Speaker 1: Hello, and welcome to another episode of the Odd Thoughts Podcast.
Speaker 1: I'm Tracy Allawitt and I'm Joe. Joe. What was the
Speaker 1: biggest thing that happened in markets in recent months over
Speaker 1: the summer. It's like a test. I think it's like
Speaker 1: a test of, you know, what people are looking at
Speaker 1: the moment, what they find interesting. I mean, the FED tightening. Obviously, yes,
Speaker 1: this is the correct answer. Okay, I'll stop there. I
Speaker 1: got it right, So I'm just gonna stop there and
Speaker 1: you can go on. Okay, So the FED started quantitative tightening.
Speaker 1: We're recording this in late June, and weirdly, it kind
Speaker 1: of went by without that much fanfare, Like there were
Speaker 1: a few news articles about the FED firing the starting
Speaker 1: gun on quantitative tightening and the unwind of its very
Speaker 1: very large balance sheet, but there was so much going
Speaker 1: on at the same time, you know, there was that
Speaker 1: surprise seventy five basis point interest rate hike, and then
Speaker 1: lots of talk about inflation and things like that that
Speaker 1: it feels like it didn't get as much attention as
Speaker 1: it probably should have. Most of the attention is paid
Speaker 1: to the rate obviously, you know, queue when it was
Speaker 1: first unveiled or when Ben Berneki did QUI two, which
Speaker 1: was the real QUEI during the Great financial crazies, I
Speaker 1: got so much attention, but there still seems to be
Speaker 1: a lot of ambiguity about a how it works, what
Speaker 1: it does, what it accomplishes, and then in terms of
Speaker 1: like the degree to which unwinding the balance sheet is
Speaker 1: or is not an additional form of policy, tightening is
Speaker 1: something that I just feel like is at best, like
Speaker 1: still deeply misunderstood. It is kind of crazy that even
Speaker 1: after years and years of quantitative easing, there's still a
Speaker 1: discussion about what the impact is and how it actually works.
Speaker 1: I mean, I remember people still arguing about whether or
Speaker 1: not it pushes up asset prices and things like that.
Speaker 1: And there are people out there right now who are
Speaker 1: arguing that the reason markets have fallen might not actually
Speaker 1: have to do that much with inflation concerns and worries
Speaker 1: over a looming recession, but could just be because liquidity
Speaker 1: is starting to exit the system. No, No, I mean,
Speaker 1: it's totally it's totally valid. You know, it's worth noting
Speaker 1: that we have had, you know, markets boomed even though
Speaker 1: there was no longer a further expansion of the balance sheet.
Speaker 1: You know, we started to rally in early nineteen again
Speaker 1: even as the balance sheet shrank for a while, going
Speaker 1: into some of the tensions, but it really is wild,
Speaker 1: as you say, like how little we know and how
Speaker 1: little even I mean, I think even the FED knows
Speaker 1: about like quanted measuring the effects of changes to the
Speaker 1: size of the balance sheet. Well, there is also an
Speaker 1: argument to be made that the QUEI that we seen
Speaker 1: over the past couple of years is stylistically and quantitatively
Speaker 1: different than the ones we've seen prior, and so the
Speaker 1: exit is going to be different too. So we are
Speaker 1: going to dig into all of these um very big
Speaker 1: and technical questions and I'm happy to say we really
Speaker 1: do have the perfect person to discuss this. We're going
Speaker 1: to be speaking with someone who's been on the podcast before, Joe,
Speaker 1: but I think you were actually away for that effort. Yeah,
Speaker 1: so I'm thrilled to have him back. We're going to
Speaker 1: be speaking with Joseph Wang. He used to work at
Speaker 1: the New York Fed on the Open Markets desk, conducting
Speaker 1: repo operations, basically being deep in the weeds of money markets,
Speaker 1: and now he runs a blog called fed Guy, which
Speaker 1: is really a must read if you're interested in monetary
Speaker 1: policy and in all of these big questions about how
Speaker 1: it actually works. So, Joseph, thank you so much for
Speaker 1: coming back on ad thoughts. Tracy, Hey, Joe, thanks so
Speaker 1: much for your biding. Yet it's a pleasure to be here. Yeah,
Speaker 1: So maybe just to begin with, could you give us
Speaker 1: the bra outline of how quantitative tightening or the QUEI
Speaker 1: that we've seen over the past couple of years. You know,
Speaker 1: as I alluded to, it's different to the QUI that
Speaker 1: we've seen in the past. So I guess the question
Speaker 1: is how different is it this time? Like? What makes
Speaker 1: this particular exit different to previous periods of quantitative tightening
Speaker 1: that we've seen. Sure, so I think this time QUT
Speaker 1: is a different first and the level, and I think
Speaker 1: there's changes in the financial in the structure of the
Speaker 1: financial system that make a bit more difficult. So this
Speaker 1: time around, QUI looks like it's going to ramp up
Speaker 1: to about nine billion dollars a month now. In contrast,
Speaker 1: the last time around when we did this, the maximum
Speaker 1: that we ever did was fifty billion dollars a month.
Speaker 1: So in terms of pace, it's a much much more
Speaker 1: aggress pace. We're doing nine billion a month, can kind
Speaker 1: of contrast last time the maximum we did was fifty
Speaker 1: billion a month. So the way that this works through
Speaker 1: the system, I think Bradley speaking, I think of QT
Speaker 1: as having two mechanisms. One is that it increases the
Speaker 1: supply of treasuries into the market. That's one, and that's
Speaker 1: kind of how the FET thinks of it. It. By
Speaker 1: increasing or increasing the supply of treasuries, you are pushing
Speaker 1: the term premium higher, so it puts upward pressure on
Speaker 1: interest rates. And the second mechanism has to do with
Speaker 1: draining liquidity out of the system. So these two mechanisms
Speaker 1: are related but also operate in separate ways, And they
Speaker 1: also have a lot of moving parts into how they
Speaker 1: actually can play out. And these moving parts aren't completely
Speaker 1: within the FET's control. So because of this, QT can
Speaker 1: play out in a range of outcomes. You can have
Speaker 1: very benign QT, where it really is just washing paint
Speaker 1: dry as Railie and what mentioned before, or you can
Speaker 1: have QT that's more aggressive and very disruptive. Now, based
Speaker 1: on what I see in the current configuration of the
Speaker 1: financial system, considers so many moving parts, it seems what's
Speaker 1: happening right now is compared to last time, QT, this
Speaker 1: time is going to be a lot more disruptive. I
Speaker 1: guess I can talk about why from the So I'll
Speaker 1: go by the first mechanism, the increase in trgury supply,
Speaker 1: and then I'll talk about why draining liquidy this time
Speaker 1: will also be more disruptive. So when QT increases the
Speaker 1: supply of treasuries into the private sector, the Fed doesn't
Speaker 1: actually get to decide what tenors that reach the market.
