The new Fed TOMO (Temporary Open Market Operations) are the first sign that the Fed must move aggressively to counter the tightening of the money markets.
Now, I’ve been forecasting this for months in Liquidity Trader. We were well aware the massive waves of Treasury supply would collide with a shortage of cash. We also knew that the exponential growth in margin and repo lending would end badly. But the necessity for the Fed to act aggressively has come upon us much quicker than I thought it would.
And this could be a game changer.
The Fed Has No Choice- It Must Print
The Fed must print wads of money to counter the immense supply pressure of wave upon wave of newly issued US Treasury securities of all durations. This supply pressure will virtually never end, as the government finances a booming US economy with constant, massive deficit spending, or, what some call “defecate” spending.
The Fed has actually been tight since 2014. It got tighter in 2017 with “normaliztion” of the balance sheet. The ECB and BoJ effectively tightened in 2018. All 3 of the big boy central banks were forced to reverse course over the past couple of months. The ECB is loosening more aggressively than the Fed. The Fed had merely gone from tight to less tight.
Until this week. Suddenly, the Fed has been forced to become loose, very loose.
That’s because there’s no longer enough cash in the system to absorb what the US government deficit spending dumps on to the market. The shortgage of cash has meant that dealers and others have been forced to use debt in the form of repo and margin borrowing to finance the ever growing wads of US TP (Treasury paper) bombarding the markets.
With Cash Shortage, Fed Must TOMO Repo
If the Fed wants to maintain the appearance that it controls interest rates, it has no choice but to print the cash needed to buy up enough paper to keep private market short term rates from continually spiking to 5-10% as they have this week.
The Fed’s instant reaction so far has been to use the tool of Fed TOMO — Temporary Open Market Operations. It began issuing repos, overnight repurchase agreements, which are nothing more than overnight loans to Primary Dealers.
These loans enable the dealers to finance and carry the record and growing levels of Treasury inventory that they’ve been forced to carry. This forced carry has grown as the Federal government’s deficits grow, and the Treasury issues debt to fund them.
We Saw This Coming; The Fed Must Be Blind
How can the Fed not have seen this mess coming? We saw it. It’s so simple — basic supply and demand stuff. The supply of paper has been growing. And unlike during the QE era when central banks were either buying or financing the equivalent of all new US government debt issuance every month, the Fed stopped doing that in 2014. It even went into reverse from October 2017 to August 2019, pulling money out of the system under its program of balance sheet “normalization.”
But even that ended last year. So the dealers had no choice but to finance those inventories with debt, and boy did they ever. The problem now is that they are leveraged to the hilt as they hold record levels of inventory. This is not a good thing. As a result, the Fed is now forced to do TOMO, and probably soon, POMO (Permanent Open Market Operations).
Why Tight Money and Excessive Leverage Haven’t Yet Triggered Cataclysm
There are a couple of reasons that this massive increase in leverage hasn’t already caused a cataclysm was that the ECB and BoJ were still printing until 2018. Many of the correspondents of those two Fed cohorts are US Primary Dealers. So for a time they had enough cash to finance their growing inventories.
When those market support programs ended in 2018, and the Fed went into draining mode, the dealers and others stepped up their borrowing to finance their record purchases of Treasuries. Negative rates in Europe also helped to drive money out of Europe and into the US markets.
The Grace Period Has Ended- Fed to the Rescue
We now have clear evidence from this week’s money market dislocations, that the dealers and other big players have reached the limit of their ability to absorb.
So the Fed stepped in on Monday with massive repo operations, offering the dealers a mind boggling $75 billion in a single operation.
Just to give you a little perspective, back in the old days pre the Great Financial Crisis, TOMO was a daily thing. The Fed kept system reserve balances to a minimum so that it could control the Fed Funds rate by adding and subtracting a small amount of reserves each day.
