Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 1: I'm Tracy Allaway and I'm Joe Wisenthal. Joe, it's a
Speaker 1: busy week.
Speaker 2: It is a busy week.
Speaker 3: It sort of snuck up on me. You know, I
Speaker 3: knew it was FED week, like it's also jobs week.
Speaker 3: It's also and I'm not even sure like the degree
Speaker 3: to which it matters, quarterly refunding week sort of controversial.
Speaker 3: There's a lot going on.
Speaker 1: I got tipped off to the fact it was quarterly
Speaker 1: refunding week when everyone started talking about deficits. On Monday,
Speaker 1: you got the estimates of borrowing needs everyone. That's the
Speaker 1: day suddenly everyone becomes really worried about the credit worthiness
Speaker 1: the future United States of America.
Speaker 3: There's this theory that's going around. It's kind of controversial.
Speaker 3: I see it on Twitter sometimes that like this is
Speaker 3: like really important for markets that like some mix of
Speaker 3: bills and bonds and how much really matters. I don't really,
Speaker 3: you know, I'm like sort of like skeptical, but maybe
Speaker 3: there's something to that. But you know, a lot of
Speaker 3: moving parts right now, and of course it is FED week.
Speaker 3: I don't think anyone expects a rate cut but I
Speaker 3: think the expectation is some sort of like maybe declaration
Speaker 3: of victory and which can then be used to set
Speaker 3: up the beginning of the cutting cycle.
Speaker 1: Well, it's interesting you mentioned this theory about it having
Speaker 1: a potential impact on markets, because, of course the other
Speaker 1: thing that we expect the FED to discuss this week
Speaker 1: is quantitative tightening, so the shrinking of the balance sheet.
Speaker 1: And I find this is the thing that gets people
Speaker 1: really riled up, the idea that you know, stocks are
Speaker 1: up because of central bank liquidity and once QT begins,
Speaker 1: it's all going to wash away and stocks are going
Speaker 1: to fall. Of course, we haven't seen that, but we're
Speaker 1: still waiting on a lot of additional info about the size,
Speaker 1: the shape, the speed of QT, and there's a lot
Speaker 1: of discussion over whether or not that could change. And
Speaker 1: I should just say the meaning is tomorrow. But I
Speaker 1: don't think we're going to get a lot of detail
Speaker 1: on QT until the minutes actually come out in February.
Speaker 1: But the point is there is loads to discuss.
Speaker 3: Yeah, totally, you know. And the one thing I'll say
Speaker 3: to on the balance sheet, I'll say two things. One is,
Speaker 3: for a long time, it was just the story the
Speaker 3: FED is pumping money into the markets, and as soon
Speaker 3: as the balance sheet starts to shrink, then that's going
Speaker 3: to be bad for risk assets. That, in my opinion,
Speaker 3: has now officially been disproven because the balance sheet has
Speaker 3: been shrinking basically since the middle of twenty twenty two
Speaker 3: and stocks are at all time high. So that's over
Speaker 3: that story. It's a thesis is broken in my opinion.
Speaker 3: But what it means for banks, what it means for
Speaker 3: bank liquidity, how far they can shrink it before it
Speaker 3: creates problems such as what we talked about I think
Speaker 3: it was in twenty nineteen. This still matters quite a
Speaker 3: bit and they're still interesting policy questions related to that.
Speaker 1: Absolutely, So who better to discuss all of these issues
Speaker 1: than Mark Cabana, rates strategist over at Bank of America. Mark,
Speaker 1: thank you so much for coming on the show.
Speaker 2: Thanks for having me.
Speaker 1: We are a longtime fans of your work, and it's
Speaker 1: kind of a treat for us that we could do
Speaker 1: this and release the episode on the day of the
Speaker 1: FED meeting, So we're recording it just the day before,
Speaker 1: so we're going to get all your thoughts on what's
Speaker 1: going on at the moment. But with your rates hat on.
Speaker 1: When you look at a week like this, when you
Speaker 1: have the QRA, you have jobs, you have the Fed,
Speaker 1: what are you most interested in? How are you weighing
Speaker 1: those different events?
Speaker 2: Sure? Well, thanks for having me. I'm also a big fan,
Speaker 2: so it's a real thrill to be here. Thank you.
Speaker 2: So when we think about the rates outlook, we think
Speaker 2: that the expected path of the overnight rate is really
Speaker 2: the most important determinant of where rates go. Henceforth, the
Speaker 2: Fed is clearly the most important consideration for us this week.
Speaker 2: The payroll report and other date of this week will
Speaker 2: inform that and then still important, but perhaps secondary, is
Speaker 2: the quarterly refunding from the Treasury that supply announcement. Though
Speaker 2: I agree with Joe, it has certainly been a focus
Speaker 2: in markets, and probably much more so than the Treasury
Speaker 2: ever would have wanted. And that's really because they've surprised
Speaker 2: the market with the last two refundings.
Speaker 1: Oh that's right, because it wasn't it the August refunding
Speaker 1: announcement that kicked off that initial big surge in bond yields,
Speaker 1: and then it was the November one that kind of
Speaker 1: calmed things down.
Speaker 2: So yes, that's generally right. So they surprised by issuing
Speaker 2: more longer dated coupons in the August refunding. They then
Speaker 2: surprised by issuing fewer long dated coupons in the November
Speaker 2: of funding, and this was seen by the market as
Speaker 2: a factor that was a meaningful driver of where term
Speaker 2: premium was going. Now, I'm using air quotes as I
Speaker 2: say that. I know your listeners can't see the air quotes,
Speaker 2: but that is because the term premium is sort of
Speaker 2: this catch all, unexplained factor, at least by certain FED models,
Speaker 2: and I think one can view term premium with a
Speaker 2: healthy dose of skepticism. But nevertheless, the market perceived that
Speaker 2: those supply announcements were big drivers of movements in term premium.
