The assumption has been that ON RRP drainage was protecting bank reserves and that, only once these reserves started to fall would we have to worry about a rerun of 2018. The Fed also now has a backstop for the banks — the Standing Repo Facility — that can be drawn down in the event of unexpected liquidity squeezes. But the ON RRP may have been playing an altogether riskier role in bond markets — financing the proliferation of the so-called hedge fund 'basis trade’, whereby hedge funds borrow to buy Treasuries and sell Treasury futures to make a tiny return, leveraged up multiple times. This trade has caught the attention of regulators on both sides of the Atlantic. The problem is that the basis trade is financed in the private repo markets, and it is money market funds — drawing down their ON RRP cash — that are financing this trade. The box diagram below, from the New York Fed, shows how ON RRP money can end up financing hedge funds (“Non Bank Financial Institutions”) repos:
Levered NBFIs Purchase New Treasury Securities © New York Fed This has created the possibility of a worrying chain reaction — from the Fed’s balance sheet, via the money market funds and the private repo market, through the basis trade and on to the demand for Treasuries, at a time when the US government is coming to market with massive amounts of issuance. Instead of scarce bank reserves creating liquidity problems and forcing the Fed to stop QT, it may well be the exhaustion of the ON RRP and the upending of the hedge fund basis trade that causes problems in 2024. The worrying difference now is that there is no Fed backstop for hedge funds and the high degree of leverage used in the trade could lead to liquidity problems proliferating even more quickly through the financial system. It seems unlikely that the Fed is unaware of this issue. Indeed, it may be no coincidence that Fed messaging on QT is already shifting, with Dallas Fed President Lorie Logan already suggesting that QT should taper once the ON RRP runs dry. This may be too late to avert a severe bout of bond market volatility, though. Either way, the Fed is on course to end QT and restart QE in the coming months, against a backdrop of loose fiscal policy and a still-resilient economy, opening the door to a reappearance of inflationary pressures that the Fed may have little appetite (or ability) to restrain. Further reading — 'Slower for longer’ |
|