WEBVTT - What the Fed's Big Balance Sheet Unwind Means for Markets 0:00:10.080 --> 0:00:13.400 Hello, and welcome to another episode of the Odd Thoughts Podcast. 0:00:13.480 --> 0:00:16.880 I'm Tracy Allawitt and I'm Joe. Joe. What was the 0:00:16.920 --> 0:00:21.640 biggest thing that happened in markets in recent months over 0:00:21.640 --> 0:00:24.119 the summer. It's like a test. I think it's like 0:00:24.160 --> 0:00:27.200 a test of, you know, what people are looking at 0:00:27.360 --> 0:00:33.600 the moment, what they find interesting. I mean, the FED tightening. Obviously, yes, 0:00:33.880 --> 0:00:37.479 this is the correct answer. Okay, I'll stop there. I 0:00:37.520 --> 0:00:40.120 got it right, So I'm just gonna stop there and 0:00:40.240 --> 0:00:44.240 you can go on. Okay, So the FED started quantitative tightening. 0:00:44.600 --> 0:00:48.240 We're recording this in late June, and weirdly, it kind 0:00:48.280 --> 0:00:51.800 of went by without that much fanfare, Like there were 0:00:51.840 --> 0:00:56.120 a few news articles about the FED firing the starting 0:00:56.160 --> 0:00:59.400 gun on quantitative tightening and the unwind of its very 0:00:59.480 --> 0:01:01.720 very large balance sheet, but there was so much going 0:01:01.760 --> 0:01:04.160 on at the same time, you know, there was that 0:01:04.240 --> 0:01:07.280 surprise seventy five basis point interest rate hike, and then 0:01:07.360 --> 0:01:10.120 lots of talk about inflation and things like that that 0:01:10.240 --> 0:01:13.160 it feels like it didn't get as much attention as 0:01:13.200 --> 0:01:17.000 it probably should have. Most of the attention is paid 0:01:17.000 --> 0:01:20.200 to the rate obviously, you know, queue when it was 0:01:20.280 --> 0:01:23.680 first unveiled or when Ben Berneki did QUI two, which 0:01:23.760 --> 0:01:26.600 was the real QUEI during the Great financial crazies, I 0:01:26.720 --> 0:01:30.600 got so much attention, but there still seems to be 0:01:30.680 --> 0:01:34.360 a lot of ambiguity about a how it works, what 0:01:34.440 --> 0:01:37.560 it does, what it accomplishes, and then in terms of 0:01:37.600 --> 0:01:41.080 like the degree to which unwinding the balance sheet is 0:01:41.200 --> 0:01:45.040 or is not an additional form of policy, tightening is 0:01:45.080 --> 0:01:47.760 something that I just feel like is at best, like 0:01:47.960 --> 0:01:52.360 still deeply misunderstood. It is kind of crazy that even 0:01:52.400 --> 0:01:55.400 after years and years of quantitative easing, there's still a 0:01:55.440 --> 0:01:59.960 discussion about what the impact is and how it actually works. 0:02:00.360 --> 0:02:03.440 I mean, I remember people still arguing about whether or 0:02:03.480 --> 0:02:06.040 not it pushes up asset prices and things like that. 0:02:06.400 --> 0:02:08.639 And there are people out there right now who are 0:02:08.720 --> 0:02:12.480 arguing that the reason markets have fallen might not actually 0:02:12.480 --> 0:02:14.920 have to do that much with inflation concerns and worries 0:02:14.960 --> 0:02:18.320 over a looming recession, but could just be because liquidity 0:02:18.440 --> 0:02:20.520 is starting to exit the system. No, No, I mean, 0:02:20.600 --> 0:02:24.079 it's totally it's totally valid. You know, it's worth noting 0:02:24.200 --> 0:02:30.600 that we have had, you know, markets boomed even though 0:02:30.639 --> 0:02:33.800 there was no longer a further expansion of the balance sheet. 0:02:34.360 --> 0:02:38.120 You know, we started to rally in early nineteen again 0:02:38.280 --> 0:02:41.919 even as the balance sheet shrank for a while, going 0:02:41.960 --> 0:02:45.760 into some of the tensions, but it really is wild, 0:02:46.000 --> 0:02:48.440 as you say, like how little we know and how 0:02:48.520 --> 0:02:50.839 little even I mean, I think even the FED knows 0:02:50.880 --> 0:02:55.000 about like quanted measuring the effects of changes to the 0:02:55.000 --> 0:02:58.040 size of the balance sheet. Well, there is also an 0:02:58.120 --> 0:03:00.239 argument to be made that the QUEI that we seen 0:03:00.320 --> 0:03:04.320 over the past couple of years