Speaker 1: That's a decision by the U S. Tresury techne. Overall,
Speaker 1: what happens is that um when the feed is doing QT,
Speaker 1: it's it's receiving repayments for the tresury that it owes
Speaker 1: that that it owns. So the U S Trsury issues
Speaker 1: new debt and takes that money and repays the ft.
Speaker 1: That's what happens. So it's the U S. Treasury that
Speaker 1: gets decide what are the new what are the tenors
Speaker 1: of the new treasuries that the market absorbs. Now, you
Speaker 1: can do this in a way that's very market neutral.
Speaker 1: So let's say the U S. Tregury issues a lot
Speaker 1: of short data debt, Treasury builds now, the market can
Speaker 1: absorb these treasury bills very easily. If you think back
Speaker 1: to the first quarter of the tresury issued two trillion
Speaker 1: dollars in bills in the market just lapped that up easily.
Speaker 1: So in a sense, it's because bills are so cash like,
Speaker 1: it's they don't really have any interest rate impact. But
Speaker 1: what the U. S. Treasury is doing this time around,
Speaker 1: it's actually cutting bill issuance, so because it had received
Speaker 1: a lot of tax payments in April above its expectations.
Speaker 1: So all the q T increase in supply over the
Speaker 1: next few months is going to be in coupons, and
Speaker 1: coupons are more difficult for the market to absorb, so
Speaker 1: it's probably going to place more upward pressure on interest rates.
Speaker 1: There are also a lot more mechanics behind this that
Speaker 1: that make it the same around more disruptive. So, for example,
Speaker 1: we're having a big change in who the Marshall wires
Speaker 1: are in this market. Well, actually, I'll sit back a
Speaker 1: bit and say, so the increases imply this time around
Speaker 1: is much higher than it was last time around. I
Speaker 1: think it's useful to think about treasury rates in terms
Speaker 1: of supply and demand. So in terms of supply, the
Speaker 1: sime around the amount. Taking into account of QT the
Speaker 1: estimates for the increase in supply to the private sector,
Speaker 1: it's going to be about one point five trillion dollars
Speaker 1: a year, so for the next three years. Now, just
Speaker 1: for context, pre COVID, the amount of supply that was
Speaker 1: going into the market was about five dred billion dollars
Speaker 1: a year, and so the pace of the supply is
Speaker 1: just so so much higher than than it was the
Speaker 1: last time we did this. And that is happening in
Speaker 1: the context of from the say demand side, from the
Speaker 1: buyer side, where the Marshall buyer is changing and the
Speaker 1: market structure doesn't seem very strong. The Marshall buyer for
Speaker 1: treasuries before COVID was actually the hedge fund the hedge funds.
Speaker 1: So what the hedgemunds were doing they were buying let's say,
Speaker 1: hundreds of boons haves and treasuries several hundred billions and treasuries,
Speaker 1: but they were buying it as part of a basis trade,
Speaker 1: so they actually didn't really care about things like growth
Speaker 1: and inflation. It was really about the spread between the
Speaker 1: cast treasuries in the future. So there were the marginal buyers.
Speaker 1: Post COVID, it was all about the FED and the
Speaker 1: commercial banks. The commercial banks, because of regulation, they have
Speaker 1: to own a lot of liquid assets and they were
Speaker 1: buying tremendously. So those players are not in the market anymore.
Speaker 1: And there were also players who are much more agnostic
Speaker 1: to things like where the interest rates were because they
Speaker 1: have to buy them as part of a pair's trade
Speaker 1: or for regulation. Those people are out, and you're having
Speaker 1: to a situation where we're looking for the new Marshal buyer,
Speaker 1: and that new Marshall buyer is probably going to be
Speaker 1: more sensitive to things like inflation rates. And you know
Speaker 1: as well as we see and this happening in UH inflation,
Speaker 1: it's it's not clear what that is, nor what defense
Speaker 1: policy rate will be going forward, So there's gonna be
Speaker 1: some volatility there. M And one more thing, and you
Speaker 1: can see chair Power and mentioned this again, Trojery market
Speaker 1: liquidity is not pretty good. So when we have this
Speaker 1: tremendous increase in supply changing demand amidst very low Tridrey
Speaker 1: market liquidity. So just just for some context, so every
Speaker 1: day in the trojury market, we do about six hundred
Speaker 1: billion dollars in cash cash transactions, and we have about
Speaker 1: a twenty three trillion dollar trojury market for the private sector.
Speaker 1: So if you rewind the clock twenty years ago, we
Speaker 1: had about seven trillion dollars in net market. About treasuries
Speaker 1: daily volumes are about four hundred billion, So today the
Speaker 1: total treasuries volumes have more than triple toe trillion, but
Speaker 1: the liquidity daily liquidity is only a little bit higher,
Speaker 1: from four hundred billion to six hundred billion, So you
Speaker 1: can have in a sense, you can think about let's
Speaker 1: say the stadium getting a lot bigger, but the doors
Speaker 1: are not really increasing, and that's a big reason why
Speaker 1: we see these huge moves and treasury utes recently. I
Speaker 1: think a few weeks ago, we sell the tenure, just
Speaker 1: jump twenty five basis points, we sell the treasury market
Speaker 1: break in March, and we've had flash crashes in the past,
Speaker 1: so it's kind of there's this storm brewing from my perspective,
Speaker 1: where you have enormous issuance, you have a weak market structure,
Speaker 1: and you also have a demand side for treasuries that
Speaker 1: that's becoming a little uncertain. So uh, that's just with
Speaker 1: the treasury please no, So I want to explore like
Speaker 1: the liquidity side a little bit more. And one of
Speaker 1: the things that we talked about in a recent episode.
