Via Zoltan Pozsar at Credit Suisse:
The FOMC should forget about r* for the moment and focus on Sagittarius-A* – the supermassive black hole at the center of global dollar funding markets. The black hole is the foreign RRP facility, which has seen close to $100 billion of inflows since the beginning of the year. The driver of these inflows is the curve inversion, and the longer the inversion persists the more inflows will follow.
The trade war is also contributing to the inflows – given the inversion, as foreign central banks weaken their currencies they “buy” the foreign RRP facility and not Treasuries like in the past. Foreign central banks are rate shopping… …and an uncapped foreign RRP facility is what enables that.
Like the matter that enters a black hole, the reserves that are sterilized by the foreign RRP facility are gone for good – like the reserves “shredded” via taper.
Even if the Fed stopped taper cold on August 1st, taper will effectively continue for as long as an uncapped foreign RRP facility attracts inflows – and given the inversion, we think inflows will continue and eclipse $200 billion by year-end.
In English, that means that collateral supply between now and year-end will be $1 trillion – $800 billion from primary issuance and $200 billion from sterilization.
We maintain our view that given the inversion, the solution to this supply problem should not be a technical fix through a standing repo facility or asset purchases – if the Fed opens up its balance sheet to collateral supply during an inversion, it will end up monetizing way more Treasuries that it may feel comfortable with.
Furthermore adding reserves through a standing repo facility or asset purchases while having an uncapped foreign RRP facility sterilizing reserves would be odd.
The Fed overdid the hiking cycle and it priced Treasury supply out of the market – that’s what the FX-hedged yield of Treasuries relative to JGB yields tells us, and what inflows into a foreign RRP facility paying elevated o/n rates tells us.
For that fundamental problem, rate cuts, not technical fixes, are the solution…
The rate cuts will need to be significant to reverse it:
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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