Speaker 3: By the way, for listeners, Tracy, that was a minute ago.
Speaker 3: I was drum rolling that sound because I always love
Speaker 3: when eminent guests confirm my biases. So nothing feels better
Speaker 3: than that. Setting aside market perception in your own work,
Speaker 3: how important was the mix? So I guess there's two elements.
Speaker 3: Just the total size of the borrowing each quarter, which
Speaker 3: is just a sort of economic reality that is just
Speaker 3: you know, the gap between expenditures and the amount the
Speaker 3: government brings into taxes, and then there is okay, there's
Speaker 3: that mix that you described, how much is the Treasury
Speaker 3: going to issue at the long end versus the short end?
Speaker 3: How important are these things too, setting aside what the
Speaker 3: market perceives or even what the market did, like what
Speaker 3: when you see these announcements, like what are you looking for?
Speaker 3: And how significant?
Speaker 2: So they certainly matter in terms of the relative mix
Speaker 2: of what treasure is going to issue and how the
Speaker 2: private sector is going to take that down, But in
Speaker 2: terms of determining the overall direction of bond yields, we
Speaker 2: think that they are secondary important, but secondary, and what's
Speaker 2: more important is macroeconomic information, growth, inflation, jobs, et cetera,
Speaker 2: and how that's expected to impact the overall path of
Speaker 2: the FED. And what we saw really in the third
Speaker 2: quarter was, yes, you did get a larger than expected
Speaker 2: supply announcement from the Treasury, but you also had nominal
Speaker 2: GDP that was running at about five percent real nine
Speaker 2: percent nominal that we think was the much larger driver
Speaker 2: of the movement in rates. Treasury supply announcement didn't help,
Speaker 2: but again we think that the sharp upward moving rates
Speaker 2: was largely driven by better data, and conversely, in the
Speaker 2: fourth quarter data moderated to some extent, the Fed turned
Speaker 2: more dubvish. The Treasury surprise to the downside on supply,
Speaker 2: and that helped reverse some of the big move that
Speaker 2: we saw in late summer early fall. So these supply
Speaker 2: announcements from Treasury, they do matter. They influence market perception.
Speaker 2: They certainly matter in terms of how investors think about
Speaker 2: how much supply they're going to have to take down,
Speaker 2: how aggressive or not they are to bid, how dealers
Speaker 2: manage the inventory on their balance sheets. But generally speaking,
Speaker 2: we do think it's a secondary factor, secondary to the
Speaker 2: incoming economic data that influences the expected path policy mark.
Speaker 1: One of the other narratives that it became kind of
Speaker 1: popular over the past year or so was this idea
Speaker 1: of who is going to buy the bonds. So, you know,
Speaker 1: with inflation rising, with the deficit growing, with a lot
Speaker 1: of natural buyers potentially stepping back, maybe some geopolitical concerns
Speaker 1: mixed in there, there was this narrative that the traditional
Speaker 1: buying base of US Treasury debt wouldn't be as large
Speaker 1: as it had been previously. And yet fast forward to
Speaker 1: the end of twenty twenty three, we had bond yields
Speaker 1: on the tenure basically taking a round trip. They're a
Speaker 1: little over four percent right now. What do you think
Speaker 1: about that particular narrative.
Speaker 2: Yeah, So, the number one question that we were getting
Speaker 2: over the course of twenty twenty three is indeed, who's
Speaker 2: going to buy the bonds? And it is a challenging
Speaker 2: question to answer when you are seeing inflation surprise to
Speaker 2: the upside, when the FED is more hawkish than expected,
Speaker 2: and when bond yields are losing value. No surprise, investors
Speaker 2: don't really want to buy bonds when they're not holding
Speaker 2: their value, and as a result of that, we did
Speaker 2: see that demand weakened from a whole host of traditional
Speaker 2: investors over the course of twenty twenty three, though they
Speaker 2: did come back to some extent towards the tail end. Now,
Speaker 2: when we think about who's going to buy the bonds,
Speaker 2: we really think about maybe four or five traditional buyer bases, banks,
Speaker 2: pensions and insures, overseas investors, asset managers, and then the FED,
Speaker 2: and whether or not they are buying or selling at
Speaker 2: any particular point in time. They're obviously selling right now
Speaker 2: for those buyer bases. We really saw transformation in twenty
Speaker 2: twenty three from those who really had stepped away from
Speaker 2: the market largely in the first three quarters of the years,
Speaker 2: or some that had tried to buy tens at let's
Speaker 2: say four percent and then got burned as tens rose
Speaker 2: much more materially over the course of the year, and
Speaker 2: they had really taken a step back. But once we
Speaker 2: saw macroeconomic data, certainly inflation data, confirmed that the peak
Speaker 2: and inflation was over, that the FED was not going
Speaker 2: to be hiking much more likely next step would be cutting,
Speaker 2: we saw that demand return quite meaningfully. And we've seen
Speaker 2: that from those traditional buyer bases. Banks commercial banks have
Speaker 2: stepped into the market moderately. Pensions and insurers we see
Speaker 2: they have generated the largest amount of stripping activity. A stripping, remember,
Speaker 2: is when you separate a long term treasury security into
Speaker 2: a principal component and an interest component. They like to
Speaker 2: buy the principal components because they're essentially zero coupon bullets.
Speaker 2: After they've been stripped, they have low dollar values, they
Speaker 2: can add duration easily, and that helps them manage their
Speaker 2: overall liability mix. But that pension and insurance community, we
Speaker 2: think is stepped back a bit. Some foreign demand has
Speaker 2: re emerged, not from Japan, not from China, but from
Speaker 2: other parts of the world has emerged. And we've also
Speaker 2: seen that asset managers have been returning back to the
Speaker 2: market as yield stop rising. We're also now talking about
Speaker 2: the possibility that the FED will go from as active
Speaker 2: of a net seller through QT. They don't functionally sell
Speaker 2: into the secondary market, but they're responsible for more supply
Speaker 2: that the US Treasury in turn has to issue the
Speaker 2: private sector. And they're talking about slowing QT, and now
Speaker 2: we're wondering what if they're slowing, when might they stop?