is stylistically and quantitatively 0:03:04.480 --> 0:03:07.160 different than the ones we've seen prior, and so the 0:03:07.200 --> 0:03:09.919 exit is going to be different too. So we are 0:03:09.960 --> 0:03:13.680 going to dig into all of these um very big 0:03:13.720 --> 0:03:16.760 and technical questions and I'm happy to say we really 0:03:16.760 --> 0:03:19.200 do have the perfect person to discuss this. We're going 0:03:19.240 --> 0:03:22.080 to be speaking with someone who's been on the podcast before, Joe, 0:03:22.200 --> 0:03:26.040 but I think you were actually away for that effort. Yeah, 0:03:26.120 --> 0:03:28.800 so I'm thrilled to have him back. We're going to 0:03:28.840 --> 0:03:31.680 be speaking with Joseph Wang. He used to work at 0:03:31.680 --> 0:03:34.639 the New York Fed on the Open Markets desk, conducting 0:03:34.720 --> 0:03:39.320 repo operations, basically being deep in the weeds of money markets, 0:03:39.720 --> 0:03:42.320 and now he runs a blog called fed Guy, which 0:03:42.360 --> 0:03:44.760 is really a must read if you're interested in monetary 0:03:44.800 --> 0:03:47.440 policy and in all of these big questions about how 0:03:47.480 --> 0:03:50.320 it actually works. So, Joseph, thank you so much for 0:03:50.400 --> 0:03:53.360 coming back on ad thoughts. Tracy, Hey, Joe, thanks so 0:03:53.440 --> 0:03:56.760 much for your biding. Yet it's a pleasure to be here. Yeah, 0:03:56.920 --> 0:03:59.480 So maybe just to begin with, could you give us 0:03:59.520 --> 0:04:03.440 the bra outline of how quantitative tightening or the QUEI 0:04:03.600 --> 0:04:06.160 that we've seen over the past couple of years. You know, 0:04:06.240 --> 0:04:09.480 as I alluded to, it's different to the QUI that 0:04:09.560 --> 0:04:11.960 we've seen in the past. So I guess the question 0:04:12.080 --> 0:04:15.200 is how different is it this time? Like? What makes 0:04:15.240 --> 0:04:19.640 this particular exit different to previous periods of quantitative tightening 0:04:19.640 --> 0:04:23.240 that we've seen. Sure, so I think this time QUT 0:04:23.680 --> 0:04:26.360 is a different first and the level, and I think 0:04:26.360 --> 0:04:28.719 there's changes in the financial in the structure of the 0:04:28.760 --> 0:04:32.159 financial system that make a bit more difficult. So this 0:04:32.240 --> 0:04:34.560 time around, QUI looks like it's going to ramp up 0:04:34.560 --> 0:04:38.080 to about nine billion dollars a month now. In contrast, 0:04:38.240 --> 0:04:40.760 the last time around when we did this, the maximum 0:04:40.839 --> 0:04:43.440 that we ever did was fifty billion dollars a month. 0:04:43.600 --> 0:04:46.560 So in terms of pace, it's a much much more 0:04:46.560 --> 0:04:49.840 aggress pace. We're doing nine billion a month, can kind 0:04:49.839 --> 0:04:52.240 of contrast last time the maximum we did was fifty 0:04:52.240 --> 0:04:54.760 billion a month. So the way that this works through 0:04:54.760 --> 0:04:57.919 the system, I think Bradley speaking, I think of QT 0:04:58.160 --> 0:05:01.719 as having two mechanisms. One is that it increases the 0:05:01.760 --> 0:05:05.839 supply of treasuries into the market. That's one, and that's 0:05:05.880 --> 0:05:08.200 kind of how the FET thinks of it. It. By 0:05:08.240 --> 0:05:12.000 increasing or increasing the supply of treasuries, you are pushing 0:05:12.880 --> 0:05:15.520 the term premium higher, so it puts upward pressure on 0:05:15.720 --> 0:05:19.720 interest rates. And the second mechanism has to do with 0:05:20.040 --> 0:05:24.880 draining liquidity out of the system. So these two mechanisms 0:05:24.960 --> 0:05:28.280 are related but also operate in separate ways, And they 0:05:28.440 --> 0:05:31.400 also have a lot of moving parts into how they 0:05:31.440 --> 0:05:35.080 actually can play out. And these moving parts aren't completely 0:05:35.160 --> 0:05:38.800 within the FET's control. So because of this, QT can 0:05:38.839 --> 0:05:41.600 play out in a range of outcomes. You can have 0:05:42.040 --> 0:05:44.680 very benign QT, where it really is just washing paint 0:05:44.720 --> 0:05:47.720 dry as Railie and what