The “Market Neutral” Fed

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A whole lot of misinformation has been floating around about how the Fed is adding so much liquidity to the market, much of it slyly fostered by the Fed itself. But when you look closely at the Fed’s language and, more importantly, its actions over the past week, it just is NOT so. The Fed has apparently cut its asset base by $4.5 billion over the past 5 days, not including whatever amount is fed out through the Discount Window today for the rescue of Bear Stains. Over the past two weeks it looks like they have cut about $12 billion. (For those who want to verify, you can find the data on the NY Fed website for the SOMA and the FRB website for the TAF.)

I get into more of the nitty gritty details in the daily Fed and Treasury Report in the Wall Street Examiner Professional Edition, but for now I want to address the mechanics of what the Fed has done via this supposed $100 billion increase in liquidity with the introduction of 28 day term repos that the Fed ballyhooed last week. Actually the 28 day repos aren’t new. They were used by the Fed for years until replaced by the 14 day repo a couple of years ago.

So far the Fed has done two of these 28 day term repo operations totaling $30 billion, but looking at the overall impact on the amount of cash in the system, it’s zero. The Fed did $30 billion in redemptions and sales of T-bills from its System Open Market Account holdings completely canceling the impact of the $30 billion in new 28 day term repo cash lent to the Primary Dealers (PDs). The Fed conducts all its operations through these 20 PDs, which are actually affiliates of 20 of the largest banks and brokerages in the world. 10 of these are US based, and 10 are foreign. Among the more infamous names in this august group are Countryfried Securities, the aforementioned Bear Stains, and all the other names you know so well as well as a few you don’t, but that’s a story for another time. Today I just want to think out loud with you a bit and get your feedback on the impact of these recent offsetting operations with the 28 day repos versus the bill sales and redemptions.

When the Fed engages in Open Market Operations (OMO) it uses temporary operations (TOMO) and rarely, permanent operations (POMO).

In temporary operations the Fed loans money to the dealers for short terms, usually overnight, but up to 28 days, in the form of repurchase agreements. Repurchase agreements put cash into the PD accounts and expand the System Open Market Account (SOMA) portion of the Fed’s balance sheet. They rarely use reverse repurchase agreements to drain reserves, but we have seen them from time to time.

The Term Auction Facility (TAF) introduced in December, is not the issue here. It is not included in the SOMA, but it is part of the Fed’s monetary asset base and is reported as a separate line item. The TAF is not directly related to this discussion, but you should be aware that the Fed is canceling out the TAF money too. It has not added new money to the system via the TAF.

In permanent operations (POMO), the Fed buys or sells securities directly between the SOMA to the Primary dealers. When the Fed buys securities it used to be called a Coupon Pass, or Bill Pass, but the Fed no longer uses that terminology, now preferring the term “permanent purchase”. These have been few and far between this year. Permanent purchases put cash directly into dealer accounts, and increase the size of the Fed’s assets on its balance sheet.

Lately the Fed has been redeeming many of the T-bills they hold when they come to term. This does not directly impact PD accounts, but it does impact the Fed’s balance sheet, the monetary base, by reducing the assets the assets the Fed holds. The Treasury must pay off the bills. This momentarily takes cash out of the system, but the Treasury needs to replace that cash with another borrowing, this time from the market, rather than from the Fed. It forces the market to put up more cash for Treasury paper. The Fed has been responsible for some of the increase in Treasury borrowing due to these redemptions. When the PDs buy the Treasuries, they can then pledge them as collateral in return for cash in Fed repo operations. This is why on days when the Treasury has large new borrowings settling, usually Thursday, we usually see big increases in Fed repo operations on Wednesday and Thursday. The Fed has to enable the PDs to pay for the Treasury securities they have ordered.

The Fed can also sell Treasuries directly from the SOMA. In the 6 years I have been watching the Fed daily, this last week is the first time I can remember the Fed doing this. They did it in an amount, when combined with bill redemptions, that was equal to the amount of 28 day repos issued this week, $30 billion. The Fed issued temporary money in return for T-bills which were due to mature in the short run, in most cases a couple of months. This exchange initially made little sense to me because it is a wash. They took cash in from the PDs in return for Treasuries, which the PD’s now use as collateral to replace the cash the Fed took in.

Short term Treasury paper now has a negative carry. Repo rates are higher than the yields on shortest term Treasuries. It costs the dealers money to carry them. On the other hand, MBS and Agency paper still has a positive carry, as do longer term Treasuries. So what advantage is there to putting more short term Treasuries into dealer accounts? Unlike the MBS paper they hold, the dealers can sell that paper. They need not borrow from the Fed to carry it. So they get the cash back on their balance sheets. They also have the cash from the 28 day repos for which they have put up the Agency and MBS collateral which is burying them.

Does this amount to a big deal? I have to think about it some more, but it would seem to at least give them breathing room. It certainly doesn’t add reserves to the system as a whole when considering the offsetting effects of the Treasury sale and the equal amount of repos, but it would seem to have the effect of giving the PDs a little more cash on their balance sheets while keeping the impact on the system net neutral.

The dealers are the Fed’s wholesalers to the banking system. The wholesalers cut the stuff and add filler called margin just like drug dealers when they push it out to the system. The Fed has added exactly the same amount of repos as it subtracted via the bill sales, so it is absolutely net neutral system wise, but it changes the dealers asset mix to a higher proportion of cash versus securities, since they would immediately sell the Treasuries they just bought from the Fed rather than hold them at a negative carry, plus they also have the 28 day repo cash. So what it does is change their asset mix, but it doesn’t add a nickel to the monetary base.

The Fed is just playing the old street corner shell game in its attempt to manage expectations. It wants to keep its actions neutral as far as the Fed Funds target and the overall amount of liquidity in the system. They said as much in their various postings regarding the new programs, and confirmed it with me in a direct conversation I had with an official at the Fed. In my mind this is much ado about nothing. The Fed is pulling lots of levers while running in place in a desperate attempt to stop the hemorrhaging.

Frankly, I don’t know if there’s much more than it can do.

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