Speaker 2: So that is an important determinant in shifting some of
Speaker 2: the supply demand dynamics in the rates market. So that's
Speaker 2: a long winded way of saying that we have seen
Speaker 2: those supply and demand dynamics shift. Really demand is returned
Speaker 2: to some extent, and we remain cautiously optimistic that that
Speaker 2: demand will persist over the course of twenty twenty four,
Speaker 2: assuming that macroeconomic data continues to play along with the
Speaker 2: broad narrative of slow moderation over time.
Speaker 3: Let's talk about quantitative tightening. You know, like I said
Speaker 3: in the beginning, there's always been like this one. I
Speaker 3: guess I would call it like Twitter macro or it's
Speaker 3: like one line goes up, another line goes up. They
Speaker 3: must be connected. And I think the idea that like
Speaker 3: balance sheet policy is some incredible driver of risk asset
Speaker 3: valuation is kind of debunked. But when we're discussing how
Speaker 3: far they will go to wind down and at what
Speaker 3: level that will be, who does that really matter for
Speaker 3: and why? Like, who are the actors in the market
Speaker 3: that for whom this is an important debate that they're having.
Speaker 2: Sure, I generally think of two or three actors for
Speaker 2: which it really matters in terms of how far the
Speaker 2: FED shrinks the balance sheet. First and foremost commercial banks,
Speaker 2: because they can be directly impacted by the amount of
Speaker 2: reserves or overnight liquidity that the FED is providing two
Speaker 2: commercial banks, or that it's available in the system that
Speaker 2: commercial banks can try and bid for. The second big
Speaker 2: actor is treasury and mortgage market participants, for whom if
Speaker 2: the FED is shrinking its balance sheet or growing its
Speaker 2: balance sheet, the total amount of private sector supply in
Speaker 2: the treasury or agency mortgage market can be directly influenced
Speaker 2: by that. And then the third cohort, and Joe, I
Speaker 2: think your comments have referred to this on a few
Speaker 2: times as sort of the broader risk asset investor. I
Speaker 2: almost think of them as the quote unquote M two
Speaker 2: equity investor, the type of equity investor who just wants
Speaker 2: to buy or sell equities based upon what's happening with
Speaker 2: the broader money supply. And this, I will tell you,
Speaker 2: is a very real cohort of the market, at least
Speaker 2: as far as the folks who reach out to us
Speaker 2: on the b A rate strategy team. We also view
Speaker 2: it with a healthy dose of skepticism. We don't believe
Speaker 2: that there is a particular clear connection between how many reserves,
Speaker 2: let's say, are in the banking system and then what's
Speaker 2: going to happen with the equity market. But that doesn't
Speaker 2: dissuade them. They look back at history and they say, well,
Speaker 2: when the FED was growing its balance sheet, risk assets
Speaker 2: did well. When they shrunk the balance sheet or reserves
Speaker 2: went down, the opposite happened. And really, what we think
Speaker 2: they are picking up on is the fact that the
Speaker 2: FED and other central banks use their balance sheets to
Speaker 2: almost reinforce the broader stances of monetary policy. So if
Speaker 2: they're growing the balance sheet, they're typically doing so because
Speaker 2: they're trying to stimulate activity lower long term borrowing costs.
Speaker 2: And if they shrink the balance sheet, they're generally trying
Speaker 2: to tighten policy and they're raising interest rates at the
Speaker 2: same time. So if you think about the balance sheet
Speaker 2: as reinforcing the broad stance of monetary policy, we think
Speaker 2: that the MT equity trading stance makes sense. But we
Speaker 2: would encourage investors not to blindly follow what happens with
Speaker 2: the balance sheet or with the reserve quantity and the
Speaker 2: system as an indicator of buying or selling risks.
Speaker 1: There's one sort of under the radar thing at the
Speaker 1: moment that I think is going to end up being
Speaker 1: a big deal in twenty twenty four, which is sort
Speaker 1: of the changes around liquidity requirements and regulation for banks
Speaker 1: and all of that happening against the broader backdrop of QT.
Speaker 1: But how do you see that playing out? Because there's
Speaker 1: a number of things here, so you know, there are
Speaker 1: the basil endgame proposals, there are LCR suggestions that maybe
Speaker 1: make those liquidity ratios get a little bit bigger. There's
Speaker 1: changes to I have to be careful here because I
Speaker 1: always end up saying bt FD, the BTFP, not by
Speaker 1: the F dick the BTFP and a few other things
Speaker 1: happening in the back end.
Speaker 3: So funny that this was a market mantra for like
Speaker 3: fifteen years, and then the FED came out with an
Speaker 3: emergency program in March twenty twenty three that sounded so similar, Like,
Speaker 3: let's just acknowledge that is very funny. I never even
Speaker 3: heard of that other acronym BTFD. You need to spend
Speaker 3: more time online, dear FED. You know, I want to
Speaker 3: look at Twitter.
Speaker 2: Okay, next day.
Speaker 3: We just acknowledge the elephant in the room.
Speaker 1: I'm glad we introduced mark to thank you.
Speaker 2: I learned something.
Speaker 1: I appreciate it all right, But it does feel like
Speaker 1: changes are coming for the banks. And banks are big
Speaker 1: buyers of things like treasury bonds and mortgage backed securities
Speaker 1: and things like that. So how do you see all
Speaker 1: of that playing out?
