Why NIRP may trump QE4

FOMC Dot Plot for 2015

The Fed unsurprisingly chickened out from the much touted September hike. International conditions and a disapproval from Mr. Market was enough to unnerve an increasingly bewildered FOMC board.

Less well known is the fact that the FOMC gave a strong, and unexpected, signal to the Pavlovian world of central bank front runners. Dovish hold as the enlightend call it. It is all about managing expectations – see Goebbelnomics where we said

As the Keynesian revolution was merged with the models of Robert Lucas, it eventually morphed into something called neoclassical economic thought. The general gist was that economic agents can be tricked into changing their behaviour through surprises in monetary policy, which yes, has somewhat miraculously become the mainstay of central bank economists… … the academic transition led to the “economics of money shifting to economics of psychology”.

With this in mind it seem untenable that the radical change in the dot-plots is due to a rogue, independent minded FOMC member. On the contrary, everything coming out of the Federal Reserve is well coordinated and is there to signal to the rest of the world where the Fed would like speculators to place their bets, or in this case, should not put their money.FOMC Dot Plot for 2015FOMC Dot Plot for 2016Source: Federal Reserve, Bawerk.net

With the probability of the Federal Reserve’s funds rate going negative in 2016 suddenly much higher, the one way bet on a stronger dollar (and hence emerging market crash) is put into question. Investors will thus think twice before sending their money into the dollar from now on. This is obviously a desperate move from the FOMC in a futile attempt to stem the emerging market capital exodus.

As the chart below shows, large movements in the dollar coincide with emerging market bubbles and busts. The FOMC, wrongly, believes the strong dollar causes the bust, but in reality it is just a symptom of massive capital misallocations unable to service their debt and a consequent retrenchment in the Eurodollar leverage and velocity. Insisting on maintaining the unsustainable capital flows will only make the inevitable bust that must larger.

In other words, by adding international developments to the FOMC action function the health of the Eurodollar has become the de facto guiding target for the Fed. The Global Central Bank has officially been born.US Dollar IndexSource: Federal Reserve of St. Louis, Bawerk.net

It also tells investors, especially Wall Street banks with USD2.2 trillion held in a depository account at the Federal Reserve, that they should not necessarily expect to receive 25 basis points on their excess reserves for ever. Some of these banks were undoubtedly looking forward to the day the FOMC was forced to raise the rate on excessive reserves (IOER) because it  would create even more scarce “capital” for the banks to play around with. In addition, those same reserves the Fed is paying banks to hold are part of an intricate  re-hypothecated collateralised financial chain, helping to prop up risk throughout the investable world. We touched upon this in Corporate Foie Gras.  

To banks, excess reserves are a highly valuable commodity. It receives an income (the IOER) as an immobile cash pile at the Fed and can simultaneously be used to trade ever rising markets.

However, the recipient of such collateral will use the very same collateral for their funding needs (re-hypothecation), creating long collateral chains dependent on the excessive reserves staying put.

However, if the cost of keeping  reserves increases it will at some point be better to use the money directly – id est. withdrawing the money from the Fed. Note, the original holder of these deposits only benefits from the IOER and the first link in the collateralised chain. If the interest received  go negative (and markets drop) it is easy to see that the cost of maintaining excess reserves will easily outweigh the benefits. The holder will thus refrain from keeping reserves at the Fed. This will in turn break the collateralised re-hypothecated chain, which will lead to widespread deflation (just as the QE’s wreaked havoc with the shadow banking system) and a general market sell-off through a fall in collateral velocity and leverage.

In the latest update on depository institutions Federal Reserve deposit holdings we may just have gotten a taste of what to expect. Banks withdrew an unprecedented USD405bn in one week; incidentally a week when the S&P500 lost more than 6 per cent. Hardly a coincidence.Deposit held at FEDSource: Federal Reserve (H.4), Bawerk.net

So why would the FOMC risk so much by signalling NIRP when they could just keep interest rates unchanged and leave it at that? First of all, we don’t think they have a clue on what is going on behind the most obvious  – the thing that is seen to use an expresson from Bastiat. The perception of central bank omnipotence may be a thing on Wall Street, but we don’t buy it.

Secondly, as mentioned above, they want to stem the strong dollar movement (which is just another way of saying propping up a crumbling Eurodollar).

Third, and this is where we think the Fed is going with this, they need to make sure there is a bid on TSYs as the global vendor funding machine is currently in reverse. Emerging markets and commodity producers have become net sellers of TSYs on a 12mth rolling basis and if the Eurodollar deflates further from here this selling will only intensify.

Imagine what would happen to “risk” if the all the banks, pension- hedge- and mutual funds would sell stocks and corporate bonds to buy TSYs in a deflationary down spiral. Rosengren’s Ternary Mandate would obviously not be met according to standard.EM TSY purchaseSource: US Treasury – Treasury International Capital (TIC), Bawerk.net

To assure a TSY bid, NIRP, or the possibility of NIRP, should induce banks to reallocate their excessive reserves to the treasury market; especially if there were a chance the Fed may lure them in with hints of both QE4 and NIRP.

In Europe something very similar happened. When the ECB lowered the deposit rate to zero banks moved funds from the deposit account to the current account to avoid the added cost of using the overnight deposit account, but then slowly moved money out of the ECB system and into sovereign bonds.European Bank use of ECB deposit facilitySource: European Central Bank (ECB), Bawerk.net

The striking similarity between Greek bond yields and excess liquidity within the euro bloc clearly suggest banks started to front run the ECB by buying sovereign bonds as the cost of holding excess reserves rose and the lure of buying sovereign bonds increased due to hints of ECB QE.Euro Area Excess LiquiditySource: European Central Bank (ECB), Bloomberg, Bawerk.net

Greek yields are obviously affected by the dire political situation and negotiations with the quadriga and can make massive moves on the whims of European politicians. However, investor front running the ECB with the use of excess reserves is clearly shown in other markets too, such as the Bunds, Oats and BTPs thus substantiating our argument. 10YrsSource: Bloomberg, Bawerk.net

The European experience with NIRP is exactly what the Fed is looking for. Releasing excess reserves to buy the TSYs being sold by panicking emerging markets. In addition, the mere mentioning of NIRP could actually deter further dollar strength.

The fact that the re-hypothecated collateral chains that currently holds up risk will break and become highly deflationary and that the dollar strengthens because of a crumbling Eurodollar and not some perceived strength in the US economy will be lost on our money masters.

We believe the US will be in recession before the end of 2016 and then things will be really interesting. How will the public receive news of more QE, NIRP, forward guidance, cash bans and capital control in a time when faith in central bank omnipotence disappears?

Ceterum censeo Federal Reserve esse delendam