Turbulent Exit Redux
A lot of people have speculated about what would happen when the Fed raised rates, and almost all of them have been surprised.
One of them is Zoltan Pozsar, who boldly went on record with the view that corporate cash pools of various kinds would shift out of bank deposits into government-only mutual funds, which would invest the funds in the new Fed RRP facility, so shifting the balance of Fed liabilities from reserves to RRP.
So far that hasn’t happened, and in an important new paper Pozsar tries to understand what did happen instead, and why.
There has been $100 billion shift out of bank deposits, but that is much smaller than expected, and most importantly it hasn’t shown up in the new Fed RRP facility at all. Pozsar’s main question is, Where did those funds go?
(A subsidiary question is whether even $100 billion is enough to force some banks to reallocate their HQLA portfolio, selling Level 2 and buying Level 1 assets, perhaps harbinger of bigger things to come. Pozsar suggests that it might be, but I leave that aside.)
Another thing we know is that the balance of Fed liabilities has shifted, out of reserves and into both the Treasury General Account and the RRP facility that the Fed offers to foreign central banks. Most the former happened before the hike, but the latter is a new thing to the tune of $220 billion.
Pozsar’s idea is that we should connect these dots. Corporate cash pools, he thinks, are shifting out of bank deposits as expected, but they are shifting into Treasury bills not government-only mutual funds. And the source of those Treasury bills is first the Treasury itself (issuing bills to fund its TGA account) and second foreign central banks who are shifting out of Treasury bills into Fed RRP.
So far as I can see, this is a guess not a fact, since we don’t have contemporaneous data on cash pool holdings, only on the Fed balance sheet numbers. And it should be said that there are other things that could be causing the numbers we observe, for example flows rather than portfolio shifts. When I paid my quarterly estimated tax in January, that reduced my Citibank deposit account and increased the Treasury’s TGA account without putting any new Tbills into circulation. Similarly, it is at least possible that foreign central banks are accumulating reserves out of official balance of payments surplus, perhaps putting them in RRP rather than Treasuries because the Fed is offering a higher yield.
But let us entertain the Pozsar Hypothesis and see where it goes. The style of analysis certainly has a lot to offer, using the discipline of accounting to spin a possible story.
Pozsar thinks it’s all a plot of the FOMC: “In the end, the Fed’s long-standing aversion to money funds (whether prime or government-only) seems to have dominated the FOMC’s thinking.” Instead of allowing markets to take their natural course (i.e. “Turbulent Exit“), the FOMC somehow got the Treasury and foreign central banks to sell Treasuries to the cash pools directly, and then to transfer their proceeds to the Fed, which caused the shifting liability balance.
The problem with this story is that there are other deciders in the room. Maybe it was foreign central banks responding to volatility in the Treasury market, realizing that the RRP facility is a superior reserve in times of trouble, and the interest on RRP was just a bonus. Maybe the Treasury has its own reasons to want to help the Fed reduce its reserve exposures. Surely I am not the only one who recalls the kerfuffle when Bernanke floated the trial balloon that the Fed might issue its own F-bills, in competition with T-bills. The Treasury did not like that one. The RRP facility is not an F-bill, but even so it definitely competes with T-bills, and that cannot make the Treasury completely happy.
Be that as it may, Pozsar is absolutely right to emphasize that both the Treasury balances and the foreign central bank balances are naturally limited. If there really are a trillion dollars of corporate cash pools out there that are going to shift out of bank deposits into something else, not to mention the shift from soon-to-be floating NAV prime funds, then Pozsar’s original scenario remains on the table as a possible future. Maybe it is just early days, or maybe it is happening but has been swamped by confounding effects coming from elsewhere.
Others have also noticed the foreign RRP number, and wondered about it, going so far as to suggest that foreign central banks are somehow helping the Fed to raise rates, but I’m not convinced. The problem is that foreign RRP is not an asset available to any market participant, only to central banks who are under no obligation to pass that rate along to their own depositors (indeed, most are easing while the Fed is tightening).
We remain in uncharted waters. It is a good time to be a money watcher.