Speaker 1: You know, like treasuries and reserves are not that different
Speaker 1: from a sort of like economic perspective, Right, So, Okay,
Speaker 1: you talk about there's a huge increase into the market
Speaker 1: of these treasuries that the FED will be getting rid
Speaker 1: of reducing, but on the other hand, it's also diminishing
Speaker 1: the reserves the liability side of the balance sheet, and
Speaker 1: so on some level there's an evenness to it. And
Speaker 1: economically they're not radically different, they are somewhat different. Explain
Speaker 1: further the effect on liquidity from swapping two assets that
Speaker 1: are not that different. Yeah, that's a really good question.
Speaker 1: So I think there's a couple of things to this.
Speaker 1: One is that reserves can only be held by commercial banks,
Speaker 1: so occurrence, So reserves are basically deposits at the FED,
Speaker 1: and only commercial banks probably speaking, can have deposits at
Speaker 1: the at the FED. So from a commercial banks standpoint, Joe,
Speaker 1: you're you're right, it's it's very equivalent. I mean, there's
Speaker 1: more interest rate risk in a treasury, for example, but
Speaker 1: for a commercial banks standpoint, I can have reserves in
Speaker 1: my liquidity portfolio, or I can have treasuries. And what
Speaker 1: they've been doing for the past couple of years is
Speaker 1: they're making that choice to say that I want to
Speaker 1: have treasuries rather than reserves, since treasuries are using much
Speaker 1: more than interest on reserves. But that's not the decision
Speaker 1: faced by people who are not banks. So for example,
Speaker 1: you and me, we have deposits at a commercial bank.
Speaker 1: We don't we're not eligible to hold reserves at the FED.
Speaker 1: So when the FED is doing QT, from from our perspective,
Speaker 1: the deposits in the system are declining. So when the
Speaker 1: FED does QT, it reduces reserve assets at commercial bank
Speaker 1: which are often backed by deposit liabilities. So it's this
Speaker 1: two tiered monetary system we have where non banks have
Speaker 1: deposits at banks and banks sold deposits at the FED.
Speaker 1: So from our perspective, we're losing bank deposits, which are
Speaker 1: you know, carry credit risk and don't earn idle R.
Speaker 1: So the substitution is it's not perfect. But I think
Speaker 1: more broadly, the point though, is it seems like right
Speaker 1: now what's happening is that treasury start becoming less cash.
Speaker 1: Like you can see this in the lack of flight
Speaker 1: to safety in market volatility, bonds are selling off and
Speaker 1: stocks are selling off. So when we have high inflation
Speaker 1: and we have a lot of rate volatility, it seems
Speaker 1: like the market is not rushing to treasuries as safety.
Speaker 1: They're rushing through just cash. And so that that makes
Speaker 1: it I think this asset swap that that you talked about,
Speaker 1: which is broadly what QUE is not as perfect substitutes
Speaker 1: for each other. So I just want to touch on
Speaker 1: on one consequence of the dynamic you just described before
Speaker 1: we go more into q T and the mechanics there.
Speaker 1: But we've spoken about this before, I think last year,
Speaker 1: but the implication that banks aren't necessarily buying treasuries but
Speaker 1: because they think that, you know, interest rates are going
Speaker 1: to go up or down, but they're buying them because
Speaker 1: they have to buy treasuries to satisfy liquidity coverage ratios
Speaker 1: and regulatory requirements and things like that, and treasuries are
Speaker 1: sort of the best option of the assets that are
Speaker 1: available to do that. So what does that actually mean
Speaker 1: when it comes to treasury yields? Like when we look
Speaker 1: at a treasury yield, now, how much information is that
Speaker 1: actually giving us about investors, expectations for the future direction
Speaker 1: of the economy and things like that. When I look
Speaker 1: at tragedy yields, I don't actually think there's a lot
Speaker 1: of information content. And I don't think so because as
Speaker 1: you as you know to Treasury Tracy, there's a lot
Speaker 1: of people who buy treasuries for different reasons. So you
Speaker 1: do have investors who, let's say, look at growth and
Speaker 1: inflation and look at yields and make a judgment. But
Speaker 1: treasuries are very special in the financial system and that
Speaker 1: they are considered a high quality asset, a credit risk
Speaker 1: free asset, and under a range of regulations people have
Speaker 1: to buy them just because the regulations tell them too.
Speaker 1: And banks, for example, they have to hold high quality
Speaker 1: liquid assets, as you mentioned, under things like the liquidity
Speaker 1: coverage ratio. What qualifies as high quality looquoid assets a
Speaker 1: very very narrow range of assets, treasuries being one of them,
Speaker 1: and so they have to buy some of that. But
Speaker 1: it's not just them. Um, if you look at let's say,
Speaker 1: government sponsored emprises like Fannie may or Freddie Mac, they
Speaker 1: also have similar regulations that they have to buy high
Speaker 1: quality liquid assets. Or if you look abroad, if you
Speaker 1: are a foreign reserve manager, if you're managing the foreign
Speaker 1: reserves of let's say Japan or China or some other countries,
Speaker 1: you can't really buy just equities or anything like that.
Speaker 1: You usually other than the substational make usually you're very
Speaker 1: very conservative, and so you can only buy things like treasuries.
Speaker 1: So there's a there's a lot of demand for treasuries
Speaker 1: that that's just not that UH driven by fundamentals. And
Speaker 1: of course you can have hedge funds who are just
Speaker 1: buying it as part of a basis trade where they
Speaker 1: care about the spread between the trusuries and something else
Speaker 1: rather than the absolute level of the trusuries as measured
Speaker 1: by UH. It's the economic fundamentals. So it's it's really
Speaker 1: hard to to look at from my perspective, to look
Speaker 1: at price and infer economic conditions. So thinking about, you know,
Speaker 1: in terms of like the mechanics or the implications of
Speaker 1: quantitative tightening, why don't we start off with a sort
Speaker 1: of kind of basic question. But it's like, why does
Speaker 1: the Fed feel an impulse to reduce the size of
Speaker 1: its balance sheet because it has the rate channel it
Speaker 1: can hike rate it has it's been hiking fairly aggressively
Speaker 1: seventy seventy five at the last meeting. Where does the
Speaker 1: urgency or just even the impulse come from to decreased holdings?
