From Credit Suisse, December 5:
I am stunned every time a client asks me if I am worried about the current level of reserves in the U.S. banking system. The market’s search for the level of reserves at which the system “breaks” implies that the market is worried about a repeat of the 2019 repo blowup. Such fears are misplaced. To be clear, there are risks lurking in funding markets, but they have nothing to do with the draining of reserves via QT (watching paint dry). Rather, they have to do with the draining of reserves via geopolitics (Russia responding to price caps).
The fundamental difference between QT during 2018-2019 and QT today is that the first episode of QT happened while balances in the o/n RRP facility were zero. The U.S. financial system didn’t have a penny of excess reserves, except for what banks had over and above their lowest comfortable level of reserves (LCLoR). The bid for repo funding was immense and the marginal repo lenders were banks with excess reserves to lend... until they ran out of reserves to lend.
When the reserves ran out, o/n repo rates spiked and the music stopped until the Fed started to print reserves anew and broadcast them using a new o/n repo facility (the SRF). The chances of the same happening today are low. Worrying about how close banks are to their LCLoR is pointless for three reasons.
First, demand for repo funding is weak today, in sharp contrast to demand during 2018-2019 when demand was breaking new highs every single day. Similarly, demand for dollar funding in the FX swap market is weak too, as FX-hedged buyers of Treasuries are now scaling back their positions and economic uncertainty and higher nominal rates are driving a wave of deleveraging.
Second, balances in the New York Fed’s o/n RRP facility represent reserves that the financial system did not bid for during the day. In other words, the balances in the o/n RRP facility represent cash the system does not need. Today, that amount is over $2 trillion. That’s $2 trillion that large U.S. banks sweep off their balance sheets at the end of every day and that foreign banks and dealers don’t bid for to fund their loan books, inventories, or market making. That’s $2 trillion of reserves coming out of the market’s ears. In plain English, the $2 trillion in the o/n RRP facility is the system’s “cash under the mattress”.
Third, if for some reason we still end up in a situation of LCLoR miscalibration, the system has two pools of liquidity to tap: the $2 trillion under the mattress (see above) or the SRF. The raison d'être of funding markets is to mobilize excess cash; today, $2 trillion is waiting to be mobilized through funding markets... ...so don’t sweat a repeat of 2019.To emphasize: LCLoR today is a red herring. LCLoR mattered last time because we had no excess reserves in the RRP facility and no SRF. When JPMorgan ran out of excess reserves (reserves > LCLoR) to lend, the interbank market froze up because other banks did not have any excess reserves to lend either. Today, if banks run out of excess reserves to lend, they have two alternatives to tap (the o/n RRP facility and the SRF), so the system is backstopped very well: both at the bottom (lots of cash to mop up) and also the top (lots of cash to call on) – so don’t sweat the LCLoR from a QT perspective. But worry about it from a...
...geopolitical perspective....
....MUCH MORE (5 page PDF)
HT it was out: QF Research