mentioned before, or you can 0:05:47.760 --> 0:05:52.240 have QT that's more aggressive and very disruptive. Now, based 0:05:52.240 --> 0:05:54.640 on what I see in the current configuration of the 0:05:54.640 --> 0:05:58.200 financial system, considers so many moving parts, it seems what's 0:05:58.200 --> 0:06:01.039 happening right now is compared to last time, QT, this 0:06:01.080 --> 0:06:04.320 time is going to be a lot more disruptive. I 0:06:04.320 --> 0:06:09.520 guess I can talk about why from the So I'll 0:06:09.560 --> 0:06:12.120 go by the first mechanism, the increase in trgury supply, 0:06:12.560 --> 0:06:14.800 and then I'll talk about why draining liquidy this time 0:06:14.839 --> 0:06:18.200 will also be more disruptive. So when QT increases the 0:06:18.240 --> 0:06:21.400 supply of treasuries into the private sector, the Fed doesn't 0:06:21.400 --> 0:06:25.200 actually get to decide what tenors that reach the market. 0:06:25.680 --> 0:06:29.279 That's a decision by the U S. Tresury techne. Overall, 0:06:29.360 --> 0:06:32.640 what happens is that um when the feed is doing QT, 0:06:34.040 --> 0:06:37.240 it's it's receiving repayments for the tresury that it owes 0:06:37.640 --> 0:06:40.640 that that it owns. So the U S Trsury issues 0:06:40.720 --> 0:06:43.120 new debt and takes that money and repays the ft. 0:06:43.320 --> 0:06:46.039 That's what happens. So it's the U S. Treasury that 0:06:46.040 --> 0:06:48.840 gets decide what are the new what are the tenors 0:06:48.920 --> 0:06:53.080 of the new treasuries that the market absorbs. Now, you 0:06:53.120 --> 0:06:55.919 can do this in a way that's very market neutral. 0:06:56.200 --> 0:06:58.200 So let's say the U S. Tregury issues a lot 0:06:58.240 --> 0:07:01.400 of short data debt, Treasury builds now, the market can 0:07:01.440 --> 0:07:04.480 absorb these treasury bills very easily. If you think back 0:07:04.480 --> 0:07:07.880 to the first quarter of the tresury issued two trillion 0:07:07.920 --> 0:07:10.640 dollars in bills in the market just lapped that up easily. 0:07:11.200 --> 0:07:13.800 So in a sense, it's because bills are so cash like, 0:07:14.000 --> 0:07:16.520 it's they don't really have any interest rate impact. But 0:07:16.640 --> 0:07:19.240 what the U. S. Treasury is doing this time around, 0:07:19.400 --> 0:07:24.200 it's actually cutting bill issuance, so because it had received 0:07:24.240 --> 0:07:26.760 a lot of tax payments in April above its expectations. 0:07:26.840 --> 0:07:29.600 So all the q T increase in supply over the 0:07:29.680 --> 0:07:33.200 next few months is going to be in coupons, and 0:07:33.280 --> 0:07:36.840 coupons are more difficult for the market to absorb, so 0:07:36.920 --> 0:07:41.120 it's probably going to place more upward pressure on interest rates. 0:07:41.480 --> 0:07:43.960 There are also a lot more mechanics behind this that 0:07:43.960 --> 0:07:48.040 that make it the same around more disruptive. So, for example, 0:07:48.840 --> 0:07:52.480 we're having a big change in who the Marshall wires 0:07:52.480 --> 0:07:55.680 are in this market. Well, actually, I'll sit back a 0:07:55.680 --> 0:07:59.120 bit and say, so the increases imply this time around 0:07:59.320 --> 0:08:01.640 is much higher than it was last time around. I 0:08:01.680 --> 0:08:05.360 think it's useful to think about treasury rates in terms 0:08:05.360 --> 0:08:08.440 of supply and demand. So in terms of supply, the 0:08:08.480 --> 0:08:13.040 sime around the amount. Taking into account of QT the 0:08:13.160 --> 0:08:16.360 estimates for the increase in supply to the private sector, 0:08:16.360 --> 0:08:19.200 it's going to be about one point five trillion dollars 0:08:19.200 --> 0:08:22.480 a year, so for the next three years. Now, just 0:08:22.920 --> 0:08:26.520 for context, pre COVID, the amount of supply that was 0:08:26.560 --> 0:08:29.280 going into the market was about five dred billion dollars 0:08:29.320 --> 0:08:32.560 a year, and so the pace of the supply is 0:08:32.600 --> 0:08:35.520 just so so much higher than than it was the 0:08:35.559 --> 0:08:38.880 last time we did this. And that is happening in 0:08:38.920 --> 0:08:42.960 the context of from the say demand side, from the 0:08:42.960 --> 0:08:46.560 buyer side, where the Marshall buyer is changing and the 0:08:46.600 --> 0:08:50.400 market structure doesn't seem very strong. The Marshall buyer for 0:08:50.520 --> 0:08:56.320 treasuries before COVID was actually the hedge fund the hedge funds. 