Speaker 1: I think from the FETs perspective, it's it's a lot
Speaker 1: like you and Tracy suggested earlier in the show, the
Speaker 1: FETE doesn't really understand what exactly happens, and so they
Speaker 1: want to do with something that they understand they think
Speaker 1: they understand well, like the overnight rate. So it seems
Speaker 1: from what I hear, they want to get out of
Speaker 1: this Balanciet stuff and go to something that they feel
Speaker 1: like they're more comfortable with, which is raising the over
Speaker 1: night rate. And you know, as you said, as you mentioned,
Speaker 1: you have disagreements within the FED as to what exactly
Speaker 1: QUI does. How you have people who would be like, oh,
Speaker 1: you know, he doesn't really do anything, just solving one
Speaker 1: asked for another. And you have people in the market
Speaker 1: who look at KUI and just max long because QWI
Speaker 1: makes the market go higher. So I think there's a
Speaker 1: there's just not very clear what it actually does, and
Speaker 1: they don't want to be doing things that they don't
Speaker 1: really understand. What do you think it does? Can you
Speaker 1: sort of describe for us what draining liquidity would look
Speaker 1: like in the current period versus draining liquidity from say
Speaker 1: or nineteen, because I think that might help us sort
Speaker 1: of understand the differences here and the difference in the mechanism. Sure,
Speaker 1: so when the FED drains liquidity out of the financial system,
Speaker 1: it doesn't actually have control where the liquidity comes out of.
Speaker 1: It can come out of the banking system, which you
Speaker 1: would drain reserves and deposits, or it can come out
Speaker 1: of the RAP, which which just decrease the RAP size.
Speaker 1: Now the RAP, as you see right now, it's very large.
Speaker 1: It's two two point two trillion. The the RP you
Speaker 1: can think of as just the true excess liquidity in
Speaker 1: the final nancial system. There's all this money that people
Speaker 1: have nowhere else to invest in, and so they just
Speaker 1: leave it on deposit at the FED at the end
Speaker 1: received the IRP rate. So when you do q T,
Speaker 1: if money is coming out of the IRP, you're it's
Speaker 1: going to be a very benign because you're taking money
Speaker 1: out that really nobody wants, or you could take it
Speaker 1: out of the banking system, which conceivably someone somewhere is
Speaker 1: reliant upon that that that liquidity. The FED beforehand doesn't
Speaker 1: actually know what will happen if you listen to fit
Speaker 1: precedents tak over the past few months. They just look
Speaker 1: at the RAP and they think that there's a lot
Speaker 1: of excess liquidity in the system, and so they can
Speaker 1: they can we can just do aggressive QT, no problem.
Speaker 1: But if you notice what's happening right now is that
Speaker 1: the RP is not declining, it will probably go much
Speaker 1: higher in my view, right so I have to say,
Speaker 1: we're recording this right before quarter end, so right before
Speaker 1: the end of June, and there is a very high
Speaker 1: chance that it could shoot up. I think in May
Speaker 1: it went above something like two trillion dollars, which was
Speaker 1: a record at the time, but we could get another
Speaker 1: record before this episode actually publishes. Yeah, when I used
Speaker 1: to round the rap, we were very surprised for like
Speaker 1: five billion. Now that that's that's too low. Um, what happens.
Speaker 1: So the reason is that you have all this liquidity. Um,
Speaker 1: how it gets strained ultimately depends on who buys the
Speaker 1: newly issued treasuries and how they finance it. If the
Speaker 1: treasuries are purchased by people who are levered investors, then
Speaker 1: a drain it's the RP. For example, if you are
Speaker 1: a hedge fund and you buy the newly issued our
Speaker 1: treasuries with repo loan, then the cash from that repole
Speaker 1: loan ultimately comes from the RAP. A money market fund
Speaker 1: will withdraw money from the RP and lend it in
Speaker 1: repo to the hedge fund investor. Money fund investors can
Speaker 1: only lend, can only make specific investments, very narrow one
Speaker 1: of them is repo, so that's basically the only that
Speaker 1: in increased bill issuance, but broadly speaking, that would be
Speaker 1: how you get the RP lower. On the other hand,
Speaker 1: if the people who buy the newly issue treasuries are
Speaker 1: let's say cash investors who are buying it with deposits
Speaker 1: they held out commercial banks, then what you will see
Speaker 1: is that liquidity will be drained out of the banking system.
Speaker 1: So that means that what's being drained is not necessarily
Speaker 1: liquidity that's held in the RAP that no one wants
Speaker 1: that's access, but liquidity in the banking system that maybe
Speaker 1: someone somewhere is relying on. Now beforehand, it's hard to
Speaker 1: see where the where the liquidity will be drained, but
Speaker 1: the way that I look at this is I just
Speaker 1: look at what's actually been happening the past few months.
Speaker 1: So the past few months, when the Treasury has been
Speaker 1: issuing coupon debt, the people who have been buying it
Speaker 1: have been people who are holding money at a commercial bank.
Speaker 1: So you can see that what the increases over the
Speaker 1: past few months, the amount of reserves in the commercial
Speaker 1: banking system is declining, but the amount of in the
Speaker 1: RP is not declining. So just how the financial system
Speaker 1: is currently configured that there doesn't seem like there's going
Speaker 1: to be any increased demand for leverage treasury investing. So
Speaker 1: going forward, what you can actually see is that the
Speaker 1: draining from QT comes out of the commercial banking system,
Speaker 1: whereas the RAP continues to increase. This, in a sense,
Speaker 1: is kind of like a double tightening effect because when
Speaker 1: the RAP goes higher, it's also draining liquidity out of
Speaker 1: the banking system. So this is why it seems on
Speaker 1: this side of the equation. From my perspective, draining liquidity
Speaker 1: can also be disruptive. You're not draining liquidity out of
Speaker 1: the RAP, which would be painless for the financial system,
Speaker 1: You're draining it out of the banking system, and the
Speaker 1: RAP is also suching liquidity out of the banking system.
