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Fed Liquidity and Coupon Passes


Business as usual???!!!


There's been a lot of talk on Minyanville about the Federal Reserve injecting liquidity into the system in an effort to provide the oxygen necessary to keep the economy from burning out. More specifically, much of that discussion has focused on the use of the Fed's Permanent Market Operations and the use of coupon passes to do this.

I certainly don't profess to be an expert on such matters as it isn't really data that I've followed very closely. But the beauty of Minyanville is that we are able to delve deeper into such topics and open them up for further open discussion and debate (well, at least while Scott Reamer is on vacation anyway).

You can access historical information on the Permanent Open Market Operations carried out by the Federal Reserve Bank of New York on their website.

Using that data I put together a simple chart to look at the monthly amounts in question as it's always easier to see the data graphically.

There is obviously much more to this discussion (and I'm not arguing the provision of Fed liquidity at all by the way) but it would appear based simply on this admittedly cursory analysis that coupon passes may not be the vehicle to inject said liquidity. The notion of back door Fed liquidity injections just doesn't really seem to be supported by this data - if anything it would seem that this year is light on coupon passes. John can likely add some additional clarification and perspective here. I would also point out that this data only goes back to 2000 so much more data should be analyzed here in attempting to understand the whole picture.

I did speak to a number of folks in analyzing the topic further and received some interesting responses regarding what one should read into the Fed's activity as far as sending some sort of a larger message.

One very trusted fixed-income watcher noted, "If they target the Fed funds rate, then they have to add or subtract whatever is necessary to keep the funds rate at the target. That's all this is. If the funds rate were to ever deviate more than a few basis points on average over a 2-week maintenance period (as was the case right after 9/11), then it would be a bigger story."

The view from bond traders I spoke to essentially pointed out that since the Fed has a discreet funds target (which is very knowable in advance) coupon passes should really be viewed as nothing more than regular business. One would need to look at repo (temporary liquidity) for a more detailed picture, but they don't think that picture supports the notion of a real money liquidity injection.

As we all know, the Fed often injects liquidity needed around month and quarter end, holidays, and auction settlements. Repo's are a little larger than normal in the last week or so, but one data point does not mean anything. What's more, the Fed typically rotates through the whole curve in a cycle of passes when they engage in them.

Not sure that clears up the issue or simply results in more questions but the suggestion from those who follow that market exclusively is simply "sometimes business as 'usual' is just business as usual."

Finally I ran the issue by the very knowledgeable folks at Wrightson ICAP, a firm that carefully studies and predicts the activity of the Federal Reserve. The firm's Chief Economist, Lou Crandall provided the following thoughts:

"Sadly for old-time Fed-watchers (like us) who predict open market operations, there is little to be learned about broader financial market conditions from permanent injections. The Fed used to divide its operations into two categories: "defensive", which simply offset seasonal swings in the underlying supply of reserves, and "dynamic", which were meant to alter financial market conditions. Today, all operations are defensive. The market for reserves is now so small (thanks largely to Fed connivance in the growth of reserve-requirement-evading internal sweep programs) and so artificial that it is sensitive to even small changes in the supply-demand balance. A permanent $1 billion injection that was not defensive - that is, which boosted excess reserves rather than offset some autonomous reserve factor - would literally drive the funds rate to zero. And a $1 billion permanent shortfall would drive the funds rate well above the discount rate, which is set at a penalty level 100 basis points above the funds target. Analysts increasingly have come to recognize that the Fed affects overnight rates through announcement effects - everyone (for now) believes that the Fed could impose its target, so they see no reason to fight the new target rate when it is announced. That's not necessarily a stable "operating procedure", but it works for now so the Fed is happy with it. (One of the problems with the system lately is the fact that the market tends to front-run the Fed, moving the funds rate up even before the new target is announced. The Fed's Open Market Desk originally contemplated trying to fight this anticipation effect, but realized that it would be messy and was given the OK by the FOMC to ignore upward pressure in the days leading up to FOMC meetings.

As it happens, much of the discussion in the money markets around the time of the defensive coupon passes arranged in mid-August was about the string of increases in discount window borrowing at the end of recent maintenance periods. The fine balance in the funds market tipped the wrong way at the end of both the August 3 and Aug 17 reserve maintenance periods, forcing the overnight market up and requiring banks to borrow from the window to meet their reserve requirements. That is conventionally seen as a sign that the Fed's open market operations are stingy rather than generous."

Lou Crandall
Wrightson ICAP

No positions in stocks mentioned.

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