As I was walking down the street one day, a man came up to me and asked me what the time was that was on my watch, yeah....And I said...
Does anybody really know what time it is? Does anybody really care?
If so I can't imagine why, we've all got time enough to cry...
Robert Lamm in the debuting Chicago Transit Authority wrote that great song about people who were running around worried about what time it was while the important things in life were passing them by. This is how I think market participants are viewing monetary policy. All they care about is when the Fed will start raising interest rates; they are seemingly uninterested in the details of how the Fed will orchestrate such an unprecedented tightening of policy.
This week the FOMC will meet, and by all accounts everyone is going to be running around focused on those ridiculous dots that forecast where Fed officials see the target Fed funds rate at year-end. At the March meeting, most members saw the Fed funds rate at 1% by the year-end 2015, and between 2%-3% by 2016. The longer-run objective continues to be 4%.
Before we worry about when they get to 2%, or the highly optimistic 4% longer-run objective, we need to see if and how the Fed will get overnight rates simply to 25 basis points. What is the magnitude of reserve drainage that will need to occur before it can even attempt to get rates off the floor? I don't think anybody really knows. For that matter we don't even know if the Fed is going to use the funds rate as its primary policy tool.
Nevertheless, Fed officials keep talking about when they will raise interest rates, as if this is the same rate-targeting regime of previous cycles. The focus is on whether it will be sooner than market participants expect. However the devil is in the details. I think that actually physically raising interest rates in this quantitative regime is going to prove much more difficult than simply talking about raising rates, something officials have done with ease.
On Wednesday at an investment conference, JPMorgan (NYSE:JPM) CFO Marianne Lake outlined the exit process the bank was preparing for, raising some risk management hurdles. Considering no one knows exactly how the Fed is going to execute this tightening (including the Fed), JPMorgan is likely on the forefront of developing the framework, making its statements on the matter highly relevant and most significant. Lake said the following (emphasis mine):
In terms of sequencing, what we expect is that the Fed will seize asset purchases by the end of this year. The likely next step would be to drain liquidity from the systems, potentially as much as $1 trillion or so using the reverse repo facility with non-banks. This is likely to happen over a short period of time, maybe a quarter or two and probably in the second or maybe in the second-half of 2015. After which the Fed funds rate will start to raise and lastly reinvestment in order to shrink the remaining balance sheet, but over time.
The second important assumption we're making is that as rates continue to normalize over time, we're all likely to also see a migration of stickier high quality retail deposits in favor of more attractive rates in money funds. We think ultimately those deposits will likely find their way back to bank balance sheet in the form of wholesale deposits, which of course is very important particularly in light of regulatory liquidity standards, when notably, if you take a retail deposit that has a low outflow assumptions and ultimately replaced with a wholesale deposit that has a high outflow assumption, it could substantially reduce your liquidity.
This is a remarkable statement coming from JPMorgan, the largest US depository. It sounds like it is hunkering down for a rapid and sizable reduction in balance sheet liquidity. This concern raises an important issue, because since the financial crisis, US bank deposits have become highly concentrated. Of the approximately $10 trillion in US deposits at the 25 largest banks, roughly half resides on the balance sheets of the four largest banks: JPMorgan, Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), and Citibank (NYSE:C), who all control about $1 trillion each. The next largest depositor, US Bank (NYSE:USB), only has about $250 billion.
A substantial and rapid reduction in highly concentrated liquidity could have an exponential impact in the market. As this current liquidity buffer goes away, these four banks may pull back existing liquidity facilities for their counterparties. If half of the liquidity is forced to de-lever at the same time, everyone else is forced to de-lever at the same time. In the blink of an eye, a system that's flush with excess liquidity suddenly becomes massively illiquid.
It's becoming obvious these liquidity concerns are making their way back to Fed officials. An article in the Wall Street Journal discusses a major caveat of the full allotment reverse repo facility:
But now, it seems the "full allotment" aspect of the reverse repos is falling out of vogue. Late last month, Mr. Dudley said the central bank could now envision circumstances in which a significant market disturbance could send a destabilizing wave of cash the Fed's way.
Mr. Dudley said May 20 it was possible unlimited reverse repos could take away money from the banking sector and drive it into less regulated financial firms. But more importantly, he worried that market trouble could cause short-term investors to drain all of their money out of private markets such as commercial paper and pour it into the Fed's safe harbor.
"Under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets," in a blow to overall financial stability, Mr. Dudley said.
That doesn't sound like a technical problem with execution. That sounds like an inherent systemic risk within the reverse repo mechanism.
With the risk-free Fed entering the counter-party business in times of market stress, the deposit facility becomes a de facto flight-to-quality destination, sucking money out of all other assets, including US Treasuries, the usual recipient of the flight-to-quality bid. Again, the following is according to the Wall Street Journal:
Eric Rosengren, president of the Boston Fed, is also anxious about allowing the reverse repos to be unlimited in size. He shares Mr. Dudley's concerns and said Monday in a speech that the "potential to create significant private sector financing disruptions during times of stress" likely argues in favor of "capping the size of the reverse repo facility."
Capping the full allotment reverse repo facility means that it is not full allotment. As my friend Kevin Ferry repeatedly reminds us, you can target the quantity or the price, but not both. It remains to be seen whether the Fed can successfully raise the level of interest rates while capping the reserves to be withdrawn. The excess liquidity above the capped counter-party allotment will seek a home. Will it compromise the Fed's ability to raise rates? We won't know until we get there.
After the FOMC decision on Wednesday, the financial media, market participants, and Wall Street strategists will be focused on the dots. They will be focused on what time it is. Meanwhile the closer the time comes, the more the details remain elusive. Does the Fed really know what time they will raise rates? Does the market even care? If so I can't imagine why. The market doesn't really care about time. It cares about size, and if we've all got size enough to buy.
No positions in stocks mentioned.