The Moment of Truth Just Got a Bit Closer

Hey There Income Hunters,

 

A couple of weeks ago I wrote about Treasury repo rates going negative and how you, dear reader, could now have the pleasure of paying someone else to borrow your money.

 

I also noted that the Fed would have to use its balance sheet to absorb all the excess reserves flooding into the system by employing the overnight reverse repo rate facility, which the Fed provides for cash lenders … 

 

Well, the issue is getting worse and it could ultimately force the Fed to — brace yourselves … 

 

Taper!

 

When the Fed tapers its balance sheet — meaning it cuts back on quantitative easing (QE) — the market gets very angry and bonds pitch a “Taper Tantrum,” which results in sizable drawdowns …

 

Tapering has a direct impact on the markets since, as I often talk about, QE injects cash into the banking system. Although that doesn’t increase economic growth directly, it does help the Treasury distribute bonds to fund government debt …

 

Removing reverse repo and initiating tapering could make it harder to distribute debt and interest rates would have to rise to compensate potential investors.

 

The chart illustrates the impact on the iShares 20+ year Treasury Bond ETF (Ticker: TLT) the last time the Fed announced QE tapering, 2013 …

 

 

As you can see above, TLT plummeted $20. That’s a big move for an ETF with 10% volatility.

 

Other Problems Caused by QE Taper

 

The minutes from the April Fed meeting were released yesterday and touched on the problems with having so much cash floating around in the system.

 

A boatload of money doesn’t sound like a bad thing, right? But here’s the scoop …

 

Treasury Secretary Janet Yellen released $1 trillion that was leftover from the Trump administration into the system last month …

 

The banks, however, didn’t have the balance sheet capacity to accept the excess cash as deposit, so the money ended up going into the repo market at negative rates. 


Why was that allowed to happen?

 

Because investors need Treasury collateral for funding operations, so they invest despite the negative rates.

 

The Fed, meanwhile, doesn’t want those red numbers in the system, so they lend the Treasuries from QE and offer higher rates for the excess cash.

 

(This is the basis for the Fed’s reverse repo program, in which the Fed sells Treasury securities to holders of excess cash with a repurchase agreement for the cash holders to buy back the next day. The Fed also sets reverse repo interest rates.)

 

Of course, if you put the flows together, you end up with the Fed buying bonds via QE and lending bonds via reverse repo …

 

In essence, they are monetizing the debt and, bada bing, bada boom — you end up with  Modern Monetary Theory (MMT) … The legal version would be the Fed and the Treasury joining forces  so the Treasury can issue as many bonds as they need and sell them to the Fed who would hold them on their balance sheet until they mature… However they do not have the legal ability to do this yet….

 

And reverse repo is growing very rapidly as foreigners are getting rid of dollars, which makes the excess cash situation even worse.

 

The chart below illustrates the dramatic increase in size of the RRP program …

 

Chart courtesy of Zero Hedge

 

Taper Time?

 

Yesterday’s Fed minutes also revealed board members suggesting they open discussion on QE taper.

 

Tapering reduces the amount of excess cash in the system, but also increases the risk of tightening credit — which could cause a market meltdown like those in the chart above.

 

This is the trap we knew the Fed was in all along.

 

The endgame for the Fed and Treasury is official MMT, through which the Fed could legally monetize the debt …

 

Banging on the Banks

 

However, this would also spell huge trouble for banks …

 

1. Trading Profits Would Sink

QE is a cash cow for banks, who are in the middle of every trade. They buy bonds from the Treasury in the auction and then sell to the Fed when the Fed executes QE.

 

This then goes on the Bank’s books as Federal Income Clearing Corp. (FICC) trading revenues, which have been a major earnings bright spot for years.

 

2. Banks Inventory Would Lose Value

 

As you can see from the graph below the, banks today hold record amounts of Treasury and Agency securities. Pulling back on QE would remove the Fed as a buyer for bonds and puts the  onus on investors to purchase at the auctions.

 

Yields would have to rise significantly in order to compensate investors enough to purchase the trillions in Treasury bond supply that is issued every quarter. Yet, tising yields means lower prices on all the inventory the banks are holding.

 

 

3. Banks Woulds Get Cut Out of the Fed/Banks/Treasury Food Chain

 

For decades, the banks have sat in the catbird seat of the U.S. monetary system. They bought bonds from the Treasury and sold them to the Fed.

 

Here’s how the system has operated for decades …

 

 

The problem has always been that the banks were never required to lend to Main Street …

 

And most of the time they didn’t — because they made more money using the proceeds to trade the markets.

 

This has been a major drag on economic growth … 

 

So, Fed Chairman Jerome “J-Pow” Powell and Janet Yellen are planning on cutting the banks one of two ways:

 

      1. Amending the Federal Reserve Act of 1913, to give the Fed the ability to use the dollars they print as legal tender and send it directly into the economy.
      2. Creating a special-purpose vehicle that would establish a separate entity under which the Fed could send dollars that the Treasury could direct into the economy.

 

In either case, they would bypass the banks and get money directly into the economy.

 

For #Income Hunters this would be Hyperinflationary and be very negative for the banks… meaning oversized profits by supersizing inflation trades and putting on bearish Financial Select Sector SPDR Funds ETF (Ticker: XLF)

 

Bring It Home,

 

We are in for one hell of a ride…

 

This will be a war between J-Pow and Janet Yellen on one side and Jamie Dimon and the Banks on the other.

 

And, boy, will it escalate quickly.

 

The Fed will win this fight … the question is can they win the looming war versus China.

 

Either way, it will be interesting and historic.

 

Have a great day and as always …

 

Live and Trade With Passion My Friends,

Griff

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