I have been pounding the table for months about QE and its inverse relationship with vital banking liquidity. In engaging in Large Scale Asset Purchases (LSAP) central banks, particularly in the US and Japan, are playing a very dangerous game. Despite conventional “wisdom” that when a central bank engages in such a monetary easing program it must lead to an increase in liquidity (how could “money printing” not?), such a belief is far too simplistic. QE is actually the opposite of liquidity.

Interbank wholesale money is utterly dependent on collateral to disperse “cash” beyond idleness in primary dealer reserve accounts. Without sufficient US treasury collateral, all the “dollars” created by the Federal Reserve’s active “printing” go nowhere.

The problem of QE, as we saw all too well in 2011 as QE 2 ramped up, is it active removes vital collateral from repo circulation. QE 2 was particularly insidious in that regard because of its focus on bills – the security most often associated with repo. Operation Twist “fixed” that problem by “selling” bills back into the markets and replacing them on the Fed’s balance sheet with notes and bonds.

Earlier in March 2013, there was curious activity in the 10-year US treasury repo market, with repo rates dropping all the way to the 3% fail penalty “floor”. I noted at the time that it appeared QE 4 was having a negative impact in US treasury repo liquidity, including a noticeable uptick in repo fails.

Now today the 10-year overnight US treasury repo rate for the May 2023 fell to -3%; touching the fail rate. That is a conclusive indication that the current on-the-run 10-year is in seriously short supply. The 10-year GC rate was 0.12%.

There was also news that the shortage may have forced dealers into selling off-the-run 10-year and equivalents. If that was indeed the case then it may have an outsized impact on UST prices given the relative lack of liquidity off-the-run issues receive. The net result, as with so many things about QE, is rising volatility (across markets and the economy).

There are a couple of converging trends that seem to be at work here. One is QE 4, but we can’t discount QE 3’s impact on the MBS market. There is very likely some spillover from MBS into UST as dealers hedge their MBS books with UST trades amid the heavy hand of the Fed.

The ripples of volatility across funding markets have serious implications, for not just the banking system, but also gold markets and the real economy. The FOMC is intentionally playing with liquidity fire, essentially gambling on an upside based solely on bad psychology and nothing more. It has yet to prove effective, and now it looks as if the collateral shortage and related negative liquidity factors are yet again being revisited.

The repo market is sending out warning signs, but few can see them or know how to interpret them

 

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