The Fed Cannot Reduce Its Balance Sheet For Much Longer
Losing Control
Back on January 11th about two weeks ago, Reuters reported on an anomaly, noticed by Bank of America (BAC), on money market rates controlled by the Federal Reserve. The piece, entitled "U.S. Federal Reserve may need to backstop repo market - BAML," started off by noting "extreme volatility" in the Treasury repurchase rate known as the Secured Overnight Financing Rate, or the SOFR. This extreme volatility occurred at the end of 2018. The SOFR is a relatively new rate published by a group of banks set up by the Fed as an alternative to LIBOR. LIBOR, for various reasons, is being used less and less as an interest rate benchmark. What is important to know is that the SOFR is the overnight rate charged by banks to each other to repurchase Treasuries as collateral for loans.
asically, Bank of America analysts noticed that the SOFR on December 31, 2018, shot up 76 basis points in a single day to 3.15%, trading 75 basis points above the interest paid on excess reserves (IOER). Now, obviously, the spike had a lot to do with year-end book-balancing which pushed demand for reserves artificially high for that day, which is why the spike quickly settled back down. However, BofA analysts Mark Cabana and Olivia Lima released this statement on the matter: "We believe the Fed will ultimately need to be the repo backstop of last resort after the banking system exhausts its willingness to swap reserves for (Treasury) repo."
As I've noted many times in my previous articles, the effective federal funds rate (EFFR), the rate that the Federal Open Market Committee directly hikes or cuts, is already bumping up against the IOER. They are both at 2.4%. The latter is acting as the ceiling to the former, at least for as long as there are still excess reserves to loan out. Now, finally, the Fed has actually taken notice of this problem and in its latest minutes release acknowledged the possibility of losing control of the EFFR. They have never admitted this possibility before, but nobody seems to be reporting on it.
First, money market rates are becoming more volatile, as BofA had noted. OK. The Fed now admits that the EFFR could become even more volatile as excess reserves decline and that they don't have a firm plan for dealing with this or even understand what exactly is causing it. Got that.
So, what's the obvious solution? Keep excess reserves high. In the Fed's words, "end portfolio redemptions" which is really just code for ending balance sheet normalization. There was concern about doing this because it could be misinterpreted as overly dovish monetary policy. In other words, dollar bearish. They are certainly right to be concerned about this.
So, yes, the Fed is starting to "recognize the box that it is in and that this box is tightening. I'm reminded of the Game of Thrones Season 6 battle scene where Jon Snow's forces are squeezed by the Boltons and Karstarks (excuse the pop culture reference)."
How fast is the box tightening? How much time does the Fed have before this becomes a serious problem that won't just be swept to the back pages of the financial news media while Pelosi and Trump duke it out over border wall funding? Let's extrapolate based on current rates of excess reserves depletion.
Extrapolation
The Fed's current balance sheet reduction program began in October 2017. At that point, excess reserves were at $2.129 trillion, using the Fed's H.3 report and subtracting required reserves from total reserves at Table 2. As of the latest H.3 report on aggregate reserves, we are currently at $1.536 trillion in excess reserves. OK, so that's about $600 billion in excess reserves depletion in 15 months since the Fed started reducing its balance sheet.
At this rate, excess reserves zero out in 2.6 years, or somewhere around August 2021, at which point the EFFR could go totally haywire by the Fed's own admission. But never mind that for a second. Where is the balance sheet by August 2021? Well, according to Wells Fargo, the Fed has a target of $2.5 trillion to $3 trillion in mind for where it wants to be on the balance sheet by the end of the "normalization" program. August 2021 is 31 months away and according to the Fed's H.4.1 reports, the balance sheet has been reduced by $418.7 billion since the program began in October 2017. That's about $28 billion per month of net reduction in practice.
Multiply $28 billion by 31 and we have $865 billion less on the balance sheet by August 2021. The current balance sheet is at $4.098 trillion. Subtract $865 billion and we are at $3.232 trillion, $232 billion over the upper range of the Fed's balance sheet reduction target, and this is the best case scenario.
It is much more likely that way before excess reserves are zeroed out entirely, the pressure on the EFFR will become too intense for the Fed to keep in check and it will have to stop shrinking its balance sheet long before the zero mark on excess reserves, as it readily admits in its minutes, using other terms to confuse the public. The EFFR is already being held in place by the IOER as it is. The pressure is already at maximum tolerability.
