There’s a black hole in the dollar funding market

ftalphaville.ft.com/2019/08/22/1566491938000/There-s-a-black-hole-in-the-dollar-funding-market
Seu Madruga
August 23, 2019

By: Izabella Kaminska

It’s been a while since we checked in on what’s percolating through the mind of financial-plumbing specialist Zoltan Pozsar at Credit Suisse. And it looks like this was
an error because we may have missed a whopper of a dollar funding story.

Here’s the gist from the opening of his latest note (with our emphasis, oh, and RRP stands for reverse repurchase agreement):

The FOMC should forget about r* for the moment and focus on Sagittarius-A* – the supermassive black hole at the center of global dollar funding
markets.

The black hole is the foreign RRP facility, which has seen close to $100 billion of inflows since the beginning of the year.

The driver of these inflows is the curve inversion, and the longer the inversion persists the more inflows will follow. The trade war is also contributing to
the inflows – given the inversion, as foreign central banks weaken their currencies they “buy” the foreign RRP facility and not Treasuries like in the past.

Foreign central banks are rate shopping… …and an uncapped foreign RRP facility is what enables that. Like the matter that enters a black hole, the
reserves that are sterilized by the foreign RRP facility are gone for good – like the reserves “shredded” via taper.

It’s an important point because even if the Fed were to stop tapering (a monetary tightening measure which sees central banks absorbing the proceeds of maturing
Treasuries rather than reinvesting them in further asset purchases), tightening would continue for as long as the uncapped foreign RRP facility attracts inflows. Which it
would, says Pozsar, because of the curve inversion.

He predicts such inflows could eclipse $200bn by the year’s end with the consequence of pricing Treasury supply out of the market.

This suggests the Fed may have overdone its hiking cycle, something that now can only be fixed with rate cuts. (Which incidentally also means, eek, Donald Trump
might be right about Powell’s policy.)

Key to this conclusion is how the make-up of inflows into the foreign RRP facility has been changing over time. In 2015, for example, much of the growth of the
facility was due to inflows from Japan’s Ministry of Finance.

As Pozsar explains:

...the Fed, deeply concerned that it won’t be able to enforce a floor underneath o/n interest rates as it tries to exit ZIRP, uncapped the facility to help banks
shed balance sheet by luring foreign central banks away from banks and into the foreign RRP facility, and to help ease the bill shortage in money markets
by luring foreign central banks out of bills and into the foreign RRP facility.

The important context at the time was the massive shortage of short-term safe assets in the system, which put negative pressure on short-end rates across the board. By
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diverting central bank liquidity away from commercial banks and over to the foreign RRP facility, the Fed thus released important bill supply into the market which
alleviated that pressure and thus defended the rate floor.

The rate-hiking cycle, however, has entirely reversed this situation.

RRP inflows are now being fuelled not by balance sheet constraints or a shortage of quality collateral but the inverse: intraday liquidity constraints and a collateral
surplus.

In short, there are too many dollar-denominated safe assets in the market and not enough liquidity and hence -- very possibly -- the makings of a fresh liquidity crisis.

As Pozsar explains:

Because inflows into the facility sterilize reserves and add collateral to the financial system, they worsen the collateral surplus. But don’t blame the foreign
central banks placing cash into the facility, for they do what a rational person would do when offered something that has value – take as much of the
stuff as they can, while they can.

Pozsar adds the current inversion is the most extreme relative to overnight repo rates, and that historically this is the first time that the curve has inverted relative to
these rates:

The usual structural incentive during a yield curve inversion is to sell long-term notes and buy short-term bills. This time, however, the greater incentive is
to sell long-term notes and buy the foreign RRP facility, not bills. Thus the worse the inversion gets , the more dollar they’ll put at the foreign RRP facility.
This incidentally ensures the short-term bill market doesn’t receive the offsetting flows it should.

But there’s more!

Conventionally, central banks that want to weaken their currencies relative to the dollar intervene by buying dollars and investing in Treasuries. But the recent
interventions by the PBoC seem to have seen dollars invested in the foreign RRP facility as well as in Treasuries, says Pozsar.

Every penny that flows into the facility, he says, makes it harder for banks to fund dealers, whose safe-assetinventories are growing partly due to the foreign RRP
facility, and partlydue to the circularity of the matter:

…economists would refer to the above dynamics as pro-cyclical: more collateral supply, higher repo rates, more inflows into the foreign RRP facility, even
more collateral supply.

Which we guess means the Fedshould cap or otherwise restrict the facility and begin to lower rates to avoid a major dollar funding squeeze.

But why might they not do this? One reason, says Pozsar, is that other central banks don’t cap their equivalent facilities, and the other is that the Fed is not the only one
to be paying a better rate on its facility than can be achieved in local bill markets.

According to Pozsar this is the result of strategic BoJ and ECB policy designed to encourage the lending of more dollars in the FX swap market, so as to avoid deeply
negative reinvestment yields and make more bills available in their own financial systems.

But it makes no sense for the Fed to do the same, he says. To the contrary doing so creates a paradox of thrift.

The following is a stellar point by Pozsar:

If the global financial system’s problem is a shortage of US dollars, it makes sense for foreign central banks to pull funds away from their local bill markets
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 to help improve the reinvestment returns of dollar lenders and hence ease the flow of dollars, but it makes no sense for the Fed to do the same – if it does, it
hurts the flow of dollars. Here is how… If the Fed offers a rate above Treasury bill yields on an uncapped the foreign RRP facility, it will attract inflows.
Inflows sterilize reserves and increase collateral supply on the margin – instead of buying Treasury bills at auctions, the facility incentivises foreign
central banks to deposit cash at the Fed. These dynamics put an upward pressure on local bill yields, and higher local bill yields reduce the allure of
lending dollars in the FX swap market – the flow of dollars suffers and the Fed is pushing against the efforts of other central banks.

So, unless the Fed takes action -- and by that Pozsar doesn’t mean technical action such as the creation of a standing repo facility or asset purchases -- the collateral
tsunami may continue to worsen.

It follows, Pozsar says, that if the Fed priced supply out of the market, it should now consider rate cuts instead: ”...rate cuts that are aggressive enough to re-steepen the
curve so that dealer inventories can clear; cuts deep enough to incentivise real-money investors to lend long, not short and foreign investors to buy Treasuries on an FX
hedged basis on scale again.”

That makes this weekend’s Jackson Hole meeting arguably the most significant in a decade, concludes Pozsar.

Related links:
Eurodollars, FX reserve managers and the offshore RRP issue - FT Alphaville
Will Powell swerve again at Jackson Hole? - FT

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