Buying Persists Despite Ultra Easy Financial Conditions
By the Curmudgeon
Victor said he had nothing new to add to this weeks Curmudgeon post, but is working on a future piece tentatively titled, Financial Chicanery and Fed Sorcery. It will detail how the U.S. Federal Reserve and U.S. Treasury have created a merry-go-round system where banks can purchase U.S. Treasuries at no risk in their Held-to-maturity (HTM) securities account.
With all the news about the coronavirus, Fridays strong jobs report, Trumps celebration of his impeachment acquittal, and the U.S. Democratic Party is disarray, we prefer to not comment on those topics. Instead, we expose the dichotomy of:
1.] The Fed increasing its balance sheet (again) to liquefy the repo market (which is supposedly short of cash?) by buying Treasury bills and mortgage securities .
2.] Multi-decade lows in two Federal Reserve measures of financial market stress indicates there is plenty of liquidity to fuel financial markets.
We hope that you appreciate several eye-popping charts weve included, especially T-bills on the Feds Balance Sheet. It may be quite difficult to get your brain to reconcile them.
A Peek at the Feds Balance Sheet Trend:
Victor and I as well as many others noted that the Fed started to end its runoff program, whereby they would no longer submit proceeds of maturing securities (Treasuries and mortgage bonds) they owned to the U.S. Treasury, but instead roll them over by purchasing similar securities. Our piece was titled: Feds Balance Sheet Runoff is All About Bank Reserves; Who Does the Fed Represent?
In the graph below, one can clearly see the steady decline in the Feds balance sheet up till September 4, 2019 when the Fed commenced buying T-Bills (and later mortgage securities) to provide liquidity to the repo market. The Curmudgeon analyzed that dynamic in a blog post titled: Fed Launches New Round of QE with a Stated Different Purpose.
The hockey stick like upturn in the graph below seems to now be leveling out at $4.17 Trillionnot too far from the $4.5 Trillion peak in the Feds Balance Sheet.
The Feds Repos and T-bill Scorecards:
Total repos on the Fed's balance sheet of February 5th (released Thursday afternoon February 6th) have plunged by $85 billion from the peak on January 1, to $170 billion, below where they'd first been on October 2, 2019. This is seen in the graph below:
Under these "repurchase agreements," the Fed buys Treasury securities and mortgage-backed securities (MBS), guaranteed by Fannie Mae and Freddie Mac or Ginnie Mae, whereby the counterparties commit to buy back these securities at a fixed price on a specific date, such as the next day (overnight repo) or a longer period, such as 14 days (term repo). Repos are by definition in-and-out transactions. When a repo matures and unwinds, the Fed gets its money back, and the repo on the Fed's balance sheet goes to zero.
By buying these securities, the Fed adds liquidity to the market for the duration of the repo. When the repo matures and unwinds, the liquidity gets drained from the market. When a new repo transaction occurs, the process starts over again, but with a different amount and with a different maturity date.
Meanwhile, The Fed continued to increase its ballooning holdings of T-bills (Treasuries with maturities of one year or less) at a rate of about $60 billion per month. To increase its stash, the Fed has to buy the amount of the maturing T-bills, and it has to buy the amounts needed to obtain the targeted increase of about $60 billion a month.
Over the five weekly balance sheets since January 1, the Fed has added $78 billion in T-bills, and the total amount of T-bills on the Fed's balance sheet has now ballooned to $248 billion (see graph below). These T-bills are a major part of the Fed's strategy to bail out the repo-market. The Feds T-bill purchases are supposedly an attempt to increase Excess Reserves that Fed member banks have on deposit at the Fed (for which they earn interest and are in effect paid not to lend money).
The Fed blames low Excess Reserves last September for the banks' refusal to lend to the repo market, which then caused the repo market to blow out. So, bringing up Excess Reserves to an "ample" level is the goal of these T-bill purchases. Once that "ample" level is reached, the Fed said it will back off this program.
The Feds extremely aggressive response to the repo blowout in September, as well as their timidity in pulling back from that response could be signaling to markets that this is a Fed with a very low tolerance for market fluctuations, said Blake Gwinn, a strategist at NatWest Markets, who joined the bank last year from the markets group at the New York Fed.
The Curmudgeon believes the so called ample level of excess reserves was reached a long time ago and the Fed is disguising the real purpose of its T-bill buying which is a ploy to prop up U.S. stock and bond markets. That despite they are both egregiously over-valued from a historical perspective.
As the Fed has bought T-bills with money created out of thin air, some of that new money has flowed into stocks, derivatives (like futures, options, structured products, and ETFs) and corporate/junk bonds, pushing prices significantly higher.
Financial Stress Conditions at Multi-Decade Low:
Several analysts (and the Curmudgeon) have wondered why the Fed needs to liquefy the repos market when overall liquidity seems to be plentiful. [Victor says that its because theres not enough bank cash in the repos market, even though there are plenty of excess bank reserves].
Lets look at two measures the Federal Reserve uses to gauge financial market stress and liquidity:
1. The St Louis Fed Financial Stress Index (STLFSI) measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.
The STLFSI fell to -1.6 for the week ending January 17th (readings are monthly). That was the lowest level since the index was created at the end of 1993.
Citation: Federal Reserve Bank of St. Louis, St. Louis Fed Financial Stress Index [STLFSI], retrieved from: https://fred.stlouisfed.org/series/STLFSI, February 9, 2020.
Note: The average value of the STLFSI, which began in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress.
2. The Chicago Fed's National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and "shadow" banking systems. Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate financial conditions that are looser than average.
The NFCI was at -0.79 on January 31st, which is a smidgen higher than its multi-decade low of -0.80 reached two times in 2019. That index has been negative since January 2012, implying that financial conditions have been lose (easy money) for a very long time.
Citation: Chicago Fed National Financial Conditions Index [NFCI], retrieved from: https://fred.stlouisfed.org/series/NFCI, February 9, 2020.
How does one reconcile the continued Fed purchases of T-bills when junk bond yields are at all-time lows, stock market indices are at all-time highs, mortgage rates are at multiyear lows, real rates on all Treasuries are negative and financial conditions are at multi-decade levels of easy money?
One would think such new money creation at this time would cause accelerating inflation, but that isnt happening because the newly printed money never gets into the real economy. Instead, it gets deposited at the Fed rather than being lent out and some of it finds its way into financial markets. That is where the inflation is today!
The expansion of the Feds balance sheet whether [the Fed] calls it QE or not is good for risk sentiment, said Scott DiMaggio, co-head of fixed income at Alliance Bernstein in New York.
The Fed goes out and buy bills, the seller of bills then buys coupons, the seller of coupons then buys credit and the seller of credit buys riskier credit, said Andrew Brenner, head of international fixed income at Nat Alliance Securities. There is so much excess money, he added.
I don't mean to be disrespectful, but it seems counter-intuitive that an index measuring financial market stress can be at an all-time low when at the same time the Federal Reserve feels it is necessary to add $400 billion due to repo market illiquidity, Peter Atwater tweeted to the St. Louis Fed.
Good luck and till next time .
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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