0:08:56.320 --> 0:08:59.040 So what the hedgemunds were doing they were buying let's say, 0:08:59.120 --> 0:09:02.599 hundreds of boons haves and treasuries several hundred billions and treasuries, 0:09:03.080 --> 0:09:05.680 but they were buying it as part of a basis trade, 0:09:05.720 --> 0:09:08.760 so they actually didn't really care about things like growth 0:09:08.840 --> 0:09:11.720 and inflation. It was really about the spread between the 0:09:11.760 --> 0:09:14.400 cast treasuries in the future. So there were the marginal buyers. 0:09:14.840 --> 0:09:17.760 Post COVID, it was all about the FED and the 0:09:17.800 --> 0:09:22.000 commercial banks. The commercial banks, because of regulation, they have 0:09:22.080 --> 0:09:25.160 to own a lot of liquid assets and they were 0:09:25.200 --> 0:09:30.240 buying tremendously. So those players are not in the market anymore. 0:09:30.360 --> 0:09:33.880 And there were also players who are much more agnostic 0:09:33.960 --> 0:09:37.120 to things like where the interest rates were because they 0:09:37.120 --> 0:09:39.480 have to buy them as part of a pair's trade 0:09:39.559 --> 0:09:43.520 or for regulation. Those people are out, and you're having 0:09:43.600 --> 0:09:47.400 to a situation where we're looking for the new Marshal buyer, 0:09:47.800 --> 0:09:50.840 and that new Marshall buyer is probably going to be 0:09:50.920 --> 0:09:54.240 more sensitive to things like inflation rates. And you know 0:09:54.360 --> 0:09:57.400 as well as we see and this happening in UH inflation, 0:09:57.520 --> 0:10:00.480 it's it's not clear what that is, nor what defense 0:10:00.559 --> 0:10:03.440 policy rate will be going forward, So there's gonna be 0:10:03.440 --> 0:10:07.920 some volatility there. M And one more thing, and you 0:10:07.920 --> 0:10:10.640 can see chair Power and mentioned this again, Trojery market 0:10:10.640 --> 0:10:13.520 liquidity is not pretty good. So when we have this 0:10:13.559 --> 0:10:19.280 tremendous increase in supply changing demand amidst very low Tridrey 0:10:19.320 --> 0:10:24.319 market liquidity. So just just for some context, so every 0:10:24.360 --> 0:10:27.079 day in the trojury market, we do about six hundred 0:10:27.120 --> 0:10:33.000 billion dollars in cash cash transactions, and we have about 0:10:33.040 --> 0:10:36.000 a twenty three trillion dollar trojury market for the private sector. 0:10:36.120 --> 0:10:39.760 So if you rewind the clock twenty years ago, we 0:10:39.840 --> 0:10:43.199 had about seven trillion dollars in net market. About treasuries 0:10:43.679 --> 0:10:47.480 daily volumes are about four hundred billion, So today the 0:10:47.559 --> 0:10:51.680 total treasuries volumes have more than triple toe trillion, but 0:10:51.800 --> 0:10:55.320 the liquidity daily liquidity is only a little bit higher, 0:10:55.320 --> 0:10:58.000 from four hundred billion to six hundred billion, So you 0:10:58.000 --> 0:11:00.640 can have in a sense, you can think about let's 0:11:00.640 --> 0:11:02.880 say the stadium getting a lot bigger, but the doors 0:11:03.000 --> 0:11:05.720 are not really increasing, and that's a big reason why 0:11:05.800 --> 0:11:08.680 we see these huge moves and treasury utes recently. I 0:11:08.679 --> 0:11:10.520 think a few weeks ago, we sell the tenure, just 0:11:10.600 --> 0:11:13.320 jump twenty five basis points, we sell the treasury market 0:11:13.360 --> 0:11:17.000 break in March, and we've had flash crashes in the past, 0:11:17.559 --> 0:11:21.239 so it's kind of there's this storm brewing from my perspective, 0:11:21.320 --> 0:11:25.520 where you have enormous issuance, you have a weak market structure, 0:11:25.720 --> 0:11:28.800 and you also have a demand side for treasuries that 0:11:28.840 --> 0:11:32.120 that's becoming a little uncertain. So uh, that's just with 0:11:32.720 --> 0:11:36.520 the treasury please no, So I want to explore like 0:11:36.559 --> 0:11:39.400 the liquidity side a little bit more. And one of 0:11:39.440 --> 0:11:41.720 the things that we talked about in a recent episode. 