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Wednesday, January 13, 2016

Comments On Fed Open Market Operations

In this article, I am attempting to respond to a question from a reader regarding the Fed Temporary Open Market Operations. I have not delved into the recent trends in these operations, as I believe that they have essentially no implications for anyone who is not working in the U.S. dollar money markets.

I was asked in a comment:
Can you do a post explaining the impact of temporary open market operations and their impact on liquidity and risk?
Is the fed draining less and less excess liquidity through TOMO because market risk is increasing and therefore nobody wants to lend this excess liquidity?
These operations are conducted by the New York Fed, and are described here.

What To Worry About In The Money Markets

An investor or economist should be rightly worried about any news regarding disruptions or dislocations in the money markets. Pretty well any serious financial crisis within the developed economies involves the money markets. Stock markets can crash, but this only effects the people who own those shares. A seizure of the money markets cripples financial flows within the economy, and activity would rapidly grind to a halt.

However, what matters within the money markets are the private sector instruments, as these are needed for financing activity. Dislocations in the market for (central) government backed instruments is only of interest to the people directly involved in those markets, as the Federal government is always going to find a way to keep its financing operations rolling. We should not mix up the repo market for Treasury bonds for a market that will actually have an effect on the real economy.

What Are Repos?

I have a longer article on repurchase agreements ("repos") here. The brief summary is that a repo is an agreement to buy and sell back a security, which is economically equivalent to lending to someone using the security as collateral. The term of the "loan" can be either overnight or for a term (such as 3 months).

Repos are a secure form of lending. In the case of Treasury repos, the "loan" is backed by two entities: the "borrower" as well as the U.S. Federal Government (which backs the Treasury collateral).

(The linked NY Fed page refers to both "repurchase agreements" and "reverse repurchase agreements - "reverse repos". The distinction between a "reverse repo" and a "repo" is just an arcane point of trader jargon; they are the same type of agreement, the name just reflects which side of the trade the dealer is on. Unless you are on a trading desk yourself, all you need to know is that one side is effectively lending money to the other against collateral.)

If you run a money market fund that can trade Treasury repos, you can use them as a replacement for investing in Treasury bills. Lending money in a 3-month repo agreement is pretty much the same thing as buying a 3-month Treasury bill, other than some legal and accounting details.

What Is Happening?

It is difficult for two instruments that are economically equivalent to have wildly different pricing. For banks, excess reserves are equivalent to either lending via repo, or purchasing Treasury bills (where we are looking at the expected average of interest on reserves over the lifetime of the instrument). Banks will always gravitate to the instrument with a higher yield. However, non-bank investors cannot hold reserves. This means that it is possible for the other instruments to have slightly lower yields than the interest on reserves, as theses investors cannot shift positions towards reserves.

The Fed temporary open market operations are designed to even up this imbalance. The Fed undertakes repo operations with a wider range of counterparties at a level near the interest rate on reserves. This reduces the odds that investors will be forced into "too low" yielding an investment.

Since investors can allocate into other assets (such as slightly longer maturity instruments, or credit), they will avoid instruments that are "unfairly" priced versus interest on reserves. Subsidiaries of banks are involved in repo market making. Bond investors will not be amused if they are receiving an interest rate well below what their counterparty bank is getting on its reserves. (The money lent via repo would probably end up as excess reserves.) Although a certain amount of rent seeking behaviour amongst market makers is expected, there are limits to what is acceptable. You do not want to get bond investors too annoyed with you if you are a highly levered financial entity that continuously needs to roll over debt.

Since the spread is driven by some qualitative factors, there is not going to be a hard and fast rule telling us what size of operations by the Fed will be needed to keep repo rates close to the rate of interest on reserves. In any event, I doubt that the spreads are likely to be significant (greater than 40 basis points, say; interest rates are still too close to zero to see whether the spread is significant).

Changing the financing rate on Treasury bonds theoretically should affect fair value. However, if the deviation of the financing rate from the policy is short-lived, the impact on long-duration instruments would be insignificant when compared to the volatility of rate expectations. Term interest rates are falling because the FOMC decided it was a bright idea to hike interest rates when the global commodity complex was melting down, and not because of imbalances in the repo market.

What About The Rest Of The Economy?

