“QE or not QE, that is the question…” – US Fed announces that it’s back in the market and buying US Treasuries
- Chair of the US Fed Jerome Powell has announced the resumption of outright purchases of Treasuries.
- The move into the market is explained as “helping liquidity”, especially in the repo market.
- Inter-bank short-term borrowing and lending of government securities have experienced price spikes, but the question is whether the Fed’s actions amount to a resumption of QE.
- Jerome Powell vociferously protested: “In no sense is this QE.” The markets are not so sure.
The repo market operates to allow banks to exchange less liquid assets for cash. This helps them maintain an appropriate amount of the most liquid asset, and comply with banking regulations by doing so. Preference is given to holding assets that generate some kind of yield or return, but being banks, they need to hold a certain amount of cash on their books.
The favoured assets to loan out in return for cash are government bonds, largely due to their credit rating but also because they have very transparent pricing. The repo ‘trade’ is not about finding an obscure feature of an instrument and trying to generate a profit from having a better understanding of the small print. Repo loans are more in line with pay-day loans. Government bonds are therefore an ideal instrument to sell and buy back, typically overnight. The selling bank has swapped bonds for cash on its balance sheet, and the party buying the bonds makes a quick turn by insisting that the return transaction on the next day is done at a higher price.
The repo market is a long-established means of banks managing their liquidity. The repo desk will work through the day to monitor the ever-changing balance between cash and less liquid assets. The other big deals going on across the trading floor will influence the size of the daily requirement. The problem with the repo market becoming illiquid is that, should a repo desk find that there is a late-in-the-day need to sell bonds and raise cash, they could fall foul of wider spreads. One option is for the repo desk to suck up the loss. The other is to not finance the other trade that is driving the last-minute request. A scenario to consider is the provision of a loan to corporation ABC Inc. If the repo spreads are so wide that the loan to ABC Inc. becomes a loss maker, then the ABC deal is jeopardised. When the wheels inside banks turn a little slower, the result is less investment in the real-world economy. This is not what central bankers want to happen.
A loss of confidence
The argument put forward by Powell is that the repo market is currently not working efficiently. His actions, announced Tuesday, indicate that he sees a lack of parties willing to step in and buy Treasuries and then hold them overnight and sell them back at a small gain. The lower demand then leads to wider spreads or no bids at all. Powell sees the US Treasury as an ideal candidate to take on that role. The argument is that the financial merry-go-round known as the repo market is of strategic importance. It’s less like ‘trading’ and more like providing a public service.
Methinks he doth protest too much
This raises the question, “When is repo financing not repo financing?” The answer being, “When it’s QE.”
Quantitative easing is, by definition, the act of a central bank entering the open market to buy government bonds. The issue for Powell is that what he is suggesting is also a central bank (the US Fed) going into the open market and buying its own bonds. The same action can be interpreted in two very different ways.
QE was introduced during the lowest moments of the 2008 financial crisis. It was a last-ditch attempt to support the financial markets, which looked like they were about to go into meltdown. While it has hung around to become a favoured tool of central bankers, at least when it was introduced, it was seen as being a particularly strong medicine, something to treat only the sickliest patients. Powell, in his statement on Tuesday, has unequivocally stated that:
“I want to emphasise that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.”
He continued: “In no sense is this QE.”
Taking Powell at his word is challenged by the context of the statement made during a Q&A session at the National Association for Business Economics in Denver, where Powell also said that “clearly things are slowing a bit” and that the Fed “will act as appropriate to support continued growth.”
In the Denver Q&A session, Powell is identifying a risk of economic slowdown and announcing a Treasury buying programme at the same time. The financial markets are wondering to what extent the move into the repo market signifies a return to QE.
The stock market reaction was poor. The Dow Jones Industrial Average (DJIA) was down 1.19% on the day. This mood carried over into the Asian and European sessions. The Nikkei index was down 0.61% on Wednesday, and halfway through the morning session, the FTSE and CAC index are trading down -0.32% and -0.17% respectively.
In forex, the US Dollar Index (DXY) initially ignored Powell’s comments and closed the day at 99.20, but the index slid down to 98.98 overnight.
The delay is hard to explain, but the ultimate reaction is logical considering that the speech by the Fed Chair was taken as broadly supporting a further interest rate cut at the end of October. Further delayed reactions and after-shocks can be anticipated as the financial markets digest and revisit the Fed’s move back into the bond markets.