Excellent Vitor, such a good description of the forces at play in the interbank market. One argument for allowing SOFR to trade higher is to eliminate the incentives for many of the non-interbank function-related demand for repo. The Fed has a commitment to provide ample liquidity to the banks for ordinary interbank purposes, but it does not need to ensure ample liquidity for massive spread trading by risk-taking non-banks. This is beyond the original scope of the Fed mandate. Ensuring HFs have access to stable overnight funding is an unnecessary responsibility for the Fed to take on.
Many thanks Mark. Naturally, the regime of ensuring ample reserves has nothing to do with QE and requires a much smaller balance sheet than the one at peak QE. However, I think there are two points that must be ensured:
1- Banks changed since 2007 to a preference for higher reserves as part of their liquidity, and nowadays require reserves around 10% of GDP (FED estimation) and the FED should ensure that through it’s balance sheet policy.
2- The FED introduced the SRF in 2021, after the debacle of March 2020, in order to avoid that too high repo rates would disturb markets, requiring huge interventions, and to ensure that SOFR would not distance too much from the EFFR, as they are the two prices of money that matter.
Both tasks should be carried out regardless of which institutions that are players in those two markets benefit from the FED actions.
Spot on Mark! This is just further mission creep by the Fed. They have the banking system covered with the SRF. But I for one am happy that hedgies must be getting cold feet on their basis trades, which I think are both systemic (see this April) but also not germane to monetary policy transmission.
So any kernel of sand in the wheels of the basis trade that curtails it over time, without systemically blowing it up in one instant, is to be welcomed.
SOFR spreads at current levels are quite desirable from that systemwide perspective
Very helpful - thank you! Your piece, along with Robert Armstrong's discussion of it in the FT this morning raise some questions though. Armstrong states, "if short rates rise and become more volatile, a crucial buyer of Treasury securities — hedge funds engaging in leveraged basis trades — will become forced sellers, causing a proper market mess." True at the extreme. But why wouldn't the Fed be happy allowing rate volatility to settle in a somewhat higher range in order to force hedge funds to throttle down leverage? Relatedly, Armstrong says, "If high, volatile SOFR blows the hedgies out of their trades, it will be ugly." Again, true enough, but why is higher, more volatile SOFR treated as a singular event? Hypothetically at least, some modestly higher volatility would ensure greater resilience. Finally, if the Fed increases its balance sheet every time rate vol ticks up a bit, aren't they really just acting as hostage to the hedge funds? How would such a reaction function necessarily link to growth in GDP? Wouldn't the balance sheet just keep increasing in line with the leveraged basis trade? Thanks.
You are not fooling anyone. It's QE. Period. It's market manipulation by unelected officials.
What does it even mean "growing reserves in line with nominal GDP"? Nominal GDP is driven by massive deficits, ie more supply of short term bonds. What should happen when supply of bonds go up? Prices down, Yields up! We don't have a liquidity crisis. We have a supply of bonds crisis. A debt crisis. It's not the job of the FED to monetise short term bills especially when inflation is not even at target. It's financial repression. Call it whatever you want to call it but not a liquidity crisis. A liquidity crisis is when at fixed supply market participants stop lending becuase they have no confidence. When market participants cannot keep up with US deficits that's nothing to do with liquidity. It would be great if you and your friends at central banks around the world could stop gaslighting everyone with word salad.
There is no liquidity crisis. Dealers want to sell their securities to Fed, Fed gives only reserves with the repo. ⚠️ Annual net change in banking reserves is only -$64.5B !
Fascinating, as is the following FED note on keeping track of the Basis Trade
https://organon.substack.com/p/the-cross-border-trail-of-the-treasury
Excellent Vitor, such a good description of the forces at play in the interbank market. One argument for allowing SOFR to trade higher is to eliminate the incentives for many of the non-interbank function-related demand for repo. The Fed has a commitment to provide ample liquidity to the banks for ordinary interbank purposes, but it does not need to ensure ample liquidity for massive spread trading by risk-taking non-banks. This is beyond the original scope of the Fed mandate. Ensuring HFs have access to stable overnight funding is an unnecessary responsibility for the Fed to take on.
Many thanks Mark. Naturally, the regime of ensuring ample reserves has nothing to do with QE and requires a much smaller balance sheet than the one at peak QE. However, I think there are two points that must be ensured:
1- Banks changed since 2007 to a preference for higher reserves as part of their liquidity, and nowadays require reserves around 10% of GDP (FED estimation) and the FED should ensure that through it’s balance sheet policy.
2- The FED introduced the SRF in 2021, after the debacle of March 2020, in order to avoid that too high repo rates would disturb markets, requiring huge interventions, and to ensure that SOFR would not distance too much from the EFFR, as they are the two prices of money that matter.
Both tasks should be carried out regardless of which institutions that are players in those two markets benefit from the FED actions.
Spot on Mark! This is just further mission creep by the Fed. They have the banking system covered with the SRF. But I for one am happy that hedgies must be getting cold feet on their basis trades, which I think are both systemic (see this April) but also not germane to monetary policy transmission.
So any kernel of sand in the wheels of the basis trade that curtails it over time, without systemically blowing it up in one instant, is to be welcomed.
SOFR spreads at current levels are quite desirable from that systemwide perspective
Very helpful - thank you! Your piece, along with Robert Armstrong's discussion of it in the FT this morning raise some questions though. Armstrong states, "if short rates rise and become more volatile, a crucial buyer of Treasury securities — hedge funds engaging in leveraged basis trades — will become forced sellers, causing a proper market mess." True at the extreme. But why wouldn't the Fed be happy allowing rate volatility to settle in a somewhat higher range in order to force hedge funds to throttle down leverage? Relatedly, Armstrong says, "If high, volatile SOFR blows the hedgies out of their trades, it will be ugly." Again, true enough, but why is higher, more volatile SOFR treated as a singular event? Hypothetically at least, some modestly higher volatility would ensure greater resilience. Finally, if the Fed increases its balance sheet every time rate vol ticks up a bit, aren't they really just acting as hostage to the hedge funds? How would such a reaction function necessarily link to growth in GDP? Wouldn't the balance sheet just keep increasing in line with the leveraged basis trade? Thanks.
It looks like the money market squeeze was a month end thing. The SOFR is back below the iorb.
You are not fooling anyone. It's QE. Period. It's market manipulation by unelected officials.
What does it even mean "growing reserves in line with nominal GDP"? Nominal GDP is driven by massive deficits, ie more supply of short term bonds. What should happen when supply of bonds go up? Prices down, Yields up! We don't have a liquidity crisis. We have a supply of bonds crisis. A debt crisis. It's not the job of the FED to monetise short term bills especially when inflation is not even at target. It's financial repression. Call it whatever you want to call it but not a liquidity crisis. A liquidity crisis is when at fixed supply market participants stop lending becuase they have no confidence. When market participants cannot keep up with US deficits that's nothing to do with liquidity. It would be great if you and your friends at central banks around the world could stop gaslighting everyone with word salad.
There is no liquidity crisis. Dealers want to sell their securities to Fed, Fed gives only reserves with the repo. ⚠️ Annual net change in banking reserves is only -$64.5B !