Speaker 1: Let me ask you another kind of slightly bigger picture question,
Speaker 1: But you talked about the balance sheet remains a tool
Speaker 1: that the FED is, you know, it's hard to quantify
Speaker 1: its effects, perhaps it's a little bit uncomfortable using it
Speaker 1: and so forth. And it seems to me that you know,
Speaker 1: you're thinking about the difference between post Grade Financial Crisis
Speaker 1: and post COVID that QUEI was sort of used differently,
Speaker 1: and so post Great Financial Crisis, the FED it to
Speaker 1: hit the zero lower bound and felt it needed to
Speaker 1: ease further, and so it brought assets, whereas my sense
Speaker 1: of sort of march was that there was a big
Speaker 1: l and specifically of this liquidity effect and of this
Speaker 1: uh you know, wanting to sort of credit easing and
Speaker 1: backstop credit market specifically via asset purchases. I guess you know,
Speaker 1: the question I've wondered is did they sort of backdoor
Speaker 1: themselves into using a tool that it actually never really
Speaker 1: wanted that because it had this unusual situation, they didn't
Speaker 1: really want to have to go back to QUEI, but
Speaker 1: they sort of were forced to. And it's stuck around
Speaker 1: longer because they had this sort of different need when
Speaker 1: COVID hit, I think you're you're right that they used
Speaker 1: to QUEI differently in COVID. So POSTDFC, it was largely
Speaker 1: used as a tool to lower longer dated interest rates.
Speaker 1: So the Fed hit the zero bound, they wanted to
Speaker 1: continue to ease by putting downward pressure on longer date
Speaker 1: interest rates. So in order to do that, it bought
Speaker 1: a lot of treasuries now tasks for to March, it
Speaker 1: was a little bit different because the treasury market broke.
Speaker 1: So what that meant was that people who wanted to
Speaker 1: sell their shoulders for cash cannot do that. So on
Speaker 1: a global scale, treasuries are kind of where people keep
Speaker 1: their dollars. It's kind of like a huge bank, so
Speaker 1: to speak. So for example, if you and I we
Speaker 1: go to the bank and we want to get our
Speaker 1: cash out because we need cash, we expect to be
Speaker 1: able to get that. But if the bank says, sorry,
Speaker 1: I don't have any cash, then you know, we panic.
Speaker 1: There's a there's a run on that bank. And that's
Speaker 1: what happened in March. The trosury market. Everyone wanted to
Speaker 1: sell their trogrees for cash, realized that they could not
Speaker 1: actually sell their trajury for cash. In a sense, there
Speaker 1: was a run on the market, and they started selling
Speaker 1: everything else they could to get cash. The FEDS saw that,
Speaker 1: and they wanted to help that by basically backstoppying the
Speaker 1: troldan market, becoming a liquidity privator of last resort, and
Speaker 1: they purchased let's say, about trillion dollars of tresuries in
Speaker 1: one month. That's how KEE came back in. But it
Speaker 1: stayed far, far far beyond uh, the liquidity event at
Speaker 1: that stage. I think it morphed back into easing financial
Speaker 1: conditions as you suggested, which I take to meet the
Speaker 1: original QUWI motivation of putting down red pressure on interest rates.
Speaker 1: So that's how I think about that. I agree it
Speaker 1: probably was not super necessary after after for the length
Speaker 1: of time that they kept it. You know, you mentioned
Speaker 1: the treasury market blow up in and again this is
Speaker 1: something that we've been talking about quite a lot recently
Speaker 1: on other episodes. We also had the repo blow up
Speaker 1: from and I think the response to that was the
Speaker 1: creation of the Standing Repo Facility the s r F,
Speaker 1: which basically allowed banks to exchange treasuries for dollars, And
Speaker 1: so I'm wondering, does the existence of something like that
Speaker 1: doesn't make it less possible that we're going to get
Speaker 1: some sort of major blow up or are there limits
Speaker 1: to what the SRF can do in the current environment.
Speaker 1: So last time around, QT basically contributed to the blow
Speaker 1: up of the report market, as you noted. So I
Speaker 1: don't I don't think that's going to happen this sun around.
Speaker 1: But so I mean, we we never have the same
Speaker 1: thing blow up. Usually I think stress will be in
Speaker 1: somewhere else. And I think too to understand why I
Speaker 1: think the stress would be somewhere else, it's helpful to
Speaker 1: revisit what actually happened. Why did QT caused the report
Speaker 1: market to blow up? In for some context, in twenty UM,
Speaker 1: heading into let's say, say September, when the report market
Speaker 1: blew up, there was a tremendous demand for report financing.
Speaker 1: The amount of repot demand for report financing increased by
Speaker 1: a few hundred billion in the in the months leading
Speaker 1: up to September twenty nineteen. And those are all the
Speaker 1: hedge funds doing the doing their basis trades, and that
Speaker 1: pushed report rates um steadily higher and ultimately above interest
Speaker 1: on reserves. So the banks saw the saw that report
Speaker 1: rates were above interest on reserves, and they note that
Speaker 1: lending in treasury back repo from a regulatory standpoint, is
Speaker 1: equivalent to holding reserves at the FED. So they figured
Speaker 1: that they can earn some extra return by shifting the
Speaker 1: composition of their liquidity portfolio to fewer reserves and more
Speaker 1: repot and so heading into September, the banks became the
Speaker 1: marginal lender in the report market to the tune of
Speaker 1: hundreds of billions of dollars. So QT was playing in
Speaker 1: the background, and what QT was doing it was withdrawing
Speaker 1: the amount of UH excess cash the banks out the reserves.
Speaker 1: So as we had from a demand side, continued demand
Speaker 1: for report financing, and on the supply side, thanks being
Speaker 1: the marginal lenders in the market, their extra cash bell
Speaker 1: declining because of QT. Eventually the market hid an air
Speaker 1: pocket where report rates spiked higher uncontrollably. Another way to
Speaker 1: think about this is that the markets that benefited from
Speaker 1: KWI cash were hurt by QT and the major beneficiary
Speaker 1: in QWI cash last time around, as report we don't
Speaker 1: have that problem at all. The sign because report rates
Speaker 1: are much lower than io R. Banks are not lending
Speaker 1: in report. What they have been lending in, as I
Speaker 1: mentioned earlier, is in treasuries and agency nbs to the
Speaker 1: tune of well put five trillion dollars the past couple
Speaker 1: of years. So we have this dynamic. We have a
Speaker 1: similar dynamic playing out, but just not in the report market.
