Credit Suisse's Zoltan Pozsar recently wrote an article entitled, "The Safe Asset Gulf," which tells us, "Governments tend to do the right thing at the wrong time. Trillions of deficit spending at full employment and just when the Fed is removing liquidity is one example. Issuing hundreds of billions of U.S. Treasury bills when the world no longer needs them is another. The shortage of safe assets has been the focus of academics and policymakers for the past decade. Yours truly contributed to the debate with a working paper while taking intellectual refuge as a visiting scholar at the IMF. The paper argued that the rise of the shadow banking system was inextricably linked to the rise of institutional cash pools -- large, concentrated pools of cash in the hands of corporate treasurers, reserve managers, asset managers' central liquidity desks and hedge fund treasurers -- whose natural habitat is not deposits, but the money market."
The paper continues, "Cash pools are too large to qualify for deposit insurance and have a tendency to seek refuge from unsecured bank credit risk in the sovereign Treasury bill market and the secured asset-backed commercial paper (ABCP) and repo markets. The inelastic supply of Treasury bills contributed to the massive growth of ABCP and repos before 2008, which drove the excessive maturity transformation and leverage that magnified mortgage-related credit losses during the Great Financial Crisis."
Pozsar comments, "The $400 billion in bills which were issued during the first quarter of this year has caused chronic indigestion in money markets. The scarcity premium of bills is completely gone: instead of trading well below OIS, bills now trade at or above OIS three months and in! The last time the Treasury printed this many bills, the market digested them with gusto: overnight rates did respond but stayed within the Fed's target band.... Not this time around."
He explains, "Bill supply reduced the usage of the Fed's o/n RRP facility to zero and Treasury bill yields became the effective floor for o/n rates. Bill yields pushed o/n tri-party repo rates from trading just above the o/n RRP rate to just under the IOR rate. With o/n tri-party repo being the marginal source of funding for interdealer GCF trades, the o/n GCF repo rate got pushed higher too and now prints outside the Fed's target range for the fed funds rate."
Posnar tells us, "The fed funds rate is also feeling the heat. Now that o/n repo rates are trading above the funds rate, FHLBs are lending more in o/n repo markets and less in the funds market. Reduced fed funds volumes have been the main driver of the updrift of the o/n funds rate as borrowing is increasingly less about some lazy o/n fed funds-IOR arbitrage and more about settlement constrains and LCR. The Fed's control of its o/n target rate is slipping... What has changed since last time? What caused the indigestion this time around? The answers are complex and have to do with changes in both demand and supply."
He speculates, "On the demand side, we've just lost a stalwart member of the community of cash pools -- corporate treasurers. Corporate tax reform ended the decades-old practice of corporations accumulating offshore investment portfolios.... These investment portfolios are now being unwound, and, as a result, the corporate bid for front-end Treasuries and bank debt has disappeared. Microsoft for example used to be a quasi bidder-of-last-resort for front-end Treasuries. Its bid is now gone and has turned into an offer."
The Credit Suisse think piece continues, "As Microsoft and other corporates shrink their offshore portfolios -- whether through sales or the echo-taper -- the supply of front-end Treasuries will increase for everyone else. The Treasury is currently adding to that supply by issuing hundreds of billons of bills, which overwhelmed the market. Clearly TBAC and the Debt Management Office of the Treasury ought to dynamically adjust bill issuance strategy to a changing demand-side landscape. Fewer hungry mouths argue for less feed, not more. Corporate tax reform reduced the corporate bid for front-end Treasuries by roughly $350 billion, which is roughly equivalent to the $400 billion of bills that the Treasury issued during the first quarter of the year."
It adds, "On the supply side, the changes have been even larger! Change came from four sources: increased issuance from the Federal Home Loan banks (FHLBs) as they became U.S. G-SIBs' preferred source of funding for HQLA portfolios and arbitrage books; QE and liberalizing access to central bank liabilities for non-bank institutional investors; more balance sheet for repo through new entrants and new sources of collateral supply; and last but not least, an increased supply of 'synthetic U.S. Treasury bills” via FX swaps.'"
Finally, Pozsar comments, "Money funds don't need more bills. The FHLBs have become large and structural issuers of safe assets. Yankee banks are growing matched repo books everywhere. And the Fed's o/n RRP facility provides safe assets on demand. Government money funds don't need more bills and that after $800 billion in new assets since money fund reform."
In other news, Federated Investors posted its latest "Month in Cash monthly, entitled, "Same ol', same ol' and that's OK." It indicates that no news was good news during the month of May. According to Federated, "New developments in the cash market were hard to come by in May. The month seemed a continuation of the main topics of April. That's not a bad thing; cash managers have had plenty to consider in recent quarters."
Money Market CIO Deborah Cunningham tell us, "The Federal Reserve's policy meeting in early May, and the minutes released later in the month, showed a central bank bent on keeping monetary policy in low gear, grinding on regardless of geopolitical events, market movement, trade-war talk or elections. The core personal consumption expenditures index (PCE) climbed ahead of the meeting, nearly hitting the Fed's established goal of 2% inflation."
She says, "The Fed took no rate action in May, but the content of the meeting statement suggested the next 25-basis-point hike likely will happen at the June meeting. The markets think it is a done deal, but are split between expecting one or two additional hikes the remainder of the year. We still expect a total of three in 2018, but will re-evaluate after parsing the June Federal Open Market Committee statement."
Federated continues, "While the spread between the 3-month London interbank offered rate (Libor) and the overnight index swap (OIS) slightly narrowed compared to April, it remained elevated in May relative to normal. The reason for the elevated spread remains the same: it's not driven by poor bank credit, the economic and political predicament transpiring in Italy or the potential summit with North Korea. Rather it is again due to the atypical large quantities of Treasuries the U.S. has had to issue to fund itself amid lower tax revenue and higher spending."
Finally, Federated writes, "While nothing compared to the volatility of the stock market in May, the relative fluctuation in the short end of the Treasury curve led us to shorten the weighted average maturity (WAM) of our government funds by five days to a range of 25-35 days. The range for our prime and muni funds remained 30-40 days. We continued to purchase Treasuries because of their still attractive yields on elevated supply. The short end of the Libor curve ended May in a holding pattern ahead of a likely June hike: 1-month Libor increased from 1.91% to 1.98%; 3-month decreased from 2.36% to 2.31%; and 6-month slipped from 2.52% to 2.47%."