People often fear that "draining liquidity" will be a negative for asset prices. The Fed operations do not pose any particular danger (other than psychological). Their auctions will only be taken up if repo rates are too low relative to the rate of interest on reserves. That is, they want to remove the ability to finance Treasury positions at an abnormally low rate. Returning a financing market to normality can hardly be considered risky. Nevertheless, this tells us nothing about the ability to finance positions in private sector securities. My guess is that those conditions are not looking particularly great right now, but these open market operations are broadly beside the point. Changes in the monetary base are not going to induce investors to lend money to firms that they suspect are marching towards bankruptcy.

(c) Brian Romanchuk 2015


  1. "You do not want to get bond investors too annoyed with you if you are a highly levered financial entity that continuously needs to roll over debt."

    What else are they going to do with the money? :-)

    It always has to go somewhere.

    1. Well, money won't go to businesses that are on the edge of default. And if you are a levered financial firm, all you need to do is annoy your funding base to put yourself on the edge of default.

  2. Thank you very much for this post. I will spend the weekend reading it in more details.

    On the topic of Japan (un-related to this topic, but you've written about JGB's before). Now that Kuroda essentially said that easing is done, what do you think this means for JGB's, yields and inflation expectation?

    1. I think that JGB yields are crazy low; unless they do aim for negative rates, the only way the policy rate can move is up. A 10-year bond should have some form of risk premium to account for that. It does not have to be a huge premium, but I would be nervous with a 10-year yield less than 1%. Ending JGB purchases by the Bank of Japan would allow this to happen.

      That said, things are looking pretty ugly right now. Japanese investors have large positions in foreign financial assets, which are hurting due to yen strength and risk asset price declines. It would be difficult for JGB yields to rise in this sort of investment environment. We would need some sign of renewed global growth to get any movement in JGB yields. I have a bearish world view, but I can see reasons for things to bounce back, so that we end up with growth rates similar to what we saw earlier this cycle. (Those growth rates were not spectacular, but better than nothing.)

  3. There is a paradox inherent in the operation of money and credit markets populated by banks and other financial intermediaries. In the context of US markets suppose banks hold a small but stable pool of reserves provided by Open Market Operations of Fed. If non-banks are perceived as creditworthy, banks will generate net new deposits via extension of new loans at a rate that exceeds the repayment of old loans. This causes the aggregate bank balance sheet to expand. Loans will be spent from borrowers to producers and savers, which do not want to hold checking deposits, so these units will purchase other investments in banks including savings deposits, term deposits, bonds, and paid-in equity. Some depositors will purchase shares in money market mutual funds, this causes banks to lose deposits, which would cause the bank balance sheets to shrink, since assets = liabilities + equity, however if the banks borrow from money market managers via repo then the aggregate bank does not have to shrink, it merely has to deal with money managers rather than the other types of depositors, and money managers treat repurchase agreements as secured deposits. So prior to the 2007-2008 financial crisis the financial intermediaries could convert loans into deposits and deposits into investments in banks and other financial intermediaries. The leverage of the FIs went up based on the ability of FIs to rollover investments in money and credit markets.

    During the crisis many non-bank non-financial intermediaries did not know which FIs were holding portfolios with junk loans that would require a write-off of assets. The write-off of assets requires an expense against equity. The system that appeared to be well-capitalized suddenly did not appear to have sufficient capital to absorb the write-off. Investors do not want to lend in credit or money markets to financial intermediaries that are about to take a large write-off. In theory, the money and investments must go somewhere, but in reality, money and investments are not conserved (like electric charge), but are generated and destroyed via the net rate of deals, repayments, and defaults. The rational non-banks would in aggregate attempt to withdraw investments from the leveraged financial intermediaries. Paradoxically, if a central bank or government is not available to provide liquidity in such a crisis, the markets will be driven into reverse, the financial intermediaries must sell financial assets to raise money, but banks create money by expanding assets, and destroy money by selling assets. This means a market system that has no lender of last resort (central bank) and investor of last resort (govt bailouts) will destroy money and investments whenever society attempts to convert investments into money. This paradoxical outcome is called a balance sheet recession or great depression. It is characterized by systemic defaults and lack of trust in financial markets for significant periods of time.

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