Speaker 2: Sure, So we do think that importantly with the recent
Speaker 2: rate hiking cycle from the FED and what we saw
Speaker 2: with SVB and some other regional banks, that commercial banks
Speaker 2: have really changed their preferences around liquidity in a meaningful way.
Speaker 2: And this we think will necessitate that the FED maintain
Speaker 2: a much larger balance sheet than perhaps they had originally
Speaker 2: envisioned to really accommodate this demand for overnight liquidity from
Speaker 2: commercial banks. And we think that commercial banks are demanding
Speaker 2: much more overnight liquidity for very rational and prudent reasons.
Speaker 2: The four factors that we typically cite include Number one,
Speaker 2: we all saw what happened with SVB, and the best
Speaker 2: antidote for that, we would argue, is holding lots of
Speaker 2: overnight liquidity. Number two, commercial banks are still sitting on
Speaker 2: fairly substantial unrealized securities losses and their treasury and mortgage portfolios.
Speaker 2: The recent rate rally has helped ameliorate that, but it
Speaker 2: hasn't gone away. And again, the best way to fight
Speaker 2: against those unrealized securities sowces is to hold cash. You
Speaker 2: can tell your shareholders or your regulators, don't worry about
Speaker 2: the two and a half percent mortgage or so that
Speaker 2: I bought. I'm never going to have to sell that
Speaker 2: for liquidity purposes. Because I'm holding onto so much overnight
Speaker 2: cash and I have so many deposits, we don't worry
Speaker 2: about those securities. We think that's very rational in this
Speaker 2: type of rate environment. Third reason that banks are holding
Speaker 2: more liquidity is because they perceive that some of the
Speaker 2: traditional rules of liquidity management have changed. And this goes
Speaker 2: into a fairly narrow corner of the funding markets, but
Speaker 2: it's very important, and it's around the role of the
Speaker 2: Federal Home Loan Banking System GSE that arguably had really
Speaker 2: shifted from its original intention to be a low cost,
Speaker 2: stable provider of funding for bank mortgage holdings, and regulators
Speaker 2: are well, they've asked, does this evolution of the home
Speaker 2: loan system make sense? They think, not necessarily, and that
Speaker 2: has really reduced the ability or willingness for banks to
Speaker 2: use the home loan system as a traditional funding source.
Speaker 2: The market calls the home loans, or at least the
Speaker 2: home loans have called themselves in the past, the lender
Speaker 2: of second to last resort, and that is now, let's say,
Speaker 2: not necessarily your second to last resort. It is lower
Speaker 2: on the priority list to be used. And then the
Speaker 2: fourth and final factor is that there is a perception,
Speaker 2: as you say, Tracy, that there will be additional liquidity
Speaker 2: rules and regulations coming down the pike, and all of
Speaker 2: those factors encourage banks to want to hold more liquidity,
Speaker 2: and the best type of liquidity in the world if
Speaker 2: you're a bank for all of these reasons, is cash
Speaker 2: at the FED. It is intra day liquid and if
Speaker 2: you need it, if you were to experience a large
Speaker 2: deposit outflow, you have it at the FED. You can
Speaker 2: get it on demand as long as FED wire is opened,
Speaker 2: and that has real value if you are a commercial bank.
Speaker 2: And as a result of that, commercial banks have been
Speaker 2: choosing to hold a lot more liquidity. They've been paying
Speaker 2: up through more elevated sources of borrowing such as large
Speaker 2: time deposits, CDs, other forms of termed at borrowing, and
Speaker 2: they have been doing that in order to hold more cash.
Speaker 2: And that indicates to us this increased preference to hold liquidity.
Speaker 2: And if that is indeed right, it's going to mean
Speaker 2: that the FED is unable to shrink its balance sheet,
Speaker 2: perhaps as far as it had originally thought. Now, the
Speaker 2: question in our minds is will the FED slow down
Speaker 2: or stop in time to accommodate this, or will they
Speaker 2: risk another funding market increase or sharp jump like we
Speaker 2: saw in September twenty nineteen. We don't know the answer
Speaker 2: to that yet, but folks like me who focus a
Speaker 2: lot on the plumbing, are very very interested in the
Speaker 2: guidance that we're going to get from Powell and others
Speaker 2: at the FED as they move forward in this debate
Speaker 2: and this discussion.
Speaker 1: Since you mentioned the plumbing, you're talking essentially about the
Speaker 1: repo madness of twenty nineteen. And then we saw a little,
Speaker 1: i don't want to say repeat, but a little glimmer
Speaker 1: of that same issue in I think it was December
Speaker 1: of last year when we saw not libor, but so
Speaker 1: for the libor replacement rate shoot up kind of unexpectedly
Speaker 1: in a few days and then come down very quickly.
Speaker 1: What was going on there in your mind? And how
Speaker 1: much of a concern should future volatility in the interbank
Speaker 1: lending market be for those at the FED and US
Speaker 1: market commentators.
Speaker 2: Sure? So, Just a quick point of fact, libor was
Speaker 2: indeed unsecured interbank funding, or at least that's what it
Speaker 2: was intended to be. So is importantly secured funding that
Speaker 2: has arguably a wider range of actors involved in that
Speaker 2: money market. Mutual funds who are lending cash in that market,
Speaker 2: hedge funds who are demanding leverage on the borrowing side
Speaker 2: in that market. So it is a fundamentally different space,
Speaker 2: but we do think that signals from money markets are
Speaker 2: very important indicators of what this demand for liquidity at
Speaker 2: commercial banks looks like and how much excess cash may
Speaker 2: be available to keep money markets in check. Now, how
Speaker 2: does this actually work. Well, here's our understanding of it.
