Last month was the case of Credit Suisse that perfectly predicted the current shortage of liquidity that forced three massive interventions of the FED in the last three days.
The Treasury will issue over $800 billion in net new debt and increase its cash balances at the Fed by $200 billion by the end of the year. The augmented supply pushes funding under stress.
Supply came at a very bad time, while companies are cashing in for their tax payments.
Dealer inventories are at a record. Given the curve inversion, supply is having a big impact on the front-end of the curve.
The Fed appears to sense these mounting pressures and that’s why is no longer tapering.
But cutting taper short by about $60 billion is a drop compared to $800 billion – a nice gesture, but not a solution. Solutions like asset purchases (“mini-QEs”) or a standing repo facility are unlikely to be ready any time soon as they take time to design, test and communicate – and fiscal dominance starts “tomorrow”. That’s why O/N repos are under stress.
Absent a technical bazooka, stresses will leave one option left: more rate cuts. Cuts that are aggressive enough to re-steepen the Treasury curve such that dealer inventories can clear and inventories don’t drive funding market stresses.
We never had this much Treasury supply during a curve inversion on top of record inventories with leverage constraints. The Fed has her hands tied up.
More aggressive cuts are an easier “sell” politically and optically than outright asset purchases in an environment of record Treasury issuance. Nevertheless, the FED is divided: the last cut came with only 7 members in favour out of 10.
Dealer inventories are the actual problem. Banks funding dealer inventories is the private solution, but that private solution has a huge limit: intraday liquidity.
The public solution for that is the Fed’s balance sheet. Let’s expand it again adding a permanent repo facility. But it is not so easy to set it up, and here we are.
Rate cuts must be aggressive enough to re-steepen the curve so that dealer inventories can clear .
Cuts must be deep enough that would incentivize real-money investors to lend long, not short and that would enable carry traders to borrow short and lend long again.
How many cuts are needed to keep funding stresses at bay?
Certainly more than the last shy move that left all these problems still on the table.
The plumbing are no longer able to let the enormous volume of water pass. But it seems that nobody cares about the plumbing: not the Treasury that has inundated the market with paper neither the FED.
The flattening of the last two days is a message from the plumber: I need more!