Friday was easily one of the most frantic days in terms of news flow in recent memory.
It started with a flaming Iranian oil tanker in the Red Sea, quickly progressed to more optimistic Brexit headlines, pivoted to an astonishing deposition statement by the former US ambassador to Ukraine, segued to an unfavorable ruling for President Trump around a House subpoena for his tax returns, ramped into an announcement of a larger-than-expected troop deployment to Saudi Arabia, escalated materially with the early announcement of “QE Lite” from the Fed, and then reached a screeching crescendo after lunch when Bloomberg confirmed that the US and China had struck a partial trade deal.
As I write these lines, the details of the limited trade agreement are just coming in. The US won’t hike the tariff rate on $250 billion in Chinese goods next week (it will stay at “just” 25%) and, in a disappointing development that caused stocks to pare Friday’s outsized gains, there is no decision on whether Trump will go ahead with planned 15% tariffs on $160 billion in additional goods on December 15.
China will ramp up farm purchases, and there is an agreement on FX stability. Treasury has not decided whether to remove the derisive “manipulator” label Steve Mnuchin slapped on Beijing in August. Huawei is not part of what Trump is calling a “phase one” deal.
The details around enforcement of what, by all appearances, is a wholly nebulous truce, have not been worked out and there is nothing in writing.
The broad contours of the agreement are generally in line with this week’s series of leaks. In light of recent US escalations (including the blacklisting of more than two-dozen Chinese tech firms including surveillance colossus Hikvision and a new travel ban on officials linked to human rights abuses in Xinjiang), China seems to have hardened an already calcified position. In short, any broader agreement around Beijing’s industrial policies and other key structural issues will have to wait.
But the key for markets was that something – anything, really – came out of this week’s negotiations. Tariff relief that forestalls the imminent escalation previously scheduled for October 15 is good enough, although, again, the fact that there was no decision on the December 15 tariffs caused US equities to trim gains into the close (see top pane).
Friday was the third consecutive day of solid gains for stocks, but prior to the late swoon, the S&P was on track for its best single session in two months. By the bell, we were back in “nothing to write home about” territory.
You should note that some of Friday’s gains were tied to systematic flows, as always.
“The Street has been forced into a ton of ‘crash’ protection, as they’ve had to hedge the mongo VIX Oct Call Wing- client flows they are ‘short’ while the monster S&P March downside impacts as well,” Nomura’s Charlie McElligott wrote Friday morning, before the bell, adding that “as the bullish macro catalysts have begun materializing, the various hedge expressions [in] VIX upside, S&P downside [and] Short Spooz are being lit on fire, while [the] buyside is seeing hedges go the ‘wrong way’.” Expiry is coming up next week, raising the specter that these decaying hedge expressions need to be “puked,” as it were. So, fuel on the proverbial fire.
In any event, I don’t want to get too far into the weeds on that or on the trade “deal.” The bottom line on the “limited” or “interim” or “early harvest” agreement between President Trump and Vice Premier Liu He is that it’s a near-term catalyst for markets, but won’t be any semblance of “real” until it proves to be durable – that is, until the market believes that the threat of abrupt escalations has dissipated. Clearly, what we got on Friday is underwhelming in that regard. And in any case, the damage to the global economy is already done.
I also want to briefly discuss “QE Lite”, which, as noted above, the Fed officially unveiled on Friday.
How much you “need” to know about this is really a function of how much you “want” to know. No matter what you might have heard or read, and notwithstanding the hilarity of Jerome Powell’s “The Fed chair doth protest too much, methinks” moment in Denver on Tuesday (when he repeatedly insisted that “organic” balance sheet growth to relieve reserve scarcity is not tantamount to QE), this really isn’t QE. The goal is different. The Fed is not trying to compress risk premia or engineer a glut of reserves or generate a “wealth effect.”
Rather, the Fed is attempting to reestablish an “ample” reserves regime with a “buffer,” after the wake up call they got in September, when a confluence of idiosyncratic factors conspired with well-known structural issues to trigger an acute funding squeeze in money markets. I’ve discussed this ad nauseam elsewhere and twice for this platform (here and here).
The events that took place during the week of September 16 kicked off a veritable contest among pundits, journalists and bloggers to see who could deliver the most incisive, in-depth take on the situation. That’s common whenever there’s a clog in funding markets. There’s something about a repo squeeze that makes everyone want to show off their purported mastery of the subject. I’ve been just as guilty of that as anyone over the past month.