Speaker 2: So when we think about the reboul market, we think
Speaker 2: very simply about it. It's nothing more than the relative
Speaker 2: balance of cash that is available to be invested in
Speaker 2: short term money markets and collateral that needs to be funded. Really,
Speaker 2: treasury collateral is the most frequent type of collateral that
Speaker 2: we think of, but there's a whole host of other
Speaker 2: collateral that gets funded mortgages, credit em etc. But again,
Speaker 2: we just think about it as in terms of cash
Speaker 2: and collateral. And what we saw at the end of December,
Speaker 2: also what we saw at the end of November is
Speaker 2: that we saw rebo rates spike for a period of time.
Speaker 2: In our framework, that simply indicates that there is less
Speaker 2: cash that's available to fund the collateral that is in
Speaker 2: need of financing, and henceforth repo rates go up. Now,
Speaker 2: what was happening on both sides of that equation. Well,
Speaker 2: on the cash side, what you see is that dealers
Speaker 2: to reduce their intermediation in the repo market due to
Speaker 2: month end and especially year end balance sheet reporting dates.
Speaker 1: Window dressing is the prefer you said it not, It's
Speaker 1: my preferred term.
Speaker 2: And we also see that there's big treasury settlements at
Speaker 2: the end of the month, and there's more collateral that
Speaker 2: needs to be financed, and so the rebo market is
Speaker 2: just more susceptible to moving higher because of that cash
Speaker 2: collateral dynamic that shifts on month ends. Now this links
Speaker 2: to what happens with commercial banks and their liquidity preferences,
Speaker 2: because commercial banks are indeed a big source of cash,
Speaker 2: and commercial banks we saw in twenty eighteen and twenty
Speaker 2: nineteen as the FED was doing QT and that cash
Speaker 2: collateral balance shifted. Commercial banks were big lenders in the
Speaker 2: cash market at that period of time. They were taking
Speaker 2: their overnight liquidity investing in overnight treasure GC repo, which
Speaker 2: is a close substitute, but importantly not a perfect substitute.
Speaker 2: And we now see again that as repo rates arising,
Speaker 2: commerce banks are choosing to lend a little bit more
Speaker 2: in the repo market to try and keep GC rebo
Speaker 2: in check. The question we have though, is how much
Speaker 2: cash is there truly to keep these funding markets in
Speaker 2: check as the cash collateral balance shifts, And will these
Speaker 2: banks be willing to take that cash that they're sitting
Speaker 2: on with the FED that is perfectly intra day liquid
Speaker 2: and exchange it for T plus one liquidity for a
Speaker 2: yield enhancement. That is the big question that we ask ourselves.
Speaker 2: That is the question that the FED, I think is
Speaker 2: asking themselves, and that will ultimately be what we believe
Speaker 2: is the driver of how far they can actually shrink
Speaker 2: the balance.
Speaker 1: Sheet out of curiosity. Do you see any interplay with
Speaker 1: the recent changes to the BTFP, the Emergency bank funding program,
Speaker 1: and Big Bank's willingness to fund REPO.
Speaker 2: It's too soon, I think to tell, but in theory
Speaker 2: you can imagine that there would be a connection because
Speaker 2: the BTFP, for as long as it was going to
Speaker 2: be available for new loans, served as a cheap, low
Speaker 2: cost source of additional liquidity that banks might want. That
Speaker 2: the liquidity was available on very favorable terms, not just price,
Speaker 2: but the facility was set up such that it funded
Speaker 2: treasuries or agency paper at par, not market value, and
Speaker 2: that's a big difference when you've got overnight rates that
Speaker 2: are still above five percent. So the fact that BTFP
Speaker 2: is well, the terms have now changed, and the facility
Speaker 2: we know will now be going away in early to
Speaker 2: mid March, that perhaps means that banks cannot rely on
Speaker 2: that as another source of very favorable liquidity, and all
Speaker 2: else equal for prudent liquidity management purposes might want to
Speaker 2: hold more cash as opposed to less.
Speaker 3: The FED balance sheet. You know, I didn't talk about well,
Speaker 3: I don't know. I was gonna say. I was going
Speaker 3: to say we didn't talk about it much before two
Speaker 3: thousand and eight. But the truth of the matter is
Speaker 3: I wasn't even in journalism before two thousand and eight,
Speaker 3: So who am I to say we didn't talk about
Speaker 3: it much. But I do get the impression that it
Speaker 3: wasn't is active on people's minds. Back then, it was
Speaker 3: pretty small. It was less than a trillion dollars. Then
Speaker 3: the financial crisis happened. It just keeps getting bigger and bigger,
Speaker 3: and now it's somewhere a little less than eight trillion dollars.
Speaker 3: Is there a cost to a big balance sheet?
Speaker 2: Like?
Speaker 3: I get this idea that people think, like, oh, we
Speaker 3: should normalize it, or we want to bring it down,
Speaker 3: et cetera. But you know, you describe. There are various
Speaker 3: reasons why large banks, for both regulatory and business reasons,
Speaker 3: want to have ample liquid reserves. Is there some price
Speaker 3: or some negative aspect of a large balance sheet or
Speaker 3: is there some I guess sound reason why the FED
Speaker 3: wants to continue to shrink it or normalize it whatever
Speaker 3: that means.
Speaker 2: Yes, I think there's two key reasons. The first is
Speaker 2: perhaps a little bit fuzzier, the second is much more practical.
