Wednesday, October 21, 2009

Not Good: Fed's Test of Repo System Fails

Mad scientist Ben Bernanke, with his new tool of paying interest on Fed reserves may have created the monster that we have been warning about. His interest rate tinkering has resulted in nearly one trillion in excess reserves. That's not a typo. Excess reserves stand at $918,431 million, according to the latest Fed H.3 release.

If banks start loaning out against this money, the Fed will have to raise rates quickly to stop it, raise reserve requirements or drain reserves. None of these are attractive solutions. Indeed, the Fed test of draining may have just failed.

ZeroHedge reports:
On Monday the Federal Reserve held a major reverse repo test, as was announced by the NY Fed and by Zero Hedge. We have subsequently received several unconfirmed reports that the conducted test has been a disaster...Notable about Monday's reverse repo "test" was that it was quite sizable: in the $100 billion ballpark, on parallel with the biggest liquidity extraction from 2008. The outcome was the discovery that the dealer community does not have the capacity to do reverse transactions of this magnitude. As a result the Fed was forced to go directly to the money market industry, which has been speculated as a key source of excess liquidity withdrawals...

This sets a dangerous precedent on two levels. First, if the dealer community, recently expanded to consist of such middle-market banks as Jefferies which allegedly has over $20 billion on its balance sheet compliments of various Fed repo actions, is unable to satisfy reverse repos of this size, a big question mark appears as to what is the illiquid collateral backing the Dealer community, if it is unable to comply with a $100 billion liquidity withdrawal. Second, it indicates that reverse repos as a source of liquidity extraction by the Fed will be contained to the very precarious money market industry. All that is needed, in today's hair-trigger mindset on liquidity, is for another systemic glitch to be made apparent to all market participants, before yet another run on money markets occurs"...

We will follow this topic closely, as the rumor now is that the Fed will no longer attempt dealer-based reverse repos after Monday's failure, but confine them exclusively to money markets. Whether or not the Fed is correct in gambling with the $3 trillion+ money market industry when it should be doing all it can to extract liquidity out of the very same dealer community it has so generously been rewarding for over 7 months, is very much open to debate.
Of note, according to ZeroHedge, the Fed tested in the $100 billion range. The Fed has $1 trillion in excess reserves.

As I reported, recently, the Fed seems to think it will be able to pull off a gradual drain. They are basing this on hope, this wish, on no facts. I wrote:

The Fed discussed the extremely high excess reserves. They clearly expect banks to only start loaning out against these reserves slowly. That could very well be the case, but there is certainly no data, or theory, to back this up. It is probably just as likely that a rapid employment of excess reserves could occur. Bernanke's use of new "tools" to control money growth further complicates the matter.
Bernanke is really playing with fire.

A double dip will likely cause him to start printing again, which will, at some point,l result in money no longer sitting on the sidelines. This then becomes a very inflationary scenario. Bernanke will have to do severe draining or we will face severe inflation. Very scary stuff.

But, one step at a time. Right now the concern is a double dip recession, a crashing stock market and, most likely, short to medium dollar strength.

And one further note re a future run on money markets, where I may differ a bit from Zero Hedge, it is a little unclear what he is thinking. But if a money market run occurs, and like Zero Hedge, I think it can't be ruled out, the Fed won't be draining at such a time they will be pumping at record rates supplying the system with funds just as they did in September 2008. so the drain concern, at such time would disappear.

2 comments:

  1. "A double dip will likely cause him to start printing again, which will, at some point,l result in money no longer sitting on the sidelines. This then becomes a very inflationary scenario. Bernanke will have to do severe draining or we will face severe inflation. Very scary stuff."

    Do excessive reserves at banks represent the most significant "money on the sideline"? Or are you referring to companies, investors, and other individuals who have fled to the safety of holding dollars?

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  2. I consider sideline money as money held by individuals and organzations that has the potential to be used for stock buying.

    Excess reserves is a separate pool of funds that is not currentlt active in the system.

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