One of the key points is captured in the following excerpt from the September FOMC minutes:
Money markets became highly volatile just before the September meeting, apparently spurred partly by large corporate tax payments and Treasury settlements, and remained so through the time of the meeting. In an environment of greater perceived uncertainty about potential outflows related to the corporate tax payment date, typical lenders in money markets were less willing to accommodate increased dealer demand for funding. Moreover, some banks maintained reserve levels significantly above those reported in the Senior Financial Officer Survey about their lowest comfortable level of reserves rather than lend in repo markets. Money market mutual funds reportedly also held back some liquidity in order to cushion against potential outflows.
The bolded bit essentially underscores the futility of trying to measure reserve adequacy.
“Attempts to measure where reserve scarcity kicks in were always doomed to fail, though hindsight is always 20/20,” BMO’s Jon Hill wrote, in a note out following the release of the minutes on Wednesday.
Consider that with the following excerpt from the latest note by BofA’s Mark Cabana, who has certainly made the most of the opportunity to shine afforded to short-end rates strategists by last month’s repo drama:
Increased money market sensitivity to reserve changes… can be seen in both the level and change of reserves as shown in Chart 5, Chart 6, and Chart 7. As the level of reserves declined the slope of the “reserve demand curve” appeared to become increasingly non-linear. We also note increased sensitivity between a change in reserves and money market rates, especially since the start of Q2 ’19. Prior to the mid-September corporate tax date and Treasury general account rebuild, banks had typically met large reserve drains by lowering their holdings of excess reserves at the Fed. Previously [banks] facilitated their tax date deposit outflows via reserves but drew down a more balanced mix of reserves and reverse repo allocations in mid-September. The greater reluctance to draw down reserves last month likely indicates banks didn’t want to see reserves fall given their desire to preserve them as the preferred method to meet liquidity stresses.
Those are selected passages from a much longer postmortem by Cabana that takes an exhaustive look back at the events that rocked money markets last month, and seeks to draw some conclusions as to the proximate cause, which BofA continues to insist was reserve scarcity “and not reserve distribution or reserve change issues.”
Clearly, all of this is inextricably bound up with the need for Treasury to finance the ballooning budget deficit. As Cabana goes on to write in the same note, “exacerbating factors [included] elevated UST Treasury supply [and] bloated dealer balance sheets, especially towards the front end of the curve.”
This is what the Fed sought to address with overnight and term repo operations last month. Those operations were initially upsized to meet demand, and then, once the most acute stress was beaten back, the Fed announced a schedule. Those operations were extended through November and, as of Friday morning, through at least January.
In other words, the Fed will be conducting temporary repos (“TOMO”s) alongside POMOs for at least the first three months of organic balance sheet growth. That will ensure that what happened in September doesn’t happen again around the year-end funding squeeze, and it also buys the Fed time to work out the details of the long-rumored standing repo facility.
Now, as far as the actual purchases go, the Fed said it will “purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.” The schedule shows purchases through one-year in maturity.
That pace (i.e., the initial $60 billion/month figure) means the Fed wants to move quickly to reestablish an ample reserves regime with a buffer. They’re not waiting around or slow-walking it.
Indeed, that they announced this on Friday (it will start next week) as opposed to waiting until the October Fed meeting is itself notable. Here is a rough approximation of what this will look like from Goldman (and do note that this assumes $60 billion/month for the first four months, which the Fed has not yet committed to):
T-Bill purchases will extend “at least into the second quarter of next year,” the Fed said Friday. To be clear, the Fed will have to keep buying roughly ~$150 billion worth of something annually in order to keep reserves stable once the initial “bazooka” purchases to back away from the upward-sloping part of the reserve demand curve and reestablish a buffer are on the books. So, this is going to be a permanent fixture of markets.
Presumably, the Fed will need to convert the TOMOs to permanent reserves at some point, which would equate to an additional $150 billion in POMOs, although now that the overnight and term operations will run through January, the can has been kicked on that, and it could be addressed with a standing facility. Here is a super-handy table from BofA which outlines all the various options for dealing with the kind of stress that showed up September and which “QE Lite” seeks to address on a sustained basis:
What you’ve hopefully surmised from the above is that this really isn’t “QE.” Yes, the Fed is expanding its balance sheet, but this is a technical matter and importantly, it was going to happen eventually anyway. The only thing that changed in September is that the Fed learned how easy it is to misjudge the threshold for reserve scarcity – how hard it is to observe the unobservable, if you will.
The overarching message after a truly manic day (and week) for markets, is that the “deal” between the US and China is no “deal” at all. And “QE Lite”, is not “QE.”
Of course, that’s not to say that the news is bad. It’s better to have a “phase one” agreement between the US and China that forestalls further escalations than nothing. And it’s infinitely better to have a proactive Fed that is moving aggressively to roll out a permanent solution to a problem that has still not been definitively diagnosed.
There’s no need to look at things from a glass-half-empty perspective. But you should also avoid donning rose-colored glasses.
Assuming you want to see things clearly, that is.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.