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When The Elephant Sneezes


The Federal Reserve has begun conducting small-scale tests of its mass-reverse-repo tool. This suggests, as many observers have already noted, that the Committee is thinking very seriously about whether it is time to withdraw the extraordinary stimulus measures put into place last year (which became necessary, by the way, partly because the Fed at the time of the Lehman crisis had the Fed Funds rate at 2.0% and was exceedingly shy about injecting the liquidity the market needed – so let’s skip the Bernanke-worship for “saving the system” when in fact the FOMC was partly responsible for making the crisis so bad in the first place). This is not the same as raising rates – which is something which will eventually happen, but far down the road I think – but it is a contraction of liquidity.

It isn’t crystal clear to me why the liquidity needs to be withdrawn quite so soon, but let’s leave that aside for now. The argument for not pulling back liquidity is that bank credit is still contracting (see Chart, sourced from the Fed’s H.8 report); the argument in favor of pulling it back is that asset prices – stocks, bonds, commodities – seem generally bubbly and this is partly because of all the extra money sloshing around.

Some money is going into Treasuries rather than loans

As I said, let’s leave that argument for another day. My concern is about the transition to the end game.

The Fed’s plan is to borrow money from banks, collateralized with some of their massive holdings of Treasuries and other detritus. This is a reverse repo transaction (what we used to call “matched sales”), it subtracts reserves from the system, and it’s not mechanically difficult except on the scale the Fed wants to conduct it, and because they want to widen the potential counterparty list.

What happens to all of the asset markets when the money starts to exit the system? Asset markets will go down, that’s what. The same way all of them went up, from commodities to real estate to equities, they’ll go down if the exit is premature.

I suspect that is part of the idea: scare banks into letting go of some of the safe Treasury paper whose yields are about to rise (if the Fed has its way). Distribute some of that paper to other holders, and maybe the banks will use the freed capacity to lend. But this is a delicate exercise, because maybe the banks find there’s no one to sell to and rates adjust quickly, leading to an abrupt economic adjustment and more losses at banks! The best part of the year to be long rates (early Sep to early Nov) is past, and we are moving into the spring; moreover, it seems more and more people are concerned about rates going up either from supply pressures or because they think the Fed wants to tighten. It won’t take a lot to get banks, and others, to start to unload Treasuries. And I have trouble figuring out who wants to own a lot more of them.

Economically-speaking, there doesn’t appear yet to be any reason to fear much higher rates, and until year-end is past I doubt we need to worry about a big move in bonds, but it’s the potential for volatility that has me covering my eyes. Even if everyone is prepared for the elephant sneeze, everyone still gets wet.

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