the Balance Sheet rolloff would end soon with an equilibrium at which “reserves were plentiful,” the Chairman came down squarely in favor of what has come to be known as the “Floor System” for hard-wiring all FED policy transmission.

Until 2008 the FED allowed the markets to set interbank rates and sought to influence the demand components with REPO and REVERSE that generally determined that rate.

But In 2008 the interbank markets CLOSED as the immensity of the mistake they had made letting financials fund in the wholesale markets without reserve limits (AKA “EURODOLLARS”) became evident.

The FED responded with a new policy tool called “IOER” that allowed the FOMC to administer the interbank rate by paying a “floor” under the reserves the banks would shortly be (BIBLICALLY) flooded with courtesy of the QE just invented.

The ideea is a simple one—divorce the balance sheet from the Policy rate and you can control both demand and inflation.

In Theory at least.

In fact inflation remains TOO WELL CONTROLLED, as IOER on the balances  the banks were forced to hold did way more than just compensate the banks for the opportunity cost of owning the excess reserves, it INCENTIVIZED them to hold them as near perfect (post modern) assets.

These reserve balances are said to be “sterilized” --and they certainly are.

Loan growth was anemic at best throughout the experiment as then “wealth component” of household consumption became a round about way to keep all the plates spinning --and asset prices up, UP, U P. Who doesn’t like that?

But as rates rose above zero and the balance sheet began to shrink we saw that banks had made structural changes to their demand for these now lucrative reserves, especially as the various regulatory Dodd Frank rules began to constrain  GSIB balance sheets starting last  year. These are the same banks that create the private money market credit surface, but something was different.

the following chart comes from a paper written last year by David Beckworth that show the post GFC substitution function of commercial banks shifting from loans vs UST (the way we were) to loans vs CASH (the way it be now).

Killing it

The chart shows clearly that banks have adapted to—and indeed wrapped around--the new Floor Policy System; one  that installs the FED as the "Axis Mundi” and monopoly rate setter in (what were) the private money markets.

But now we see that the “evolution” doesn’t stop there.

What is to stop the banks—the GSIB banks primarily—from gaming the system by acquiring huge portfolios of UST&A securities in anticipation of the next round of QE4 that the FED has now clearly signaled is on the way, then TRIGGERING that recession and subsequent LSAP program by cutting off credit to the economy and the non-banks in particular? 

For the most part it is the non-banks that own the risk. The GSIBs just finance it on a Senior Secured and revolving basis. 

A cursory reading of TIC and H.8 data shows this is already happening. UST&A securities are currently the fastest growing asset class on commercial bank balance sheets.

Killing it2


The C&I growth lines are almost certainly inflated by non-bank demand as indicated above. The point is that this de-risking of bank balance sheets (that David Rosenberg writes about almost non-stop) was taking place even BEFORE the FOMC confirmed that “plentiful reserves” would define the floor and guarantee that LSAPs/QE4 will be the go-to once again. 

Why not front-run? It would almost be wrong NOT do it. Because in a nutshell, the FED believes QE works. And the banks KNOW it works.

As far as the FICC lines go that is.

And with a nice warm IOER dug-out for repose in between QE “at-bats” it is hard to blame them.

It is a perfect business model:  lions eat antelopes.