This is a guest post by Precision Capital Management.
This morning, Treasury released the quarterly Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association, which is
[A]n advisory committee governed by federal statute that meets quarterly with the Treasury Department. The Borrowing Committee’s membership is comprised of senior representatives from investment funds and banks. The Borrowing Committee presents their observations to the Treasury Department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues. The Securities Industry and Financial Markets Association does not participate in the deliberations of the Borrowing Committee.
Though the Committee had some interesting things to say about 30 Year TIPS and inflation expectations, we will focus on the statements of one member’s presentation regarding the Federal Reserve’s exit strategy (with respect to the >$1 trillion in excess reserves held by banks on its balance sheet). We are not told just who the presenter is, but the Committee members comprise the most highly influential firms on Wall Street, including representatives from JP Morgan (Chairman), Goldman Sachs (Vice Chairman), Soros Fund Management, and Pimco. From the minutes:
The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve’s exit strategy and the implications for the Treasury’s borrowing program resulting from that strategy.
The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities. It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield. Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more. According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages displays this reach for yield. A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero. [This is a shot off the bow to HY and, especially, CRE—more on this in another post.]
Here’s where it gets interesting:
The presenting member then looked at the likely sequence of the Federal Reserve’s exit strategy. The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates. It was suggested that the most likely sequence would be the  draining of excess reserves from the banking system,  the cessation of the mortgage-backed securities purchase program, and  only then raising the Fed funds target rate.
Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.
The Fed’s $1.25 trillion Agency MBS buyback program is set to expire at the end of March, 2010, according to the last FOMC Announcement from September 23, 2009. The point of the “several members” is valid, because why would the Fed drain reserves, only to continue adding them as a result of MBS purchases? The presenting member points out that the Fed can avoid adding reserves after they are first drained through a revival of Treasury’s Supplementary Financing Program (SFP).
By way of background, the SFP is a special account maintained by Treasury at the Fed and is financed by cash management bills. Says Treasury on September 17, 2008, “Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.” Once the Fed gained the ability to pay interest on excess reserves in October 2008, Treasury announced that SFP would be gradually wound down as it was no longer necessary to sterilize the Fed’s balance sheet. [As an aside, no where does the presenter mention the ability of the Fed to pay interest on excess reserves, a fact of which it is highly unlikely he would be ignorant. Given the Fed’s recent statements regarding the use of other tools to manage excess reserves, we infer that the Fed does not view this as a viable option for managing excess reserves–perhaps because it is too costly, or too impotent a strategy.]
The big picture point, however, is that at least according to the presenting member (that we presume to be Fed-connected), the Fed currently envisions draining the >$1 trillion in excess reserves currently on its balance sheet by next March. While it is possible the member means that the draining will only have begun by the end of March, his focus on the use of the SFP to drain any additional reserves generated by existing MBS purchases up to the end of March would have to be a non sequitur (and we assume rational actors here).
If the Fed drains in this fashion, it is close to criminally insane, as it has been deflationary with respect to M2 money supply since April 2009 and draining reserves would only further deflate the general economy. If credit is hard to come by now, it will be immensely more so should these actions come to pass.
The mechanics of the draining are then discussed as follows:
The presenting member then addressed the options for draining reserves from the banking system. The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off. One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery. A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use. Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market. [Keeping up the public’s appetite for debt is the Fed’s de facto third mandate.]
According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear. If it is to undertake these reverse repos, the selection of counterparty is important. Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts. In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member. Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries – in the absence of loan demand. [Whether it’s the “absence of loan demand” or absence of banks willing to loan is a point for another post.]
Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.
At this point, we must consider the possibility that the presenter is acting on behalf of the primary dealers and issuing a thinly veiled threat against the Fed and its deflationary policies. QE has certainly been a profitable endeavor for them and the (recent) cessation of Treasury QE puts the primary dealers on the hook for any extra supply. We hope we’ve simply read too much into this or that the presenting member at the TBAC minutes simply does not know what he’s talking about. However, if the Fed is truly contemplating a drain of all excess reserves in such a short period of time, with the view of tightening shortly thereafter, we implore it to reconsider.
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