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Rate Hikes are a Sideshow. The Fed as Non-Buyer of Last Resort.

Proposition: Cash reserves stored at central banks are the ultimate by-product of QE.

The Fed’s big balance sheet means big reserves. These big reserves aren’t inflationary. They are sign of change.

Big reserves mean banks have no incentive to either borrow or lend these reserves. These reserve holdings are why banks no longer trade liquidity among each other. For this reason, unsecured interbank markets are dead.

Collateralized interdealer repo markets are not dead. Repo agreements occur where a party takes an asset in return for posted reserves with an agreement that at a future date the asset will be returned and the reserves given back with interest. A reverse repo agreement is where a party gives a fully owned asset in return for cash with an agreement to take back the asset at a future date and return the cash with interest.

Currency is money for people. Reserves are money for banks. Collateral is not money.

Proposition (QE Effect): The bigger the nominal economy, the bigger the banking credit expansion. The bigger the banking system, the bigger its capital buffer must be. The bigger the capital buffer, the bigger the need for reserves. The bigger the need for reserves, the bigger the Fed balance sheet.

QT shrinks the Fed balance sheets, and ultimately reverses this cycle.

Proposition (QT Impact): The smaller the Fed balance sheet, the smaller the reserves. The smaller the reserves, the smaller the capital buffer. The smaller the capital buffer, the smaller the credit expansion. The smaller the credit expansion, the smaller the economy.

Corollary: Balance sheet unwinding removes reserves and adds collateral to the financial system.

Under Basel III, bank demand for capital buffers rise. Capital buffers are measured by the level of High Quality Liquid Asset (HQLA) portfolios. Collateral heavy HQLA portfolios create imbalances because when the Fed isn’t buying collateral, sales of collateral drain liquidity from another bank.


Repo markets are important because we operate within a financial system based on promises to buy. This is because many promised payments lie far in the future, or in another currency, or with different degrees of credit risk. The financial system attempts to manufacture assets free from duration, credit, and FX risks by stripping them out of all kinds of diverse assets using swap contracts.

  • Long-term debt connects to short- term debt through the interest rate swap. The price of short-term security = price of long-term security + price of interest rate swap.

  • Defaultable securities connect to default-free reference securities through the credit default swap. The price of a default-free security = price of a defaultable security + price of credit default swap.

  • Foreign currency denominated notes connect to dollar denominated notes through currency swaps. The price of a dollar security = price of foreign currency security + price of FX swap.

Proposition: The price of “risk free” security = price of risky security + price of credit default swap + price of interest rate swap + price of FX swap.

This risk-stripping process involves credit intermediation by non-banks that transform both maturity and liquidity using posted collateral. The collateral used in secured money market funding involves a variable haircut on the value of the asset offered as security. In times of market stress, collateral haircuts are greater than at times when the collateral was originally posted. This haircut variability creates a funding gap that must be filled by another source.

Proposition: The process does not create a risk-free asset because each swap contract carries with it counterparty risk.

The resulting quasi risk-free asset may well trade at par with treasury bills under ordinary market conditions, but they will gap wide during times of crisis.

A necessary accompaniment to the implicit promise to buy is a dealer system that offers market liquidity by offering to buy whatever the market is selling, including the price of the various risks. This critical infrastructure is an interconnected system of dealers, backstopped by a central bank.

This is the fundamental problem of liquidity underlying the modern financial system, as well as the reason why a backstop is needed. From a dealer perspective, shadow banks are demanders of money funding, and suppliers of risk exposure. Mark-to-market with daily cash collateral transfer means that these liquidity problems of the asset holder are shifted onto the balance sheet of the swap counterparty which now faces its own funding gap.

To prevent a downward liquidity spiral as more and more swap contracts gap and concentrate funding pressure on counterparties, a central bank is needed to provide the necessary funding to convert the increased value of a swap into an actual cash flow. This entails a lender of last resort as well as a dealer of last resort to provide both liquidity and placing bounds on price fluctuations.

In the 2008 financial crisis, the Fed stepped in to become the market-maker; in normal times, the central bank backstop operates to support the market. As the Fed steps away from this function, it is not understanding the impact on financial markets.

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