Speaker 1: The semiround tremendous demand, continued demand for financing by the
Speaker 1: U S trusury met by the marginal lender in the market,
Speaker 1: the commercial banks having less cash to lend. So if
Speaker 1: there is another blow up because of the q T,
Speaker 1: it's very likely to be in my view, in the
Speaker 1: treasury market, since the same dynamic is playing out, And
Speaker 1: what that could eventually mean is some kind of let's say,
Speaker 1: liquidity backstop for the treasury market rather than for the report,
Speaker 1: which I think is probably very logical given what the
Speaker 1: FED is already doing. Uh if you room call. As
Speaker 1: he noted Tracy, when the report market blew up, FED
Speaker 1: stepped in with an emergency liquidity facility for report. When
Speaker 1: the ethics spot lines blow up, the FED has their
Speaker 1: FICX swot lines. When the commercial paper market blows up,
Speaker 1: they have their you know they have their tools for that.
Speaker 1: In the past, when the treasury market blew up, it's
Speaker 1: they just did qui, which is a very blunt instrument.
Speaker 1: A more calibrated instrument would probably be some kind of
Speaker 1: emergency backstop willing to buy treasuries that you know, a
Speaker 1: set interest rate set above the market as a liquidity backstop.
Speaker 1: There is a standing report facility right exactly that provides
Speaker 1: emergency liquidity. If you have treasuries, you can repull that
Speaker 1: for cash. So it provides emergency cash. It doesn't have
Speaker 1: doesn't put a ceiling on rates in case the trajey
Speaker 1: market blows up because it's selling in theory, why is
Speaker 1: that not sufficient to avoid a blow up? If any holder,
Speaker 1: if a holder of treasuries can know that there is
Speaker 1: this there's window or the desk out there that will
Speaker 1: swap at any time treasuries for cash, why doesn't they
Speaker 1: add short circuit the sort of run dynamics in the
Speaker 1: first place. Exactly, So that has to do with a
Speaker 1: balance sheet constraints, and I'll explain that a little bit
Speaker 1: more so. When the people who have access to the
Speaker 1: FEDS report facility are the primary dealers, So if you
Speaker 1: want to have liquidity flow from the standard report facility
Speaker 1: to the market, it has to go through the primary dealers.
Speaker 1: And how that would play out is the primary dealer
Speaker 1: would borrow from the FED, let's say a hundred dollars
Speaker 1: from the FED, and then let's say, on the asset side,
Speaker 1: lend out that hundred dollars, so it expands the balance
Speaker 1: sheet of a primary dealer. Primary dealers are basically like
Speaker 1: the pipes to which money flows from UH the FED
Speaker 1: or money market fled cash investors into the broader market PREGFC.
Speaker 1: There is not a lot of limit to how why
Speaker 1: these pipes could be post GFC, because I'm all the
Speaker 1: number of regulations the pipes actually have kind of a
Speaker 1: fixed size. So for example, if there's a tremendous need
Speaker 1: for liquidity, a primary Julie cannot borrow like a hundred
Speaker 1: billion dollars from the FED and just lend it out
Speaker 1: to the market because they would hit these regulatory constraints.
Speaker 1: From a high level, pre GFC, the dealers were doing
Speaker 1: about three trillion dollars in repo. Now that's you know
Speaker 1: pre GFC lets in two thousand and seven. Today they're
Speaker 1: doing about one point five trillion so you know, everything
Speaker 1: in the market has gone much bigger, but yet the repo,
Speaker 1: the amount of repo primary dealers do has gone smaller
Speaker 1: by half. And that's those are the pipes of the
Speaker 1: financial system becoming more constrained. And also why we had
Speaker 1: these blow ups in March. Dealers, even though at the
Speaker 1: time they also had access to this repo facility that
Speaker 1: FED had their balance sheets, the pipes were simply not
Speaker 1: wide enough to to accommodate all that. So um, they
Speaker 1: could there are regulatory things they can do to tweak that,
Speaker 1: and I think there's work being done on that side. Um,
Speaker 1: but at the moment it's not complete yet. So what
Speaker 1: would cause the FED to pause QT? Like, what would
Speaker 1: be the catalyst for it to step back and go,
Speaker 1: wait a second, we're doing this set too rapid a pace,
Speaker 1: or we're doing too much too soon and basically reconsider.
Speaker 1: So I think thinking is that eventually the FED would
Speaker 1: become well hike or do qut and eventually something will
Speaker 1: blow up and they'll have to to reverse. I actually
Speaker 1: think that's that's totally accurate in what happened in the past.
Speaker 1: But I think what's happening now is that the FED
Speaker 1: actually has enough tools so that they don't have to stop.
Speaker 1: So if you think about broadly speaking, the FETE has
Speaker 1: basically become a one mandate bank. For the moment, the
Speaker 1: power was telling you that it's it's can can a
Speaker 1: bit to price stability is unconditional. He's telling you that
Speaker 1: full employment is conditional price ability. So the only thing
Speaker 1: that happens that matters for him right now is is inflation.
