Thread by @biancoresearch

1/13

🧵on the stresses in the funding markets, why they are happening, and what it means. Be sure to see the last two posts (12 and 13).

Funding rates are rising relative to the Federal Reserve's administered rates (bottom panel arrow).

This signals stress in funding markets.

2/13

Another signal of stress is that the Fed's Standing Repo Facility (SRF) is getting used regularly, a new record on Friday.

If money is too expensive, banks can borrow from the Fed at 4.00%.

Note that only 40 banks are counterparties, no broker/dealers, no hedge funds. Limited

3/13

The Fed sees the stress and is ending Quantitative Tightening (QT) on Dec 1.

This will end Fed balance sheet shrinkage and slow the decline in bank reserves, now at a 5-year low.

Lower bank reserves mean banks have less ability to supply funding to the markets.

4/13

Why should we care?

Funding markets supply more than $3T/day in cash/liquidity (orange). By contrast, the fed funds market is less than $100B/day.

Rising repo rates are undoing the Fed's rate cuts by raising short-term rates, with no signs (yet) of a reversal.

5/13

To recap, funding stress is driven by rising demand (SOFR volume has more than doubled in the last 2 years), while supply is falling (bank reserves declined to a 5-year low).

This has finally reached the point that funding is getting scarce, so its cost (repo) is rising.

6/13

What to do about it?

Dallas Fed Pres Logan, who previously ran the NY Fed open market desk, on Friday

IF RECENT RISE IN REPO RATES TURNS OUT NOT TO BE TEMPORARY, FED WOULD NEED TO BEGIN BUYING ASSETS

Quantitative Easing (QE), "money printing."

7/13

What is the risk of restarting QE?

It distorts the markets and the economy.

First, after the Fed started QE in 2009, it was rocket fuel for markets.

Fed Chairman Ben Bernanke crowed about it at the time.

8/13

And overlaying the stock market (orange) and the Fed's balance sheet (blue) supported this idea.

9/13

And during the post-financial crisis period, 2010 to 2020, there were no signs of core inflation (orange) reacting to the Fed's balance sheet expansion (blue).

But that changed following COVID in 2020. Inflation and the Fed's balance sheet are now moving in tandem.

10/13

What changed?

Federal spending as a % of GDP is 23%, one of the highest levels in the last half-century and higher than during most recessions.

Only the financial crisis and COVID saw higher spending levels.

Five years after COVID, spending is still at crisis levels.

11/13

Massive government spending means massive deficits.

And these deficits need to be financed. And trillions of that financing comes from the repo market, which again, doubled in size over the last year.

"Nothing stops this train" -- @LynAldenContact

12/13

When Does The Bond Market Care?

A credible argument is NOW given the stress in the repo markets that has emerged in the last few weeks. This stress stems from the ever-increasing demand to finance $38 trillion in debt —100% of GDP —on its way to $40 trillion, which is outstripping the supply of liquidity, thanks to QT, to do so.

If stopping QT on December 1st is not enough, the Fed will have to supply more liquidity through QE (see Lorie Logan) or possibly a massive expansion of the SRF.

Either way, the Fed is supporting the continuation of massive government spending — spending as if we are in a crisis — and fueling sticky inflation well above the Fed's 2% target five years after the COVID shutdowns ended.

If the Fed denies additional liquidity through QE/SRF, a funding crisis worsens, leading to broader financial problems.

Fix Without QE?

One way is for Washington to cut spending. Currently, the opposite of this is happening. The Government is presently spending record amounts for a non-crisis period (% of GDP), yet it is shut down over demands to increase spending even further.

The other way is for financial markets to force a spending reduction upon Washington via higher rates. Stress in the funding market is an early sign that the markets are starting to raise rates. The problem with this method is that it is messy and chaotic.

13/13

Last week, we posted a version of this chart to illustrate the "K-Shaped" economy.

Those in the upper incomes are doing well, as illustrated by the stock market (red).

The broad masses are down on the economy, as indicated by flagging consumer confidence (blue).

(More thoughts/comments on the K are in the retweet below).

Our concern is that the current K-Shape, shown as the lighter gray arrows, is placing significant strain on the culture/economy.

QE, or the expansion of the SRF to keep repo rates from rising, is the Federal Reserve allowing financing for even more government spending at manageable levels. This "cheap money" will drive higher stock prices and encourage even more government spending, fueling more inflation, widening the inequality gap, and further straining the culture/economy.

The dark gray arrows illustrate this, signifying a widening of the inequality gap.

If the current K-Shape inequality is helping to vote socialists into office now, widening the K-Shape risks turning it into a full-blown movement that sweeps the country.

Widening The Pipes

Too many are treating this stress in funding markets as a plumbing problem. They are correct, but this is a too-narrow view.

When the reservoir is running low, asking the plumber in the basement to install larger pipes might work for a short time, but it won't "fix" the problem.

Too many commentators on the stress in funding markets are taking this approach, throwing out technical solutions and legislative changes to fix it.

Examples:

* Encouraging greater use of the SRF (note that it is currently constrained by a stigma against its use, as it is perceived that only troubled banks use it, and only 40 banks are counterparties, no broker/dealers or hedge funds)

*The Fed should buy low-duration Treasury Bills via open-market operations (aka "not" QE) rather than longer-duration notes and bonds (aka QE).

* Make changes to the banking supplemental leverage ratio

* Switch the Fed's target interest rate from fed funds to the tri-party repo rate.

All of these are good technical suggestions, but they are akin to installing larger pipes to get water from a low reservoir.

More concerning is the assumption behind technical fixes: that the stresses in the funding markets are consequence-free. It only needs a technical fix, and the problem goes away without affecting anything else.

The problem is that the Government continues crisis-level spending without a crisis. This is pumping up financial markets and keeping inflation high, worsening inequality, and stressing the culture/economy. This will encourage an even bigger backlash.

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