In September last year, the US money market experienced massive distortions that could have quickly spread to the entire financial system, as during the financial crisis. Money market rates skyrocketed: the repo rate jumped to around 5.25%. The US Federal Reserve had to calm the situation with massive liquidity injections by means of repo transactions. To prevent such turbulence on the important money and repo markets in future, the Fed also launched a massively expanded repo blueprint for the coming months. As a result, the Fed's balance sheet is growing again at a rapid pace. It now once again, includes assets of over 4.1 trillion USD and is thus approaching its high of 4.5 trillion USD.

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Do these liquidity injections by the Fed represent a new form of QE?

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Many market participants are claiming this is the case - perhaps this is also what they hope for, since QE (quantitative easing) is known to stimulate assets. Unfortunately however, it is easy to see these observers are wrong. With QE, a central bank buys large quantities of long-term debt instruments from the financial sector, especially government bonds, and in return gives out assets that are more liquid but carry much lower interest rates. This has two effects: First, financial players receive liquid assets that they can hold in their Fed current account. Secondly, the prices of these debt instruments rise, which is tantamount to lower long-term interest rates. The situation is quite different with Fed interventions in the repo market to inject liquidity into the financial system: In this case, the central bank buys securities from financial institutions for a limited period of time (often just for one day, "overnight"), also in order not to influence long-term interest rates. The commercial bank in question is credited the amount of money in the current account with the central bank for its free disposition. The interest rate on short-term government bonds is currently 1.60%. And for these short-term treasuries, the Fed pays with central bank reserves, which it credits with an interest rate of 1.60% as well. So unlike with QE, the banks do not exchange higher-interest securities for lower-interest securities; with the Fed's repo liquidity injections, the liquid funds received earn the same interest as the securities sold. This means there is no need to replace lost interest income and the incentive for commercial banks to seek new investments based on yield considerations comes to naught.

 

What do these yield considerations have to do with distortions on the money market?

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Before the important tax deadline at the end of September, sight deposits of commercial banks at the Fed fell to below 1.4 trillion USD, the lowest level in almost a decade. This in turn restricted commercial banks' room for maneuver to such an extent that they were no longer able or willing to lend money to other financial market participants on the repo market. According to the BIS, this was particularly true for the four big banks, the supposed top lenders on the interbank market. The fact that the commercial banks' sight deposits with the Fed were so low, however, is only at first glance due to the tax deadline. The main reason for this is the unconventional QE monetary policy, in the course of which there were considerable shifts in the US banking system: Since then, it has become much more attractive for banks to invest their free funds in government bonds, for example, than to hold (low-interest) sight deposits with the Fed. In September, the four big banks held more than 50% of the treasuries held by banks in the US. By contrast, the four big banks now hold only about 25% of all bank sight deposits with the Fed, i.e. money that can be made available immediately as repo loans. And these available funds for repo lending are further restricted by the more restrictive capital adequacy rules. This applies especially to the systemically important big banks. Repo activities are included in the calculation of their capital requirements: The more repo loans a bank grants, the more equity it needs. In order to save equity capital, systemically important big banks in particular, such as JP Morgan Chase with its particularly high capital adequacy guidelines, therefore hold off lending on the repo market.

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Dr. oec. Susanne Toren

Chief Economist

Assetco Management

susanne@assetco.ch