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Interest Rate Normalization Requires Huge Reverse Repo: Fixed Income Volatility and Opportunity

  1. The Fed intends to raise rates in an effort to "normalize" the financial ecosystem.

  2. The Fed pretty much knows that without draining liquidity, short rates will remain out of their control because excess reserves make IOER unresponsive to other short rates.

  3. Basel III ensures that liquidity can only be drained by Fed reverse repo--no other player has the balance sheet capacity.

  4. Reverse repos will need to be very large to accomodate money market needs.

  5. For every financial action there is an offset somewhere else. The offset is occurring in the capital market.

  6. The price of liquidity in risky debt is he cause of fixed income volatility. The all-in yield on risky debt will generate excess returns.

Watch out. For the Fed to effectively control short term interest rates, raising the discount window rate (and by implication Fed funds) is not enough. They will need to drain a lot of liquidity from the financial system. Otherwise, it won’t appreciably affect wholesale funding markets and their course to policy “normalization”—whatever that means. Without huge reverse repo operations, a policy rate hike won’t be reflected and augmented throughout the system. Let us explain.

Central banks are no different than any other species in the financial ecosystem. They don’t make the rules. They are instead ruled by the circumstances. The circumstances are excessive liquidity, huge pools of bank reserves, and a gigantic demand for short-term, money-like assets by corporate treasuries, sovereign wealth FX managers, and asset manager desks. In short there, is a huge reserve to accommodate wholesale funding and a shortage of fixed NAV share products because banks as broker-dealers are being regulated out of the business.

In this context, the Fed will not find this easy to control short term rates and there will be large ramifications as they try to strengthen their control. Banks have been regulated out of the central role in the monetary transmission process. In effect, central banks have lost their key historical control level in the financial system. Basel III has placed capital charges and balance sheet restrictions on banks. When financial innovation or rules change, the least constrained entities are more profitable and grow faster than others. In effect, the shadow banking system is privileged at the expense of the traditional banking system and is set to continue its growth. Central banks thus find losing control of wholesale funding rates likely unless they drain significant liquidity as they raise rates.

Pre-crisis, funding was sourced from the private sector borrowing short and lending long to finance asset manager risky bond purchases. The funders pocketed the spread, or loosely-speaking, “carry” and the borrowers profited from risk factor exposure. Post-crisis, there is a shift from private to central bank funding, with central bank profits stemming from seigniorage on its carry trades. The borrowers in turn have deep incentive to lever up on purchases of high quality liquid assets—Basel’s HQLA capital requirement. This means government bonds and its equivalents in lieu of corporate issues. The broker-dealer footprint in money markets and as agents that warehouse risky debt is diminished, enshrined by Basel III.

As these Basel mandates increase the cost of private bonds, the asset manager mandate to return equity returns with bond volatility has the potential to morph into equity-like returns with equity-like volatility. This is an inevitable consequence of the evolving financial ecosystem.

There are two channels for funding the economy: retail deposits under the umbrella of banks, and secured repos issued by broker-dealers in the wholesale funding market. The latter is both a larger pool and cheaper to source from a regulatory standpoint. Thus US money markets are dominated not by deposits but by the shadow banking system. This trend will not change and it is a hallmark of an age of huge income disparity and the 1% imbalanced against the 99%.

Contrary to thinking of Basel III as independent of secular trends, the reality is that it is a response to them. Poorly conceived and ultimately self-defeating, but nevertheless in place in service of policy goals intended to mitigate perceived threats to the financial ecosystem. The coming IV, V, VI and the other cheap-quality, low-budget sequels that focus on restricting broker-dealer actions of banks will only marginalize their role in the financial system and in turn limit central bank effectiveness.

There are actually several short-term interest rates: the Fed’s interest on excess reserves (IOER), fed funds, the Fed overnight reverse repo rate (RRP), the overnight collateralized repo rate, and the overnight AA (pretty much top tier bank) commercial paper rates.

IOER historically served as the center of gravity in the financial system, but it is not particularly responsive as of late. It is not an effective floor on short-term interest rates, since we see lending to banks at rates less than the Fed pays in IOER. This is because QE satiated banks with excess reserves. These reserves are not evenly distributed across all banks, held in large part by the two major clearing banks, JP Morgan and State Street, and foreign banks. There is a capital charge on these reserves and FDIC operating fees that make IOER less a center of gravity than it used to be.

The liquidity embodied in excess reserves has to be drained of IOER is to regain its former sensitivity. As we explained, secured repo will not serve this function unless Basel III is relaxed. Treasury bills will be in insufficient supply unless treasuries alter their term profiles. The only option is an expanded supply of RRPs to accommodate the government fund liabilities from the shadow banking system.

This will require an offset somewhere else. I suspect in a very general way the money market needs (meaning maturities generally no further out than 1 year) will be served at the expense of the capital market (meaning maturities 2 years +). This will correct in time as curves steepen enough for all-in credit yield to migrate savings out of the money market.

It will be a volatile but ultimately profitable waiting game.

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