Speaker 2: The first reason is that the FED, and what they say,
Speaker 2: is that they don't want to have an outsized footprint
Speaker 2: in financial markets. They don't want to be distorting financial
Speaker 2: markets to the extent beyond what is absolutely necessary to
Speaker 2: achieve their key monetary policy or financial stability objectives. So
Speaker 2: that's one. But the second reason is much more practical,
Speaker 2: and that is that there is a cost, a very
Speaker 2: measurable cost to having a large balance sheet. If you
Speaker 2: think about the Fed's assets and liabilities. On the asset side,
Speaker 2: they pretty much have treasury securities and mortgage bonds. Those
Speaker 2: right now are probably yielding all in somewhere in the
Speaker 2: neighborhood of two and a half to three and a
Speaker 2: half percent all told. But on the liability side of
Speaker 2: the fed's balance sheet, there are two big cost items
Speaker 2: that are there. One is the interest on reserve balances
Speaker 2: rate that they pay to commercial banks. That rate is
Speaker 2: currently five point four percent. And then the other is
Speaker 2: the rate that they pay on their overnight reverse repo facility,
Speaker 2: and that is five point three percent. And between the
Speaker 2: two of these there is close to four trillion dollars
Speaker 2: that is kept with the FED, and where the FED
Speaker 2: is paying a rate that is between five point three
Speaker 2: and five point four percent. So they are very much
Speaker 2: paying out a higher rate on their liabilities than they
Speaker 2: are taking in on their assets. And what that has
Speaker 2: resulted in is that the FED is actually insolvent. They
Speaker 2: are running negative NIM and they have seen their capital
Speaker 2: essentially move into negative territory. And it's over one hundred
Speaker 2: billion now. I think the number is close to one
Speaker 2: hundred earth one hundred and thirty to one hundred and
Speaker 2: forty billion.
Speaker 1: I can't bring myself to do a drum roll, Joe,
Speaker 1: but I broke that story. Yeah, when they first when
Speaker 1: they first went negative, I think it was late. Now
Speaker 1: I can't I can't do drum rolls. I can't.
Speaker 2: So the FED calls this a deferred asset, and essentially
Speaker 2: what it represents is the amount that they will withhold
Speaker 2: in the future to repay the negative equity position that
Speaker 2: they have got themselves in. They will take any excess
Speaker 2: income on their securities portfolio and remit that to the
Speaker 2: US Treasury. Remember when rates were really low or near zero,
Speaker 2: but the curve was somewhat upward sloping, the FED was
Speaker 2: buying treasuries and mortgages. They were essentially taking in I
Speaker 2: don't even know if it was a one percent coupon
Speaker 2: at the time, and they were paying out functionally zero
Speaker 2: on their liabilities. And they were in that position for
Speaker 2: a very long time, and they used to generate tens
Speaker 2: of billions of dollars for the US taxpayer, something like
Speaker 2: seventy billion eighty billion dollars that they would remit to
Speaker 2: the US Treasury. Well now they're not doing that, and
Speaker 2: they're essentially accounting for this by claiming an IOU that
Speaker 2: they will repay to themselves to cover these losses before
Speaker 2: they start those remittances to the US Treasury. And what
Speaker 2: this means is that the inflows to the US Treasury
Speaker 2: are lower than the otherwise would have been. So this
Speaker 2: is a very real and measurable cost. Now what's surprising,
Speaker 2: at least to me, is that this has not been
Speaker 2: a political issue whatsoever in the US when you think about, well,
Speaker 2: who is the FED accountable to. They're accountable to the
Speaker 2: American public, and who is designed to maintain that accountability.
Speaker 2: It's Congress. Yet when the FED share goes and testifies
Speaker 2: in front of Congress, this issue never comes up. And
Speaker 2: it's very surprising to me that it has not come up.
Speaker 2: And for what it's worth, this issue in the US
Speaker 2: is not unique. It's also an issue in Europe in
Speaker 2: the UK, but this issue is of much more prominence
Speaker 2: in those jurisdictions because in the case of the euro Area,
Speaker 2: they literally have to figure out, well, which government is
Speaker 2: going to pay for the negative equity on the ECB's
Speaker 2: balance sheet, And in the UK there is quite literally
Speaker 2: a regime by which they have to raise taxes in
Speaker 2: order to pay for the negative equity at the Bank
Speaker 2: of England. In the US, we just you know, it
Speaker 2: sort of sits there and it's thought that it'll be
Speaker 2: paid back over time, and it is not an issue
Speaker 2: of prominence. If it were to be an issue of prominence,
Speaker 2: if it were to be a larger political issue, then
Speaker 2: I would think that the FED would have a greater
Speaker 2: incentive to try and shrink the balance sheet, or at
Speaker 2: least to try and get themselves out of this negative
Speaker 2: equity position faster, certainly negative nim position that they are
Speaker 2: in faster. So again, are their costs, Yes, there are.
Speaker 2: They are only real costs if let's say we care
Speaker 2: about them, we collectively as a electorate in the US.
Speaker 2: But that issue, at least in my perception, is very
Speaker 2: low on the list of congressional priorities, in the list
Speaker 2: of voting priorities in the US.
Speaker 1: This is such an interesting topic to me. And again,
Speaker 1: in addition to writing when the FED finally went into
Speaker 1: a negative capital position in late twenty twenty two, I
Speaker 1: had a peace out in March of twenty twenty two
Speaker 1: and the title of it was why the FED losing
Speaker 1: money might matter for monetary policy, Because, as you say, Mark,
Speaker 1: the conventional wisdom is that, like, it doesn't really matter,
Speaker 1: it's all accounting. Maybe it'll be a bit embarrassing if
Speaker 1: Powell has to testify before Congress and someone is like, oh,
Speaker 1: you're losing money, But it does seem to me like
Speaker 1: you could get a situation where the central Bank does
Speaker 1: have to adjust something like QT in order to take
Speaker 1: into account ongoing interest rate expenses, and that could actually
Speaker 1: affect policy sort of at the margins, it feels like
Speaker 1: I agree.