Banks that were short of reserves borrowed those Fed Funds from other banks or the Fed, to maintain reserves at required levels. When the Fed Funds rate rose above the target, the Fed added money to the system via repo operations.
Before the Fed commenced its alphabet soup menu of financial system rescue programs, in the last year of regular TOMO, 2007, the financial system was already under stress. But the Fed kept attempting to maintain the appearance of normalcy. The Fed’s repo operations were typically never more than $10 billion daily.
Contrast that with this week’s daily operation of $75 billion. On Tuesday, the beginning of this program surprised the dealers. They could only get their act together to take up “just” $53 billion. But by Wednesday they bid for $80 billion. And when the the Fed rolled the operation over again on Thursday, the demand rose to $83 billion.
I suspect that this number will keep growing, particularly at the end of this month when the dealers and investors must absorb another $70 billion of new Treasury paper.
Next Up, The Standing Repo Facility
What will the Fed do then? The market won’t suddenly have $70 billion in cash lying around to absorb that. Will the Fed simply add to the existing $75 billion in repos it has already issued?
It brings to mind the Fed’s discussions of instituting a “standing repo facility.” That neat trick would simply allow the Fed to issue whatever amount of repos were necessary to fund the Treasury market ad infinitum. This would be QE without calling it QE. It would add up to the amount of the Federal deficit, to the Fed’s balance sheet each month. That’s projected to run at an average $100 billion per month as far as the eye can see.
Return To QE is Next
Or will it simply throw up its hands and offer to buy it all through Permanent Open Market Operations (POMO). That would be a return to overt QE. But if they can’t allow the repos to expire and instead must perpetually roll the over, then TOMO is effectively a stealth QE.
Powell said that they’d study the issue for the next 6 weeks.
You don’t have 6 weeks, Jerry. The market is saying, “Show me the money.” Now.
Tightening Money Market Was Baked In, Foreseeable, and Foreseen
Yesterday I got into a discussion with my old friend Jorma, who has been posting on the Capitalstool.com message board for 17 1/2 years. He said:
I still think the little kerfluffle in the overnight the last 2 nights was scripted. If not it just as well have been. It was sort of baked into the cake, easy enough to pull off.
I don’t think so. Money market conditions have been tightening. The tightening was foreseeable and conditions will only get worse from here.
If the Fed really intends to keep Fed Funds below 2%, these gargantuan repo operations will quickly become a feature. They will grow to the point where issuing and rolling hundreds of billions in repo will soon require a return to $100 billion per month in QE.
Will New QE Inflate Asset Prices Again?
Under normal conditions, that would drive another massive inflation of asset prices. But with the Treasury’s insatiable appetite for huge deficit funding for as long as we can imagine, this time could be different. The Fed may ultimately have no choice but to allow rates to rise to the levels the market would require without massive intervention. God knows what that level is.
In the meantime the Fed will try to fight the upward pressure on rates with massive QE, whether stealth QE via TOMO, or outright QE via POMO.
Show us the money Jerry!
Follow this Money Saga Right Here
In 2002 I began tracking and charting the money that the Fed pumped into Primary Dealer accounts each week. The chart achieved some notoriety when Rick Santelli featured it on CNBC. I still update it weekly, and post it in Liquidity Trader on a regular basis. I’ve also reported regulary on the fantastic explosion of repo finance supporting the Treasury and stock markets with this chart.
You can follow these indicators and more, along with my analysis and recommendations by subscribing to Liquidity Trader today.
You can get up to speed right now, with instant access to the current report, all past reports, and the next report ahead. Try Lee Adler’s Liquidity Trader risk free for 90 days! Satisfaction guaranteed or your money back.
Get the First Month Free and 90 Days Risk Free If You Join Now
Subscribe by 3 PM Eastern Time Thursday, September 19 and get the first month free!
Free first month, and 90 day risk free trial offer is for first time subscribers only. Quarterly billing will begin on the 31st day unless you cancel before that date.