0:11:41.720 --> 0:11:46.920 You know, like treasuries and reserves are not that different 0:11:46.960 --> 0:11:50.439 from a sort of like economic perspective, Right, So, Okay, 0:11:50.480 --> 0:11:53.720 you talk about there's a huge increase into the market 0:11:54.320 --> 0:11:57.000 of these treasuries that the FED will be getting rid 0:11:57.040 --> 0:12:00.120 of reducing, but on the other hand, it's also diminishing 0:12:00.360 --> 0:12:03.000 the reserves the liability side of the balance sheet, and 0:12:03.040 --> 0:12:06.480 so on some level there's an evenness to it. And 0:12:06.559 --> 0:12:12.000 economically they're not radically different, they are somewhat different. Explain 0:12:12.200 --> 0:12:18.360 further the effect on liquidity from swapping two assets that 0:12:18.760 --> 0:12:22.400 are not that different. Yeah, that's a really good question. 0:12:22.760 --> 0:12:25.600 So I think there's a couple of things to this. 0:12:26.480 --> 0:12:29.840 One is that reserves can only be held by commercial banks, 0:12:30.520 --> 0:12:33.920 so occurrence, So reserves are basically deposits at the FED, 0:12:34.640 --> 0:12:38.520 and only commercial banks probably speaking, can have deposits at 0:12:38.520 --> 0:12:42.480 the at the FED. So from a commercial banks standpoint, Joe, 0:12:42.679 --> 0:12:45.040 you're you're right, it's it's very equivalent. I mean, there's 0:12:45.080 --> 0:12:47.880 more interest rate risk in a treasury, for example, but 0:12:48.000 --> 0:12:51.120 for a commercial banks standpoint, I can have reserves in 0:12:51.160 --> 0:12:54.640 my liquidity portfolio, or I can have treasuries. And what 0:12:54.679 --> 0:12:56.800 they've been doing for the past couple of years is 0:12:56.840 --> 0:12:59.080 they're making that choice to say that I want to 0:12:59.120 --> 0:13:02.679 have treasuries rather than reserves, since treasuries are using much 0:13:02.679 --> 0:13:05.840 more than interest on reserves. But that's not the decision 0:13:06.000 --> 0:13:09.880 faced by people who are not banks. So for example, 0:13:10.000 --> 0:13:13.640 you and me, we have deposits at a commercial bank. 0:13:13.920 --> 0:13:17.080 We don't we're not eligible to hold reserves at the FED. 0:13:18.080 --> 0:13:21.040 So when the FED is doing QT, from from our perspective, 0:13:21.559 --> 0:13:25.040 the deposits in the system are declining. So when the 0:13:25.040 --> 0:13:29.920 FED does QT, it reduces reserve assets at commercial bank 0:13:30.280 --> 0:13:33.800 which are often backed by deposit liabilities. So it's this 0:13:33.920 --> 0:13:37.280 two tiered monetary system we have where non banks have 0:13:37.520 --> 0:13:40.200 deposits at banks and banks sold deposits at the FED. 0:13:40.600 --> 0:13:45.000 So from our perspective, we're losing bank deposits, which are 0:13:45.200 --> 0:13:49.040 you know, carry credit risk and don't earn idle R. 0:13:49.120 --> 0:13:52.800 So the substitution is it's not perfect. But I think 0:13:52.920 --> 0:13:57.120 more broadly, the point though, is it seems like right 0:13:57.160 --> 0:14:01.240 now what's happening is that treasury start becoming less cash. 0:14:01.320 --> 0:14:03.640 Like you can see this in the lack of flight 0:14:03.720 --> 0:14:07.240 to safety in market volatility, bonds are selling off and 0:14:07.440 --> 0:14:12.319 stocks are selling off. So when we have high inflation 0:14:12.559 --> 0:14:15.840 and we have a lot of rate volatility, it seems 0:14:15.920 --> 0:14:18.720 like the market is not rushing to treasuries as safety. 0:14:19.000 --> 0:14:21.600 They're rushing through just cash. And so that that makes 0:14:21.640 --> 0:14:24.560 it I think this asset swap that that you talked about, 0:14:24.560 --> 0:14:28.280 which is broadly what QUE is not as perfect substitutes 0:14:28.320 --> 0:14:46.680 for each other. So I just want to touch on 0:14:46.680 --> 0:14:49.960 on one consequence of the dynamic you just described before 0:14:50.000 --> 0:14:52.640 we go more into q T and the mechanics there. 