Speaker 2: At the margins, know the Feed is not going to
Speaker 2: let this dictate their core objective of maximum employment and
Speaker 2: price stability, but if they were getting a lot of
Speaker 2: heat for it, it would mean that they want to
Speaker 2: try and shrink the balance sheet, arguably by more than
Speaker 2: they otherwise would have and be less accommodative for the
Speaker 2: bank demand for liquidity that we were discussing earlier, or
Speaker 2: that they might try and move the prices that they
Speaker 2: pay on the core liabilities that they have again, cash
Speaker 2: that's held by commercial banks or overnight investments money funds
Speaker 2: are making with the Fed, they might try and move
Speaker 2: those lower. All e'll SQL and it's perhaps not an
Speaker 2: issue if it's not top of mind for let's say,
Speaker 2: those who hold a FED accountable, but it certainly could
Speaker 2: be if those dynamics do change.
Speaker 3: Under current political dynamics, which is Congress probably doesn't care
Speaker 3: that much because you know, it's probably not going to
Speaker 3: be a big, you know, voting issue in November would
Speaker 3: be my guest. But under current dynamics of the degree
Speaker 3: to which people care and everything, what is your forecast
Speaker 3: for where the balance she goes here? Yeah, everything we've
Speaker 3: talked about.
Speaker 2: So we have an out of consensus view and that
Speaker 2: we think that the FED is going to be slowing
Speaker 2: QT a little bit earlier than expected and likely wrapping
Speaker 2: up by let's say, mid to late summer the QT
Speaker 2: program that would see the Fed's balance sheet likely in
Speaker 2: the neighborhood of seven and a half trillion. It's about
Speaker 2: seven points seventy five trillion right now, And the reason
Speaker 2: for that is that we think that they will be
Speaker 2: a bit more accommodative and willing to provide the necessary
Speaker 2: liquidity that we perceive that commercial banks are demanding. Now.
Speaker 2: The FED is they think about how far they want
Speaker 2: to push QT has to be mindful of the lessons
Speaker 2: that they learned in twenty nineteen. Banks were demanding more
Speaker 2: liquidity than they thought. They shrunk the balanceet by too
Speaker 2: much and they cause that unnecessary rebowl market volatility and
Speaker 2: what they are likely debating today and perhaps tomorrow. Is
Speaker 2: how far do they want to push it this time?
Speaker 2: When might they slow down QT? And what are the
Speaker 2: considerations that they will be looking for? And we do
Speaker 2: believe that this very technical facility that they have set up,
Speaker 2: called the Overnight Reverse Repo Facility, which is again a
Speaker 2: facility whereby primarily money market mutual funds can invest cash
Speaker 2: overnight with the Fed on a fully collateralized basis, mostly
Speaker 2: by treasuries. They're asking themselves, well, when might they slow
Speaker 2: QT in relation to how utilization of that facility is evolving.
Speaker 2: And we do think that this is really important because
Speaker 2: we believe that as long as there is excess cash
Speaker 2: that money market mutual funds are choosing to invest with
Speaker 2: the Fed on an overnight basis, as long as those
Speaker 2: balances are positive, we think that there is clearly excess
Speaker 2: liquidity in the system. If there's excess liquidity, then the
Speaker 2: FED should feel comfortable proceding full steam ahead with QT.
Speaker 2: But once those balances are exhausted or very low, then
Speaker 2: the Fed might want to think about slowing things down.
Speaker 2: This was an argument that we heard earlier this month
Speaker 2: from Dallas FED President Lori Logan. She suggested that she
Speaker 2: would propose slowing QT once overnight RP balances were low,
Speaker 2: now very ambiguous. At low level, we think that that
Speaker 2: means balances that are two hundred to two hundred and
Speaker 2: fifty billion, but we don't really know for sure. So
Speaker 2: she wants to slow down once those balances get low,
Speaker 2: because she wants to proceed more cautiously thereafter and ensure
Speaker 2: that the FED doesn't inavertently withdraw too much liquidity from
Speaker 2: the system. Again, she wants to accommodate, or so it
Speaker 2: seems that demand that commercial banks have to hold liquidity
Speaker 2: and will be using the overnight RP as perhaps the
Speaker 2: best single indicator for the amount of excess that's in
Speaker 2: the system. We think that that line of reasoning is very,
Speaker 2: very sensible.
Speaker 1: Wait, what about bank reserves, because before the overnight RRP existed,
Speaker 1: it was always about the level of what is ample
Speaker 1: and what is not in bank reserves.
Speaker 2: That's right, and that's what they're really trying to solve for.
Speaker 2: They want to move from a clearly abundant and they
Speaker 2: use these words abundant and ample, but they don't define
Speaker 2: them in any way, which kind of makes it, you know,
Speaker 2: feel a little buzzy and a little unclear, but they
Speaker 2: say that they want to move away from an abundant
Speaker 2: regime of reserves to an ample regime of reserves. Again,
Speaker 2: definitions are unclear what the distinction is. And I think
Speaker 2: we can say that when money market rates were really
Speaker 2: low and overnight RP facility utilization was very high, they
Speaker 2: were clearly abundant. There was a bunch of excess liquidity
Speaker 2: in the system, and the overnight RP helps proxy for that. However,
Speaker 2: once RP is exhausted and it's been dropping very very rapidly,
Speaker 2: once it's exhausted, then it's not so clear that you
Speaker 2: you are in such an obviously abundant zone and you
Speaker 2: are probably moving along the lines of from abundant to ample.
Speaker 2: I know, it's these buzzwords, and well it.
Speaker 1: Comes after ample, adequate, and oh that's good. Yeah, abundant, ample, adequate.
Speaker 2: Yeah, I don't know non ample, Yeah.
Speaker 3: I don't know adequate, an adequate reserves regime.
Speaker 2: That's but the point here is that you don't know
Speaker 2: if you're the FED where you are on that path,
Speaker 2: and they don't want to push it too far. So
Speaker 2: what's going to help them determine this money market rates?