Speaker 1: And so he's going to be very aggressive in his
Speaker 1: monetary tightening, and that means of course not stopping QUT
Speaker 1: and not stopping grade hikes. He can do that now
Speaker 1: because the FED has rolled out so many new facilities
Speaker 1: such that wide sectors of the economy can be supported
Speaker 1: even if something breaks. The FED during March pioneered facilities
Speaker 1: to make the blender of last resort for wide range
Speaker 1: of markets and for ride range of sectors. For example,
Speaker 1: their back stopping the municipal bond market through their Municipal
Speaker 1: Licuity facility lasts him around, and the corporate bond market
Speaker 1: through the Corporate credit facility and Becauceivably they could also
Speaker 1: have new treasury facilities as well. So I think eventually
Speaker 1: something will break, because it always breaks but it doesn't
Speaker 1: mean that they'll stop, just means that they could use
Speaker 1: their facilities to further extend their tidying. These facilities, in
Speaker 1: my view, greatly extend the possibility of of how restrictive
Speaker 1: Monterrey policy can be simply because the remove liquidity risk. Wait, sorry,
Speaker 1: can you just explain that a little further. You're saying
Speaker 1: these new facilities, the facilities that were pioneered in these
Speaker 1: new facilities that were pioneered in Mary, the explicit backstopping
Speaker 1: of the credit markets, the MUNI facility, which was obviously
Speaker 1: extraordinary and sort of you know, this brand new thing explained,
Speaker 1: How do you see them potentially being used? Because I
Speaker 1: feel like these facilities have largely been forgotten about. No
Speaker 1: one ever talks about either one of those these days,
Speaker 1: exactly exactly, so they've all forgotten and they're not commissioned
Speaker 1: right now. So what I'm saying is that if q
Speaker 1: T or if FED rc TIKES actually breaks something in
Speaker 1: the market, the FED does not have to stop. It
Speaker 1: does not have to stop because it can continue to
Speaker 1: keep the financial markets coming along so it can repair,
Speaker 1: it can can continue to tighten in pursuit of its
Speaker 1: inflation goal. While sort of more strategically repairing potential breaks
Speaker 1: in the financial market exactly, Joe, Okay. Interesting because again,
Speaker 1: the FED has become lender of last resort to such
Speaker 1: a wide wide range of market participants, from the corporations,
Speaker 1: from the to the municipals, and indirectly to small businesses
Speaker 1: through the banking system through their mainstream lending facility. So
Speaker 1: it's basically such so significantly expanded their footprint that there's
Speaker 1: less reliance on the transmission of monetary policy through the market,
Speaker 1: and you can kind of, uh, well, it's not ideal,
Speaker 1: but you can kind of indirectly reach it through these
Speaker 1: programs such that even if something breaks, it doesn't actually
Speaker 1: mean they have to back down, lower rates and continue QB,
Speaker 1: especially if inflation is too high. What's your bet on
Speaker 1: what could break if you had to, if you had
Speaker 1: to wager something right now, like, what would it be?
Speaker 1: Where's the biggest area of weakness. I still believe the
Speaker 1: trophy market is the highest risk. That's first, because as
Speaker 1: I mentioned the report, breakup dynamics that we saw in
Speaker 1: the prior QUTY are playing out in the trophy market.
Speaker 1: Have tremendous supply coming up the few years, the demand,
Speaker 1: it doesn't seem like it's there because the marginal investor
Speaker 1: is disappearing and we have very weak, low liquidity, weak
Speaker 1: market structure, and just watching the trophy market over the
Speaker 1: past few weeks seems like it's becoming more volatile. So
Speaker 1: I think that's probably the place that that is most
Speaker 1: likely to break this time around. So one of the
Speaker 1: things you know, as you were talking about in the beginning,
Speaker 1: it can be sort of hard to well, it can
Speaker 1: be hard to predict what's going to break. It can
Speaker 1: also be hard to predict where the liquidity is going
Speaker 1: to get drained out of the system first. Like all
Speaker 1: of these things, it doesn't seem like it's a hard science,
Speaker 1: and anticipating it is. This sort of fundamentally why the
Speaker 1: FED is so uncomfortable quantifying the tightening effect of balance
Speaker 1: sheet policy, because you know, it's sort of easy to see,
Speaker 1: like the transmission mechanism of a rate increase. It's like
Speaker 1: your high rates and rates go up, and then you
Speaker 1: see it in mortgages and car loans and that titan
Speaker 1: is the housing market. It's somewhat straightforward, I think, whereas
Speaker 1: if there's so much uncertainty about where is the liquidity
Speaker 1: going to come from or be pulled from? It seems
Speaker 1: that makes it inherently a much tougher tool to quantify
Speaker 1: and calibrate. I agree completely with that, and I don't
Speaker 1: actually know if the FED under understands this. If you hear,
Speaker 1: I think there's work from the ft that's also been
Speaker 1: mentioned from by Governor Waller that you know, let's say
Speaker 1: two trillon dollars of QUEI is a QT is equal
Speaker 1: to like fifty basis points. I suspect that's probably not true,
Speaker 1: and it will be something that they wish they didn't say,
Speaker 1: because the thing is, there's so many moving parts to this.
Speaker 1: There's so many ways that it can go. It's not
Speaker 1: something that can fit it in an equation. Now, if
Speaker 1: you want to approach the world as if you are
Speaker 1: a giant equation, you need to have relationships that are
Speaker 1: consistent and don't change. And this is very much true
Speaker 1: in physics. If I drop rock here, uh, you know,
Speaker 1: my points per second square goes down, saying if I
Speaker 1: dropped it in London, or if I dropped it a
Speaker 1: hundred years ago. That works well for things that don't change.
Speaker 1: But if you're looking at the financial markets, The relationships
Speaker 1: are always changing their different regimes, and there are different
Speaker 1: actors and different regulatory changes, so you just really can't
Speaker 1: know what will happen. In the estimate, I think is
Speaker 1: is just not very useful, and so with in that sense,
Speaker 1: it's kind of good that they get out of this. Yeah,
Speaker 1: this is a related question, But what's the future of
Speaker 1: the FED and its relationship with financial markets in the
Speaker 1: sense that you know, as you've been describing now for
Speaker 1: the past at least the past ten years, you know,
Speaker 1: more than a decade since two thousand eight, Whenever something
Speaker 1: goes wrong, the FED comes up with some sort of
Speaker 1: new program to enable it to keep pursuing its policy
Speaker 1: goals or keep doing what it was doing. Is that
Speaker 1: just how it's going to be for the foreseeable future?
Speaker 1: You know, something goes wrong, the FED comes up with
Speaker 1: a new program, it gets added, Eventually it becomes the
Speaker 1: new normal. Eventually something else goes wrong and there's a
Speaker 1: new program, and so on and so forth. Or is
Speaker 1: there going to be a larger shift or break in
Speaker 1: this pattern at some point? I think going forward, I
Speaker 1: think the inventible outcome is probably a reversal of the
Speaker 1: Fedatricia Court. Simply because the FED itself is becoming so
Speaker 1: much more involved in the markets, it's going to need
Speaker 1: to have more accountability. It's it's going it's it's essentially
Speaker 1: becoming lend of lasted work to everyone in the system.
Speaker 1: But also because of changes in the structure of the
Speaker 1: economy such that the FED probably can't carry out its
Speaker 1: task the same way that it was able to say
Speaker 1: at its inception. And this has to do with how
Speaker 1: the public sector is just the bigger part of the economy.
Speaker 1: For example, if you think back hundred years ago, the
Speaker 1: government was a very small part of the economy, and
Speaker 1: the FED, with its mandate of controlling inflation, it can
Speaker 1: simply adjust interest rates, and private actors respond to that.