0:14:53.000 --> 0:14:55.960 But we've spoken about this before, I think last year, 0:14:56.280 --> 0:14:59.880 but the implication that banks aren't necessarily buying treasuries but 0:15:00.000 --> 0:15:02.880 because they think that, you know, interest rates are going 0:15:02.920 --> 0:15:05.360 to go up or down, but they're buying them because 0:15:05.360 --> 0:15:08.880 they have to buy treasuries to satisfy liquidity coverage ratios 0:15:08.960 --> 0:15:12.880 and regulatory requirements and things like that, and treasuries are 0:15:12.880 --> 0:15:16.720 sort of the best option of the assets that are 0:15:16.800 --> 0:15:20.080 available to do that. So what does that actually mean 0:15:20.120 --> 0:15:22.800 when it comes to treasury yields? Like when we look 0:15:22.840 --> 0:15:26.000 at a treasury yield, now, how much information is that 0:15:26.120 --> 0:15:30.880 actually giving us about investors, expectations for the future direction 0:15:30.920 --> 0:15:33.320 of the economy and things like that. When I look 0:15:33.360 --> 0:15:36.120 at tragedy yields, I don't actually think there's a lot 0:15:36.160 --> 0:15:41.360 of information content. And I don't think so because as 0:15:41.400 --> 0:15:43.600 you as you know to Treasury Tracy, there's a lot 0:15:43.640 --> 0:15:46.760 of people who buy treasuries for different reasons. So you 0:15:46.800 --> 0:15:49.480 do have investors who, let's say, look at growth and 0:15:49.520 --> 0:15:52.960 inflation and look at yields and make a judgment. But 0:15:53.080 --> 0:15:56.560 treasuries are very special in the financial system and that 0:15:56.600 --> 0:16:00.240 they are considered a high quality asset, a credit risk 0:16:00.280 --> 0:16:04.360 free asset, and under a range of regulations people have 0:16:04.480 --> 0:16:07.360 to buy them just because the regulations tell them too. 0:16:07.800 --> 0:16:11.720 And banks, for example, they have to hold high quality 0:16:11.760 --> 0:16:14.760 liquid assets, as you mentioned, under things like the liquidity 0:16:14.800 --> 0:16:18.320 coverage ratio. What qualifies as high quality looquoid assets a 0:16:18.440 --> 0:16:21.200 very very narrow range of assets, treasuries being one of them, 0:16:21.200 --> 0:16:23.720 and so they have to buy some of that. But 0:16:23.800 --> 0:16:26.280 it's not just them. Um, if you look at let's say, 0:16:26.800 --> 0:16:29.840 government sponsored emprises like Fannie may or Freddie Mac, they 0:16:29.880 --> 0:16:32.160 also have similar regulations that they have to buy high 0:16:32.200 --> 0:16:35.280 quality liquid assets. Or if you look abroad, if you 0:16:35.320 --> 0:16:39.040 are a foreign reserve manager, if you're managing the foreign 0:16:39.080 --> 0:16:42.640 reserves of let's say Japan or China or some other countries, 0:16:43.840 --> 0:16:47.320 you can't really buy just equities or anything like that. 0:16:48.080 --> 0:16:51.240 You usually other than the substational make usually you're very 0:16:51.320 --> 0:16:54.560 very conservative, and so you can only buy things like treasuries. 0:16:54.920 --> 0:16:58.280 So there's a there's a lot of demand for treasuries 0:16:58.360 --> 0:17:01.920 that that's just not that UH driven by fundamentals. And 0:17:02.000 --> 0:17:03.720 of course you can have hedge funds who are just 0:17:03.760 --> 0:17:05.800 buying it as part of a basis trade where they 0:17:05.800 --> 0:17:08.880 care about the spread between the trusuries and something else 0:17:09.000 --> 0:17:11.960 rather than the absolute level of the trusuries as measured 0:17:11.960 --> 0:17:15.600 by UH. It's the economic fundamentals. So it's it's really 0:17:15.640 --> 0:17:17.640 hard to to look at from my perspective, to look 0:17:17.680 --> 0:17:23.879 at price and infer economic conditions. So thinking about, you know, 0:17:23.920 --> 0:17:27.399 in terms of like the mechanics or the implications of 0:17:27.520 --> 0:17:30.480 quantitative tightening, why don't we start off with a sort 0:17:30.520 --> 0:17:33.680 of kind of basic question. But it's like, why does 0:17:33.720 --> 0:17:37.439 the Fed feel an impulse to reduce the size of 0:17:37.480 --> 0:17:40.359 its balance sheet because it has the rate channel it 0:17:40.400 --> 0:17:44.000 can hike rate it has it's been hiking fairly aggressively 0:17:44.080 --> 0:17:48.480 seventy seventy five at the last meeting. Where does the 0:17:48.600 --> 0:17:52.600 urgency or just even the impulse come from to decreased holdings? 