Speaker 2: So for where that trades within their target range, how
Speaker 2: much cash commercial banks were sitting on a big quantity
Speaker 2: of cash or going to be willing to invest in
Speaker 2: funding markets in order to keep money markets stable. And
Speaker 2: as you see money markets rise, and as you see
Speaker 2: banks move some of the money and perhaps slow down
Speaker 2: the movement of some of the excess cash that they
Speaker 2: are holding, that should be a very clear indicator to
Speaker 2: the FED that they have gone far enough and that
Speaker 2: they should slow things down. Now, one final point that
Speaker 2: I'd like to make on this is just that the
Speaker 2: FED is also likely very well aware the demand for
Speaker 2: reserves is not static. It's dynamic. It shifts with macroeconomic conditions,
Speaker 2: and importantly, it shifts with interest rates. We talked earlier
Speaker 2: about all of the reasons that we believe commercial banks
Speaker 2: are demanding a higher quantity of liquidity. Today, SVB went down,
Speaker 2: unrealized securities losses, changes in liquidity rigs past and perhaps upcoming.
Speaker 2: But when you think about what happened with SVB, and
Speaker 2: when you think about what happened with the unrealized securities losses,
Speaker 2: it's really a function of interest rates. And if the
Speaker 2: FED were too hypothetically say cut interest rates three hundred
Speaker 2: basis points very swiftly, probably not going to but if
Speaker 2: they were, we very strongly suspect that bank demand for
Speaker 2: reserves and bank demand for liquidity would go down because
Speaker 2: they would be more confident in their deposits stability. Those
Speaker 2: uninsured deposits wouldn't run as fast because they have depositors
Speaker 2: would have less attractive alternatives, and your unrealized losses on
Speaker 2: your securities portfolio may completely go away if rates are
Speaker 2: substantially lower. So the FED likely is aware that demand
Speaker 2: for reserves is varying with macroeconomic conditions, is varying with
Speaker 2: interest rates, and being more careful when interest rates are
Speaker 2: high and you've been doing QT quickly seems prudent, though
Speaker 2: you can question how long you might be able to
Speaker 2: run QT, especially if the interest rate regime is substantially
Speaker 2: lower than where it is today.
Speaker 4: Yeah, it is true that I think reserves are at
Speaker 4: something like three point four trillion dollars now, and they
Speaker 4: were less than three trillion dollars right before the mini
Speaker 4: banking crisis, so they do move around quite a bit.
Speaker 1: Mark. That was amazing, Thank you so much for coming
Speaker 1: on and sort of threading the needle between what's going
Speaker 1: on at the banks and in bond markets with the FED.
Speaker 1: Really appreciate it.
Speaker 2: Thanks so much for having me.
Speaker 3: That was great, Mark really appreciated.
Speaker 2: Thanks you, Joe.
Speaker 1: That was such an enjoyable conversation. Mark so clear on
Speaker 1: a lot of these topics which other people sometimes either
Speaker 1: seem to struggle with or obfuscate for various reasons. But
Speaker 1: that was great.
Speaker 3: That was great. I totally agree with that, Like, these
Speaker 3: are topics when you get into the stuff where it's
Speaker 3: easy to sort of get lost in the sea of
Speaker 3: like I'm not really sure what's going on. Mark was
Speaker 3: so clear and the way he like broke it down
Speaker 3: so that last point, actually I thought was super interesting
Speaker 3: about the relationship between rates policy and total demand for reserve,
Speaker 3: which is not something I guess I had like quite
Speaker 3: heard like put in pieces like that, but like this
Speaker 3: idea that you know of unrealized losses are going to
Speaker 3: fall if there's less competition for rates elsewhere, then banks
Speaker 3: feel less of an impulse to hold overnight liquidity, like
Speaker 3: very clear and not something that I had quite like
Speaker 3: put together.
Speaker 2: Quite like that.
Speaker 1: Yeah, also makes a lot more sense why the FED
Speaker 1: might be looking at something like the overnight RP, the
Speaker 1: REBO for signs of liquidity versus reserves in the system.
Speaker 1: The other thing. It just brought back to me the
Speaker 1: sort of blast from the past when we were talking
Speaker 1: about the FED reporting a loss. Yeah, I remember, this
Speaker 1: is how old I am. I remember writing in twenty
Speaker 1: eleven when the FED changed its accounting rules so that
Speaker 1: it couldn't like actually go bankrupt. It changed it so
Speaker 1: that like the most it could do is report a
Speaker 1: sort of negative position on assets. I feel old.
Speaker 3: Well, it's a good reminder actually the FED to write
Speaker 3: its own recounting rules like these are you know, it's
Speaker 3: like people look at the FEDS solvent or whatever. It's
Speaker 3: who determines that, you know, to your point, And I
Speaker 3: didn't even realize that I'd forgotten, or maybe I never
Speaker 3: knew that in twenty eleven that the FED had changed
Speaker 3: its accounting rules to avoid any problems. But it is
Speaker 3: a good reminder that if you can write your own
Speaker 3: accounting rules, that makes life easier.
Speaker 1: Well, and I think the issue was that it wanted
Speaker 1: to avoid a situation where if it had a loss,
Speaker 1: it would have to go to the Treasury for capital
Speaker 1: top up, which makes sense, and then that could be
Speaker 1: a sort of vulnerability in terms of independence. So they
Speaker 1: just rewrote the rules so that they didn't have to
Speaker 1: dzps basically. Yeah, wouldn't it be nice I feel could
Speaker 1: write our own accounting rules. Yes, anyway, we'll have to
Speaker 1: get Mark on again.
Speaker 3: Yeah, here's great. That was really good. I'm I'm glad
Speaker 3: we finally had them on.
Speaker 1: All right, and a big week for market. Yeah, lots
Speaker 1: going on. It'll be interesting to see how everything shakes out.
Speaker 1: But in the meantime, shall we leave it there?
Speaker 3: Let's leave it there, all right.
Speaker 1: This has been another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 3: And I'm joll Wisenthal. You can follow me at the Stalwart.
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