Speaker 1: It works much better. If you are a private sector actor,
Speaker 1: you care about the price of money, and if industrates
Speaker 1: are higher, you moderate your economic activity and af ingistration
Speaker 1: or lower. You know, maybe you spend more um. But
Speaker 1: the structure of the economy has changed so much over
Speaker 1: the past hundred years such that there's a greater part
Speaker 1: of the economy that's basically the public sector, and the
Speaker 1: public sector doesn't really care about interest rates. So when
Speaker 1: the FED hikes. When the FED cuts, that doesn't really
Speaker 1: affect their economic activity. Their economic activity has to be
Speaker 1: effected through the legislative process. So as this trend continues,
Speaker 1: as one, a greater part of the economy becomes insensitive
Speaker 1: to the FEDS interest rates, thus making the FED less
Speaker 1: effective in controlling rates. And two, as a FED becomes
Speaker 1: much more involved as lender of last resort to a
Speaker 1: wide range of the market, essentially becoming more in the
Speaker 1: allocation of credit business, which I think is probably something
Speaker 1: that more probably belongs to, if not the private sector,
Speaker 1: at least someone that has public mandate. So it seems
Speaker 1: we're heading towards the world. It will make more sense
Speaker 1: or more coordination between Fed and Treasury to achieve these
Speaker 1: goals simply because the FED is doing more stuff that
Speaker 1: is physical policy alike, and also it has less ability
Speaker 1: to influence economic outcomes. All right, Joseph, it was so
Speaker 1: good having you back on odd Lots. Thank you so much,
Speaker 1: really appreciate it. Thank you so much for inviting me.
Speaker 1: I love odd Lots and I really appreciate the opportunity.
Speaker 1: Thanks Tracy, and thanks Joe, thank you. It's great, great chat.
Speaker 1: So Joe, I thought that was incredibly interesting and really
Speaker 1: good to get into the weeds of some of this.
Speaker 1: And also, I mean, one thing that is becoming clear
Speaker 1: from recent episodes is that lots of people seem to
Speaker 1: be saying that liquidity in the treasury market has deteriorated
Speaker 1: for various reasons and that there are some vulnerabilities there.
Speaker 1: But Joseph's mentioned of the idea of treasury is becoming
Speaker 1: less like cash um or less cash like in the
Speaker 1: way they are traded and in their position in the
Speaker 1: financial system. That would actually be a sea change for markets.
Speaker 1: I think it's weird because, I mean, clearly, with the
Speaker 1: existence of the standing repo facility, the FEDS goal is
Speaker 1: to make it more explicitly cash like. I mean, that's
Speaker 1: the idea right there. Similar it's always been somewhat money
Speaker 1: like and similar to cash and okay, and now they
Speaker 1: have this formal standing repo facility so that at least
Speaker 1: the primary dealers can swap them into cash at any time,
Speaker 1: even when it is not an emergency. So the fact
Speaker 1: that like liquidity is still deteriorating, the fact that you know,
Speaker 1: we have had all these issues, uh, you know, raises
Speaker 1: it to his point. There's clearly still a lot of
Speaker 1: unfinished business. Yeah. The other thing that kind of struck
Speaker 1: me from that conversation was his description of how when
Speaker 1: the r r P. I don't think we ever actually
Speaker 1: said what the r r P stands for, but it's
Speaker 1: the reverse repurchase facility. But when the r RP goes up,
Speaker 1: it doesn't necessarily mean that liquidity in the overall system
Speaker 1: is going up, which I think there are still a
Speaker 1: lot of people out there that look at the r
Speaker 1: r P at two trillion dollars or whatever and they
Speaker 1: go like, oh, liquidity slashing around the system by everything
Speaker 1: I'm thinking. I'm thinking in particular of a certain sub
Speaker 1: credit where the r r P is a really big
Speaker 1: talking point. But Joseph's point that actually the RRP going
Speaker 1: up means liquidity might not be going out of the
Speaker 1: banking system and so you know, financial conditions are tightening,
Speaker 1: that's worth remembering. And just to his is broader point
Speaker 1: which he hit a few different ways, like the sort
Speaker 1: of relationship between quantitative tightening and where liquidity can come
Speaker 1: out of the market at any given time and to
Speaker 1: some degree, you know, the unpredictability of it, the faith
Speaker 1: it's different under different regimes. I think that may be
Speaker 1: like the clearest explanation of like why the FED and
Speaker 1: nobody else really even like talks about the tightening effects
Speaker 1: of QT, in part because like it's just not nearly
Speaker 1: as straightforward or predictable. So the idea of like putting
Speaker 1: a number on it or saying like, okay, QT is
Speaker 1: like worth this many rate cuts or sorry raid hikes
Speaker 1: or whatever, like it seems way harder to judge. Yeah, no,
Speaker 1: I actually just keep the balance sheet big and forget
Speaker 1: about it. Seems like it cousable. That's that's if I
Speaker 1: were there, like, let's just yeah, it's just too much
Speaker 1: of a headache. Figure it's future and whatever. I just
Speaker 1: keep it there. That would be that was well, I
Speaker 1: mean we were on the phone. That would be my vote.
Speaker 1: You know what everyone can pain for Joe for FED
Speaker 1: share Uh, you know, a simplified FED, simplified open market operations.
Speaker 1: That's Joe's that's Joe's campaign platform. Balancie. It only goes
Speaker 1: in one direction when I'm on the bed, only get
Speaker 1: We never do the opposite, you know what. I think
Speaker 1: that might actually be a very successful talking point. Okay,
Speaker 1: let's leave it there before we say anything else sounds good.
Speaker 1: Let's leave it there. Okay, this has been another episode
Speaker 1: of the All Thoughts podcast. I'm Tracy Alloway. You can
Speaker 1: follow me on Twitter at Tracy Alloway and I'm Joe
Speaker 1: Why Isn't Though. You can follow me on Twitter at
Speaker 1: the Stalwart. Follow our guest Joseph Wange on Twitter. He's
Speaker 1: at fed Guy twelve. Follow our producer Kermen Rodriguez at
Speaker 1: Kermen armand, and check out all of the Bloomberg podcasts
Speaker 1: on Twitter under the handle at podcasts. Thanks for listening
Speaker 1: year to