Losing Control Of Federal Funds: What’s Transmission Got To Do With It?

What’s transmission got to do with it? An odd question perhaps, but not when you step back and think about everything you’ve been taught or told about when it comes to this stuff. From the very beginning, they tell you unequivocally how the Fed is in the middle and everyone must simply obey. It does things with its printing press and the markets, all of them, responds accordingly.

Never, ever fight the Fed.

What happens when the Fed does things…and the market doesn’t respond accordingly? Transmission.

way more than a year already (so much for those September 2019 “technical factors”, the latest excuses).

But in purely mechanical terms, what are now two overnight repo operations may more closely resemble China’s RRR’s. When you think about what those latter truly are, meaning how they function in a way that isn’t stimulus, the resemblance is uncanny.

There’s a huge liquidity hole which the Chinese central bank is trying to manage. How? By inviting Chinese banks to fill it in with reserves they already hold. A lower RRR is the PBOC giving these institutions a bigger pile with which to work, effectively more usable reserves for all sorts of functions up to and including money markets.

And the biggest danger, as I always write, is that Chinese banks will simply refuse the license (like they did in the middle of 2015). A lower RRR may mean holders are able to use more reserves, but that doesn’t necessarily mean they will be used. Banks may instead choose, for their own reasons, to hoard that liquidity. Which turns it into its more nefarious and hugely misunderstood cousin, “liquidity.”

It is misunderstood precisely because the media uniformly, uncritically calls it that when in fact it doesn’t function in that way. Transmission.

Tuesday’s Fed overnight repo took up $53.15 billion. Who took it, though? Some unidentified bank in Singapore desperately in need of dollar funding because global repo won’t transform EM junk bonds any longer? Nope. That $53.15 billion was bid for by only the 24 primary dealers registered with the Fed in NYC (and even that was too difficult, as the whole world witnessed one embarrassing snafu after another yesterday).

What that means in functional terms is the central bank is providing these New York banks (which, going back to TAF, may mean “New York” banks) with that “additional” $53.15 billion in order to offset what must already be a major liquidity hole. The Fed is therefore counting on these same primary dealers to use these reserves in money markets, to take advantage of these arb opportunities such as fed funds.

Given more of these reserves, the central bank expects that primary dealers will then forward them into the rest of the marketplace – as a second step to lend them to that desperate bank in Singapore who is so desperate it is willing to pay essentially a penalty rate for funding. With more dealers having more reserves, the theory is that through dealer competition the penalty will shrink, rates everywhere will come down as dealers like Chinese bank put their newly sanctioned reserves to work.

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And what happened yesterday? To some degree, the primary dealers seem to have refused. Transmission.

So, the media uniformly writes up this additional liquidity when all the numbers come back and tell us it was “liquidity.” Despite that $53.15 billion, the repo rate shot up higher and for the first time since the “somehow” Global Financial Crisis the Federal Reserve totally lost control of the federal funds rate. As we said yesterday was likely to happen, FRBNY published today an effective federal funds rate for September 17 of 2.30% – 5 bps above the central bank’s target range.