0:17:53.800 --> 0:17:56.720 I think from the FETs perspective, it's it's a lot 0:17:56.800 --> 0:17:59.280 like you and Tracy suggested earlier in the show, the 0:17:59.320 --> 0:18:04.160 FETE doesn't really understand what exactly happens, and so they 0:18:04.160 --> 0:18:06.000 want to do with something that they understand they think 0:18:06.000 --> 0:18:10.119 they understand well, like the overnight rate. So it seems 0:18:10.160 --> 0:18:12.000 from what I hear, they want to get out of 0:18:12.000 --> 0:18:14.160 this Balanciet stuff and go to something that they feel 0:18:14.200 --> 0:18:17.160 like they're more comfortable with, which is raising the over 0:18:17.520 --> 0:18:20.240 night rate. And you know, as you said, as you mentioned, 0:18:20.600 --> 0:18:23.280 you have disagreements within the FED as to what exactly 0:18:23.440 --> 0:18:25.679 QUI does. How you have people who would be like, oh, 0:18:25.720 --> 0:18:27.439 you know, he doesn't really do anything, just solving one 0:18:27.440 --> 0:18:29.800 asked for another. And you have people in the market 0:18:29.840 --> 0:18:33.160 who look at KUI and just max long because QWI 0:18:33.240 --> 0:18:35.520 makes the market go higher. So I think there's a 0:18:35.840 --> 0:18:38.840 there's just not very clear what it actually does, and 0:18:38.920 --> 0:18:41.000 they don't want to be doing things that they don't 0:18:41.000 --> 0:18:43.359 really understand. What do you think it does? Can you 0:18:43.520 --> 0:18:46.440 sort of describe for us what draining liquidity would look 0:18:46.480 --> 0:18:51.800 like in the current period versus draining liquidity from say 0:18:51.440 --> 0:18:54.720 or nineteen, because I think that might help us sort 0:18:54.720 --> 0:18:59.240 of understand the differences here and the difference in the mechanism. Sure, 0:18:59.440 --> 0:19:04.160 so when the FED drains liquidity out of the financial system, 0:19:04.200 --> 0:19:07.480 it doesn't actually have control where the liquidity comes out of. 0:19:07.640 --> 0:19:09.680 It can come out of the banking system, which you 0:19:09.720 --> 0:19:12.760 would drain reserves and deposits, or it can come out 0:19:12.760 --> 0:19:15.879 of the RAP, which which just decrease the RAP size. 0:19:16.560 --> 0:19:19.600 Now the RAP, as you see right now, it's very large. 0:19:19.600 --> 0:19:22.919 It's two two point two trillion. The the RP you 0:19:22.960 --> 0:19:25.359 can think of as just the true excess liquidity in 0:19:25.400 --> 0:19:28.520 the final nancial system. There's all this money that people 0:19:28.520 --> 0:19:31.399 have nowhere else to invest in, and so they just 0:19:31.480 --> 0:19:34.119 leave it on deposit at the FED at the end 0:19:34.119 --> 0:19:38.480 received the IRP rate. So when you do q T, 0:19:39.280 --> 0:19:42.360 if money is coming out of the IRP, you're it's 0:19:42.359 --> 0:19:45.200 going to be a very benign because you're taking money 0:19:45.280 --> 0:19:48.840 out that really nobody wants, or you could take it 0:19:48.880 --> 0:19:52.199 out of the banking system, which conceivably someone somewhere is 0:19:52.320 --> 0:19:56.439 reliant upon that that that liquidity. The FED beforehand doesn't 0:19:56.440 --> 0:19:59.160 actually know what will happen if you listen to fit 0:19:59.200 --> 0:20:02.520 precedents tak over the past few months. They just look 0:20:02.560 --> 0:20:04.680 at the RAP and they think that there's a lot 0:20:04.680 --> 0:20:07.399 of excess liquidity in the system, and so they can 0:20:07.440 --> 0:20:10.320 they can we can just do aggressive QT, no problem. 