One month ago, in a bizarre attempt to mock “QE Conspiracists” such as his current colleague and former Goldman co-worker Robert Kaplan, Trump’s chief economist Larry Kudlow and Morgan Stanley CEO James Gorman – Minneapolis Fed president and 2020 FOMC voter Neel Kashkari, also known as “Chump” for his role in arranging a bailout of his former employer Goldman Sachs alongside all US commercial banks and sticking the US taxpayers with the bill, asked “someone” to explain to him “how swapping one short term risk free instrument (reserves) for another short term risk free instrument (t-bills) leads to equity repricing.”
To help the confused Kashkari, we did just that using examples from none other than his own regulator, the Bank of International Settlements, although he appears not to have understood anything we said, because just a few days later, his former Fed and Goldman colleague, Bill Dudley, echoed Kashkari and confirmed he has no clue how monetary policy actually operates, when he wrote that the Fed’s balance sheet expansion has no effect on the stock market (we wonder if a prerequisite for working at Goldman Sachs is the complete inability to grasp how financial and monetary plumbing actually operates).
In any case, just because a couple of Fed hacks and their assorted croneys fail to grasp how monetary policy works, or are unable to comprehend what we wrote in “The Fed Was Suddenly Facing Multiple LTCMs”: BIS Offers A Stunning Explanation Of What Really Happened On Repocalypse Day“, doesn’t mean that all financial professionals are in the same boat. And sure enough, overnight SMBC Nikko’s Masao Muraki, formerly one of Deutsche Bank’s most respected strategists, has written the definitive report paraphrasing everything we have said over the past ten years on this topic in easy to comprehend – even for career economists, twitter “finance professionals” and, yes, central bankers – report, titled “Fed & Investment Bank Balance Sheet Expansion: Lifeline for Leveraged Funds” in which Muraki writes “we have no doubt there exists a mechanism by which the impact of Fed money market liquidity supply operations is transmitted to long-term rates and risk premia. First, the Fed’s balance sheet expansion likely helped reassure equity and credit market investors, indirectly impacting prices in those markets. Second, without the Fed’s liquidity injection, there was a risk Japanese financial institutions and leveraged funds, which undertake massive dollar fundraising in money markets, could have sold off long-term bonds and credit product holdings.”
Since have written on this topic over and over and over, and frankly are now tired of addressing an audience that is either mentally handicapped, or its paycheck depends on simply being unable to grasp what is actually going on, we will pull the main highlights from Muraki’s report which we urge anyone who has an even passing interest in how the Fed really manipulates markets, to read.
Today’s content is about the mechanism the markets haven’t quite recognized yet. I have been monitoring entities that undertake massive dollar fundraising through repos and derivatives in money markets and invest in long-term bonds and risk assets, such as leveraged funds and banks and lifers.
Excessive risk-taking activities of those players could have possibly been one of the causes of the interest rate spike in money markets. This suggests once the Fed decreases the liquidity injection, their leverage level would no longer be maintained and therefore they could sell off long-term bonds and risk asset holdings
This also explains why Bill Dudley was so eager to “explain” why the Fed’s tapering of QE4 won’t have an impact on markets – precisely because it will. But back to Muraki:
Costs & benefits of Fed balance sheet expansion
Impact of Fed liquidity on risk asset prices
We have no doubt there exists a mechanism by which the impact of Fed money market liquidity supply operations is transmitted to long-term rates and risk premia. First, the Fed’s balance sheet expansion likely helped reassure equity and credit market investors, indirectly impacting prices in those markets. Second, without the Fed’s liquidity injection, there was a risk that leveraged funds and Japanese financial institutions, which undertake massive dollar fundraising in money markets, could have sold off long-term bonds and credit product holdings.
Key indicators for gauging Fed balance sheet policy
The Fed likely faces a difficult choice when weighing the costs and benefits of liquidity supply operations (and the associated balance sheet expansion). We will monitor the following three factors, which we think the Fed looks to in determining policy. The outlook for liquidity (especially non-reserve liability; Figure 6)…
… volatility and tightening in money markets (Figure 7)….
… and the side effects on risk asset prices (Figure 8).
Consequences of dollar liquidity shortage
Dollar crunch in money markets
Apart from seasonality (timing of tax payments, etc), we think the surge in repo rates reflected the following structural changes.
1) Decrease in liquidity owing to monetary policy (Fed balance sheet tapering), 2) decrease in liquidity owing to financial regulations like liquidity regulations (LCR), liquidity stress tests (CLAR), recovery & resolution plans (RRP), and money market fund (MMF) reforms, 3) increased demand for liquidity owing to the stepped-up hunt for yield.
Risk-taking by leveraged funds and Japanese financial institutions
Regarding point 3 above, amid the climate of falling interest rates and credit spreads, the hunt for yield has spurred activity in the “carry trade” (Note 2), ie investing short-term money in long-term bonds in order to make money on long-short interest rate differentials (incl non-liquidity premium/term spread). The Bank for International Settlements (BIS) has highlighted the role of leveraged funds in that regard (comments in Figure 2).