MeanFed POMO – Permanent Open Market Operations are continuing, even as the Fed is doing $165 billion in TOMO (Temporary Open Market Operations.)
The NY Fed announced another POMO (Permanent Open Market Operation) this morning. This is part of the Fed’s program to replace the declining MBS holdings in the SOMA (System Open Market Account).
Liquidity moves markets!Follow the money. Find the profits!
The purpose of the POMO program was to keep the size of the Fed’s balance sheet stable. If the Fed did not buy these Treasuries, the balance sheet would shrink as MBS are paid down in the normal course of business. Furthermore, paydowns accelerate when mortgage rates fall. And they had fallen a lot until this month. A shrinking Fed balance sheet would drain money from the banking system.
Fed Must Do Permanent Open Market Operations – POMO
As last week’s events proved, the system no longer has any room for shrinkage, or even zero growth. The Fed must radically expand its balance sheet to maintain even the apperance of monetary stability.
While POMO merely keep the Fed’s balance sheet stable, they directly deposit cash into Primary Dealer accounts at the Fed. In addition they take a small amount of the Treasury inventories that are choking the dealers, off the dealers’ hands.
Did that help? Nope.
This POMO is Not Enough So Along Comes Big TOMO
Clearly this program was too small to forestall the problems we saw explode into view last week. The Fed was forced to suddenly do massive TOMO (Temporary Open Market Operations) to try and control spiking overnight private market interest rates that got as high as 10% at one point.
These rates were in the repo market that dealers, banks, and large leveraged shadow bank carry traders use to finance the carry of Treasury and other high quality fixed income securities. These huge players work off the skim between the borrowing cost and the income from the securities. When the repo rates spike, banks, dealer, and hedge funds are on the hook for billions in losses.
Debt Financing of the Inventory of Treasuries Is the Problem
In a story I have been covering for more than a year at Liquidity Trader, we saw that banks, dealers, and hedge funds had been building their positions in Treasuries through massive short term debt financing that was growing at a dollar for dollar pace with the increase in their holdings of Treasuries. That surge was driven by the constant increase in new Treasury issuance as the Federal budget deficit grew.
Last week, that increase in repo financing hit a wall after increasing by 54% over the past year, and by 70% since July 2018.
Borrowing capacity is not infinite. There are liquidity rules and capital rules that place limits on how much banks can lend. But the “why” does not matter. The fact is that they hit the wall last week. The behavior of the market is prima facie evidence of that. That’s what matters.
These are essentially margin loans at near 100% the value of the collateral. If that value falls, “Wall Street, we have a problem!”
Bond values fell sharply in early September. BOOM! The shit hit the fan in the repo market as borrowers suddently could not liquidate the repo loans at 100 cents on the dollar. The collateral value had fallen below the amount lent. Margin calls went out.
The Fed Had No Choice
That market is in crisis as it chokes on a constant tsunami of Treasury supply. That forced the Fed to step int and issue massive amounts of repos to replace those called in the private market. The Fed is ballooning its balance sheet by $165 billion over two weeks to help stabilize a money market. The Fed issued and is rolling over $75 billion in overnight repos every day. This week added three, 14 day repos of $30 billion each.
No doubt the Fed will also roll those over. And it will add more as needed to absorb wave upon wave of new Treasury supply that will pound away at the market, ad infinitum.
We knew months ago that interest rates would rise. It was also clear that the Fed would have to resume QE at some point. We were able to do that because we watch the banking data, Treasury supply and demand data, and Fed data closely.
The Market Always Obeys the Law
And of course, we obey the law! The Law of Supply and Demand! It applies to the Treasury market, just like it does in the produce department of your local supermarket, or at the gas pump.
So, the situation was very clear. We knew absolutely that there would be too much Treasury supply. And we knew that there was too little cash to support demand for Treasuries at the level needed to keep prices, in this case interest rates, stable.
The question now is whether the Fed’s intervention will be enough to prevent contagion into the stock and bond markets. To get the answer and follow this story as it unfolds, join me at Liquidity Trader. There, I’ll update you regularly on the nitty gritty that will keep you ahead of the curve, and enable you to act accordingly to preserve, protect, and defend, your capital.