Conclusion
Time is running out for the Fed on reducing its balance sheet. At the rate, excess reserves are falling, the pressure on the EFFR could become too much for the Fed to control long before excess reserves are depleted by August 2021. We are already seeing evidence of extreme stress in money market rates as pointed out by Bank of America and excess reserves are still very much ample. At some time before 2021 then, maybe next year or even later this year, the Fed will probably be forced to stop reducing its balance sheet in order to keep overnight rates in range, and the effect on the dollar index, in my opinion, is likely to be very bearish, as the Fed itself obliquely noted in its latest FOMC minutes.
https://seekingalpha.com/article/4235268-fed-reduce-balance-sheet-much-longer
Losing Control
Back on January 11th about two weeks ago, Reuters reported on an anomaly, noticed by Bank of America (BAC), on money market rates controlled by the Federal Reserve. The piece, entitled "U.S. Federal Reserve may need to backstop repo market - BAML," started off by noting "extreme volatility" in the Treasury repurchase rate known as the Secured Overnight Financing Rate, or the SOFR. This extreme volatility occurred at the end of 2018. The SOFR is a relatively new rate published by a group of banks set up by the Fed as an alternative to LIBOR. LIBOR, for various reasons, is being used less and less as an interest rate benchmark. What is important to know is that the SOFR is the overnight rate charged by banks to each other to repurchase Treasuries as collateral for loans.
asically, Bank of America analysts noticed that the SOFR on December 31, 2018, shot up 76 basis points in a single day to 3.15%, trading 75 basis points above the interest paid on excess reserves (IOER). Now, obviously, the spike had a lot to do with year-end book-balancing which pushed demand for reserves artificially high for that day, which is why the spike quickly settled back down. However, BofA analysts Mark Cabana and Olivia Lima released this statement on the matter: "We believe the Fed will ultimately need to be the repo backstop of last resort after the banking system exhausts its willingness to swap reserves for (Treasury) repo."
As I've noted many times in my previous articles, the effective federal funds rate (EFFR), the rate that the Federal Open Market Committee directly hikes or cuts, is already bumping up against the IOER. They are both at 2.4%. The latter is acting as the ceiling to the former, at least for as long as there are still excess reserves to loan out. Now, finally, the Fed has actually taken notice of this problem and in its latest minutes release acknowledged the possibility of losing control of the EFFR. They have never admitted this possibility before, but nobody seems to be reporting on it.
First, money market rates are becoming more volatile, as BofA had noted. OK. The Fed now admits that the EFFR could become even more volatile as excess reserves decline and that they don't have a firm plan for dealing with this or even understand what exactly is causing it. Got that.
So, what's the obvious solution? Keep excess reserves high. In the Fed's words, "end portfolio redemptions" which is really just code for ending balance sheet normalization. There was concern about doing this because it could be misinterpreted as overly dovish monetary policy. In other words, dollar bearish. They are certainly right to be concerned about this.
So, yes, the Fed is starting to "recognize the box that it is in and that this box is tightening. I'm reminded of the Game of Thrones Season 6 battle scene where Jon Snow's forces are squeezed by the Boltons and Karstarks (excuse the pop culture reference)."
How fast is the box tightening? How much time does the Fed have before this becomes a serious problem that won't just be swept to the back pages of the financial news media while Pelosi and Trump duke it out over border wall funding? Let's extrapolate based on current rates of excess reserves depletion.
Extrapolation
The Fed's current balance sheet reduction program began in October 2017. At that point, excess reserves were at $2.129 trillion, using the Fed's H.3 report and subtracting required reserves from total reserves at Table 2. As of the latest H.3 report on aggregate reserves, we are currently at $1.536 trillion in excess reserves. OK, so that's about $600 billion in excess reserves depletion in 15 months since the Fed started reducing its balance sheet.
At this rate, excess reserves zero out in 2.6 years, or somewhere around August 2021, at which point the EFFR could go totally haywire by the Fed's own admission. But never mind that for a second. Where is the balance sheet by August 2021? Well, according to Wells Fargo, the Fed has a target of $2.5 trillion to $3 trillion in mind for where it wants to be on the balance sheet by the end of the "normalization" program. August 2021 is 31 months away and according to the Fed's H.4.1 reports, the balance sheet has been reduced by $418.7 billion since the program began in October 2017. That's about $28 billion per month of net reduction in practice.
Multiply $28 billion by 31 and we have $865 billion less on the balance sheet by August 2021. The current balance sheet is at $4.098 trillion. Subtract $865 billion and we are at $3.232 trillion, $232 billion over the upper range of the Fed's balance sheet reduction target, and this is the best case scenario.
It is much more likely that way before excess reserves are zeroed out entirely, the pressure on the EFFR will become too intense for the Fed to keep in check and it will have to stop shrinking its balance sheet long before the zero mark on excess reserves, as it readily admits in its minutes, using other terms to confuse the public. The EFFR is already being held in place by the IOER as it is. The pressure is already at maximum tolerability.
Conclusion
Time is running out for the Fed on reducing its balance sheet. At the rate, excess reserves are falling, the pressure on the EFFR could become too much for the Fed to control long before excess reserves are depleted by August 2021. We are already seeing evidence of extreme stress in money market rates as pointed out by Bank of America and excess reserves are still very much ample. At some time before 2021 then, maybe next year or even later this year, the Fed will probably be forced to stop reducing its balance sheet in order to keep overnight rates in range, and the effect on the dollar index, in my opinion, is likely to be very bearish, as the Fed itself obliquely noted in its latest FOMC minutes.
https://seekingalpha.com/article/4235268-fed-reduce-balance-sheet-much-longer
, i cannot predict the precise direction and time. but i remeber i had given a caution at a fairly early time, around 9.45/10.
