Why further strength in risk assets doesn't have to depend on Fed rate cuts

Original source: @concodanomics, monetary policy analyst Original compilation: BlockBeats The liquidity reduction in the global market has begun, and hundreds of billions of reserves will leave the system. But not only may this reduction fail to curb risk assets, it could also lead to a tightening of covert markets, allowing the Fed to ease again without needing to pivot, where liquidity in the repo market will play an important role.

More recently, we have witnessed the effects of “policy blips,” where the Fed’s silence and inaction on tightening policy has caused the financial machine to drive risky assets soaring. "TGA Supplement" Fails to End Most Nasty Rally in History - Market Needs More Tightening.

The US government is replenishing its bank accounts (TGA) to pay the bills while reducing the Fed's balance sheet through QT (quantitative tightening). If the ensuing drawdown of reserves is too severe, the Fed could be in for a surprise in the most critical funding market...

The repo market is the lubricant of the financial engine of the US empire. Without it, dollar liquidity would be dull. Bundling the Treasury cash market and the futures market through arbitrage trades (such as futures basis spreads) is just one of its many functions.

But most importantly, the repo market has allowed "secured" dollar loans to flourish around the world. It looks complicated, but it's really just a market that matches cash lenders (like money funds that have to invest in plain dollars) with cash borrowers (like hedge funds that have to fund leveraged positions).

This became clear when Conk's Repo Market Conga (Repo Conga) was revealed. The repo market is a chain of market participants looking to profit by charging a spread on top of funding costs. Cash lenders make loans to “sophisticated” borrowers through dealers, who charge spreads as intermediaries.

In a typical "conga dance," money market funds (MMFs) lend to the Fed's major dealers, who in turn lend to smaller securities dealers, who then lend to leveraged investments such as hedge funds provide loans. The goal of the repo market was to provide a steady stream of liquidity, and it succeeded in spectacular fashion.

The repo market consists of multiple segments, each of which plays a unique role in providing liquidity. At the top, tri-party repos allow cash lenders (mainly asset managers such as MMFs) to lend primarily to the Fed's primary dealers, who are tasked with distributing cash to the rest of the repo market.

Major dealers then try to profit by borrowing these funds in the “dealer-to-dealer” market and charging higher spreads. Smaller securities dealers will charge higher fees for lending cash to customers in a "dealer-to-customer" market...

At least, that's how the repo market is supposed to work. However, in recent events, increased market complexity, and even excess liquidity, have become problematic. But ironically, this will give leaders a specific "non-QE" tool to stimulate the market, namely "repo market redemptions".

In September 2019, the "repocalypse" appeared in our sights. Money market rates and even the Fed funds rate, the Fed's key policy rate, surged above the target range. The Fed's response marked the beginning of a shift from an "excess collateral" to an "excess cash" regime.

After trying to reduce its balance sheet with the first official QT (quantitative tightening), the Fed performed a 180 and restarted QE (quantitative easing), injecting reserves into the banking system to pull interest rates back to Within the scope, the cash flood has begun since then.

Then, just a few months after the "repo market crisis" and the subsequent round of QE, the COVID-19 market panic set in. Amid unprecedented uncertainty, the Fed has injected huge reserves to curb illiquidity in every key market, from foreign exchange swaps to eurodollars.

The Fed's monetary policy finally eased the financial panic, but QE continued. In 2021, reserves have become even more abundant. However, the flood of cash did not stop at the US central bank, with the US government accumulating record balances in its checking account TGA (Treasury General Account) by the end of 2021 after a sharp rise in expected benefits. This unlocks more liquidity when the government sends funds in the TGA to the banking system.

"Neutralization reserves," cash balances that cannot be invested in the economy or financial assets, are turned into liquidity reserves and fed into the banking system, prompting banks to create deposits to balance their books. The "cash flood" reached absurd proportions, and even before that, just after the COVID market panic was at its peak, the cash glut was so bad that regulators were forced to allow banks to bypass regulations imposed on the size of their balance sheets limit.

In April 2020, regulators exempted U.S. Treasuries and bank reserves from the SLR (Supplementary Leverage Ratio), a regulation that limits the amount of leverage certain financial institutions can achieve. As a result, Wall Street absorbed the excess money. The flood of cash has been hampered.

At least, for the time being. More than a year after the COVID market panic subsided, the SLR exemption expired during the most significant monetary mania in human history, causing banks to dump hundreds of billions of (now “excess”) reserves. This money has to go somewhere, and after considering all options, banks start reducing deposits by removing the incentive for customers to deposit, i.e. charging negative deposit rates and rejecting new funds, the next best thing to do for this excess cash is the reverse of the Fed purchase operation).

Investors assess risk/reward and regulations following the reinstatement of leverage limits in April 2021. Subsequently, money poured into RRP as investors believed MMFs were the best investment. Cash lenders prefer financial security and liquidity over returns. Money funds are ideal, so the trillions in fiscal stimulus end up flowing into the Fed's RRP. The main financial pipelines - those of the big banks and major dealers - are already blocked. As a result, a "cash flood" was channeled into MMFs, which invested heavily in the Fed's reverse repo operations.

The Fed's RRP is now the benchmark for measuring the balance between excess cash and collateral in the system. Cash is likely to be abundant if global financial giants channel funds into RRP. Unless the RRP balance drops to zero, there will still be too much money in the system.

In fact, cash is so plentiful that some repo rates are already lower than the Fed's RRP, the risk-free rate in the repo market. A series of QE, government spending and regulation has broken the Fed's lower limit. Even the Fed managed rates (TGCR/BGCR) are now lower than the RRP rates.

Since only certain entities can use the RRP (i.e. major dealers, government-backed businesses such as Fannie Mae, and most prominent money market funds), all other entities must accept the lower rate at a deep discount to already fully funded transactions Providers provide loans.

Unless the trillions in excess cash somehow disappear (marking the end of the era of "excess cash"), the use of the Fed's RRP facility will remain elevated and some repo rates will fall below risk-free territory. Liquidity will remain ample and a repeat of 2019 is in doubt.

But that too may change, as the era of trying to return to "excess collateral" has begun. QT and "TGA Supplement" will remove bank reserves from the system. Moreover, the spike in repo rates was only possible due to the inherent nature of the repo market. Today, however, this is unlikely to happen as the RRP is flush with cash.

If rates start to spike like they did in 2019, the trillions in the RRP will serve as the penultimate line of defense against a “repo market crisis.” Cash lenders will withdraw cash from the RRP for higher yields. If they refuse, the Fed's SRF will act as a lender of last resort, "non-QE".

Unlike the response to the 2019 repo market crisis, trading in the repo market is expected to be seen as stimulating without the need for the Fed to restart QE. It would serve as another tool to boost risk sentiment while again avoiding an "official turn".