You can only play so many games before you are often trapped in a situation of your own creation. This is the situation the Fed finds itself in. Nothing makes this clearer than the stark reality that: 1- the 5Y-10Y yield curve spread has gone negative, 2- An abrupt shift to “the possibility” of Negative Rates and 3- the quiet Supplementary Leverage Ratio (SLR) bank ‘give away’ is no longer a whispered secret and had to be stopped abruptly! We outline these issues below. As a result, the roadmap before us is now taking shape (See Likely Future Fed Roadmap Ahead)!

1- THE INFLATION CURVE INVERSION

Few appear to be noticing, with all the Inflation worry and Treasury Bond Yields heading higher, that in actuality traders are pricing in some serious DISINFLATION! The 5Y-10Y Breakeven spread is now at record negative levels (after a potential short-term burst).

2- POWELL SIGNALS POSSIBLE “SLIGHTLY” NEGATIVE RATES!

AGAIN IT IS ABOUT SHORT TERM LENDING COLLATERAL

The FOMC meeting came with a subtle (but not so subtle) increase in the RRP (Reverse Repo Program) counter-party limit from $30 billion to $80 billion per counter-party.

Repurchase agreements (also known as repos) are conducted only with primary dealers; reverse repurchase agreements (also known as reverse repos) are conducted with both primary dealers and with an expanded set of reverse repo counter-parties that includes banks, government-sponsored enterprises, and money market funds. Reverse repo transactions temporarily reduce the quantity of reserve balances in the banking system.

While at first look seems quite benign it implies the Fed is very comfortable with rates here at zero, but though they don’t want them to drop into the negatives zone, they now seem to be ok with rates dipping occasionally into the red (as they have done recently in General Collateral Repo).

NOTE: The GC is a set or basket of security issues which trade in the repo market at the same or a very similar repo rate, which is called the GC repo rate. GC securities can therefore be substituted for one another without changing the repo rate much, if at all. RRP counter-parties invest cash at the Fed in exchange for Treasury securities at a rate of 0.0%. If the cash investors can’t get collateral from the Repo market, they go to the Fed. Surprisingly, there was no RRP activity on Monday and today, and only $702 million on Tuesday. Rates are close to zero and the market isn’t even using the RRP window.

FED IS WILLING TO DO NOTHING!

The Fed appears willing to do absolutely nothing despite forecasting:

• Significant Economic Growth,
• Rising Inflation, and
• Employment Gains (with median rate expectations remaining at lows).

Meanwhile there is a hawkish tilt across Fed members who see multiple rate hikes in 2022 and 2023. (See ‘Implied Fed Funds Target Rate chart to the right)

3- THE QUIET SECRET OF THE SLR’s (Supplementary Leverage Ratio)

MARCH 31st ANNIVERSARY

The SLR exemption was quietly put in place April 1st 2020 to ensure the banks had adequate abilities to handle cash needs related to Covid-19 shutdowns and public lock-downs. It expires March 31st and Friday the Fed announced it was discontinuing it much to the shock & displeasure of the banks who expected the “gravy train” would be extended.

CONSEQUENCES:

1. Banks will no longer have the same incentive and means to return cash to shareholders through buybacks which Democrats such as Elizabeth Warren were warning about. They felt it was inappropriate that the banks were benefiting from SLR allowing Fed QE cash injects (and even more significant ones planned) to “game” the system.
2. Since large banks are the largest cash providers in the Repo market, by discontinuing the SLR exemption it means less cash is intermediated into the market and Repo rates rise making it potential more fragile and prone to funding failures,
3. Additionally, volatility is now likely to increase as repo assets move from the largest banks to the other Repo market participants.
4. U.S. banks are likely to turn away deposits and reserves on the margin (not Treasuries) to leave more room for market-making activities, and these flows will swell further money funds’ inflows coming from TGA draw-downs.
5. Banks will need to be increasingly selective regarding growth and, in particular, the growth of deposits and U.S. Treasury Holdings. Practically, that means that banks will turn away deposits by charging customers for maintaining balances (aka negative rates).
6. In U.S. Treasury auctions, firms may reduce bid size or require higher rates for larger bids. This will immediately impact the rates that the U.S. will pay for debt and hike the cost of financing the U.S. debt borne by taxpayers and, ultimately, all other borrowers because these rates materially impact the rate charged for all other borrowing.
7. Moreover, the “price” of U.S. treasury funding is an important benchmark for pricing other products including those offered to consumers such as mortgage loans. The increase in US Treasury rates will bleed into the cost of credit for retail and corporate borrowers.
8. Fridays adjustments likely means that the FRA-OIS won’t trade all the way down to zero or negative territory. FRA-OIS from here will be a function of how tight FX swaps will trade relative to OIS, but Treasury bills trading at deeply sub-zero rates is no longer a risk. While Bills have occasionally dipped into the negative territory on occasion, so far they have avoided a fullblown plunge into NIRP, which may be just the positive sign the market is waiting for to ease the nerves associated with the sudden and largely unexpected end of the SLR exemption.

OUR VIEW OF THE FED’S LIKELY ROADMAP

There is a strong possibility that the Fed will:

• Let the Long End of the Curve rise
  • Let a Crisis be a Forcing Function,
  • Using an effective “TAPER” or expected “TAPER TANTRUM” to make this happen and control rates,
• A crisis event will negatively impact an over-leverage equity markets,
  • A “Flight to Safety” will drive yields down and prices up,
  • Increased Bond prices and lower yields will assist short term funding,
  • Initially this will take the dollar higher through August
• As the economy’s focus shifts from Inflation to Deflation the Fed will launch YCC,
  • We don’t have a real Inflation Scare, we actually have a Rate Scare,
  • We don’t yet have Secular Inflation.
  • A deflationary Tsunami is ahead as evident from an Inverted 5Y-10Y Yield Curve (above.)
• YCC will be implemented as rates rise once again,
  • This will take take the US% lower thereby assisting the Fed with low rates,
  • The Fed will sacrifice the US$ to be able to stabilize lending and government debt requirements
• Stagflation similar to the 70’s is ahead.
  • This time we have too much debt to pull off a Volcker to halt inflation
  • Money printing won’t work because of MZM Velocity,
• Hyper-Inflation will be the outcome which will be halted by a new “Breton Woods”
  • This New Breton Woods will be held in Beijing v New Hampshire!
  • The problem is a global imbalance of Economies producing less than they produce