0:20:10.359 --> 0:20:12.800 But if you notice what's happening right now is that 0:20:12.880 --> 0:20:15.520 the RP is not declining, it will probably go much 0:20:15.560 --> 0:20:17.880 higher in my view, right so I have to say, 0:20:17.920 --> 0:20:21.800 we're recording this right before quarter end, so right before 0:20:21.840 --> 0:20:25.480 the end of June, and there is a very high 0:20:25.640 --> 0:20:28.680 chance that it could shoot up. I think in May 0:20:28.760 --> 0:20:32.320 it went above something like two trillion dollars, which was 0:20:32.359 --> 0:20:34.560 a record at the time, but we could get another 0:20:34.600 --> 0:20:39.639 record before this episode actually publishes. Yeah, when I used 0:20:39.640 --> 0:20:41.600 to round the rap, we were very surprised for like 0:20:41.640 --> 0:20:45.520 five billion. Now that that's that's too low. Um, what happens. 0:20:45.600 --> 0:20:48.680 So the reason is that you have all this liquidity. Um, 0:20:48.840 --> 0:20:51.919 how it gets strained ultimately depends on who buys the 0:20:52.000 --> 0:20:55.720 newly issued treasuries and how they finance it. If the 0:20:55.760 --> 0:20:59.640 treasuries are purchased by people who are levered investors, then 0:20:59.640 --> 0:21:02.679 a drain it's the RP. For example, if you are 0:21:02.720 --> 0:21:05.199 a hedge fund and you buy the newly issued our 0:21:05.520 --> 0:21:09.679 treasuries with repo loan, then the cash from that repole 0:21:09.720 --> 0:21:14.480 loan ultimately comes from the RAP. A money market fund 0:21:14.680 --> 0:21:17.879 will withdraw money from the RP and lend it in 0:21:17.960 --> 0:21:21.480 repo to the hedge fund investor. Money fund investors can 0:21:21.480 --> 0:21:25.840 only lend, can only make specific investments, very narrow one 0:21:25.840 --> 0:21:28.600 of them is repo, so that's basically the only that 0:21:28.760 --> 0:21:32.520 in increased bill issuance, but broadly speaking, that would be 0:21:32.560 --> 0:21:35.240 how you get the RP lower. On the other hand, 0:21:35.720 --> 0:21:38.320 if the people who buy the newly issue treasuries are 0:21:38.600 --> 0:21:42.720 let's say cash investors who are buying it with deposits 0:21:42.800 --> 0:21:45.720 they held out commercial banks, then what you will see 0:21:45.840 --> 0:21:49.720 is that liquidity will be drained out of the banking system. 0:21:49.760 --> 0:21:53.240 So that means that what's being drained is not necessarily 0:21:53.280 --> 0:21:56.440 liquidity that's held in the RAP that no one wants 0:21:56.560 --> 0:22:00.000 that's access, but liquidity in the banking system that maybe 0:22:00.119 --> 0:22:03.879 someone somewhere is relying on. Now beforehand, it's hard to 0:22:03.920 --> 0:22:06.159 see where the where the liquidity will be drained, but 0:22:06.480 --> 0:22:08.119 the way that I look at this is I just 0:22:08.119 --> 0:22:10.600 look at what's actually been happening the past few months. 0:22:11.280 --> 0:22:14.240 So the past few months, when the Treasury has been 0:22:14.280 --> 0:22:17.840 issuing coupon debt, the people who have been buying it 0:22:18.200 --> 0:22:22.080 have been people who are holding money at a commercial bank. 0:22:22.440 --> 0:22:25.600 So you can see that what the increases over the 0:22:25.600 --> 0:22:29.040 past few months, the amount of reserves in the commercial 0:22:29.080 --> 0:22:32.199 banking system is declining, but the amount of in the 0:22:32.280 --> 0:22:35.919 RP is not declining. So just how the financial system 0:22:35.960 --> 0:22:38.800 is currently configured that there doesn't seem like there's going 0:22:38.800 --> 0:22:42.360 to be any increased demand for leverage treasury investing. So 0:22:42.480 --> 0:22:48.159 going forward, what you can actually see is that the 0:22:48.240 --> 0:22:51.639 draining from QT comes out of the commercial banking system, 0:22:51.760 --> 0:22:55.560 whereas the RAP continues to increase. This, in a sense, 0:22:55.720 --> 0:22:58.280 is kind of like a double tightening effect because when 0:22:58.359 --> 0:23:01.320 the RAP goes higher, it's also draining liquidity out of 0:23:01.320 --> 0:23:04.040 the banking system. So this is why it seems on 0:23:04.080 --> 0:23:07.560