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What We Read Today 04 August 2014

Econintersect: Every day our editors collect the most interesting things they find from around the internet and present a summary "reading list" which will include very brief summaries (and sometimes longer ones) of why each item has gotten our attention. Suggestions from readers for "reading list" items are gratefully reviewed, although sometimes space limits the number included.

  • Downpour Slows Rescue Work After China Earthquake Kills 381 (Zhang Dingmin, Bloomberg) A magnitude 6.5 earthquake killed at least 381 people in southwest China around the city of Zhaotong in the southwestern province of Yunnan. The quake injured about 1,800 and destroyed about 12,000 homes according to reports from the Xinhua news agency. Yunnan Province is a beautiful mountainous region of China. But as residents there and in neighboring Sichuan Province repeatedly learn there are dangers living in the eastern shadow of the Himalayas. Read an interesting note by Michael Palin about Yunnan.

  • Ritalin Kid (Nick Dothee, The Fix) This is the author's personal testimony about attention deficit disorder (ADD) and addiction (his self-identified topics) and depression and OCD (obsessive-compulsive behavior), this reader's identified additional topics. It's not a long article but the story should stay with you for a long time.
  • Why the Security of USB Is Fundamentally Broken (Andy Greenberg, Wired) Next week security researchers Karsten Nohl and Jakob Lell plan to present malware they created, called BadUSB, which can be installed on a USB device to completely take over a PC, invisibly alter files installed from the memory stick, or even redirect the user's internet traffic. The functions can remain hidden long after the contents of the device's memory would appear to the average user to be deleted. The only way currently to avoid the risk of exposure is to "treat USB devices like hypodermic needles that can't be shared among users." And, of course, that negates many uses for USB devices. This may be a wise move until a new generation of USB device makers implement new security protocols.

There are 10 articles discussed today 'behind the wall', all of which cover details of the Fed's new reverse repo program.

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  • The diminishing usefulness of the Fed Funds rate (Walter Kurtz, Sober Look) The traditional tool used by the Fed to influence interest rates is the Fed Funds rate. This is the rate charged by the Fed for overnight loans to member banks and determines the rates that banks charge each other for very short-term loans. But this tool may not be as effective as in the past because banks are not lending to each other that much anymore. The next graph is provided by Kurtz to illustrate that point.

The next graph (inserted by Econintersect) gives a longer-term perspective and shows that current interbank loans are at the level last seen 30 years ago.

interbank-loans-last-30-years

The following graph (inserted and annotated by Econintersect) emphasizes the real loss of leverage experienced by the Fed Funds rate. From January 1973 to July 2009 the average of the ratio of total interbank loans to GDP was 27.2 (ratio multiplied by 1000 to avoid displaying fractional decimals). from 2009 to 2011 the ratio dropped to less than 1/4 the long-term average and between four and five standard deviations below the average.

interbank-loans-rel-to-gdp-last-40-years-annotated

See also next five articles.

  • The Fed preparing markets for the reverse repo facility (FRFA) (Walter Kurtz, Sober Look) The Fed has implemented (on an experimental basis) FRFA (full-allotment overnight reverse repurchase agreement facility). See next article for details. This is an additional Fed operation (besides the Fed Funds rate) to control and stabilize very short -term interest rates by placing a floor beneath which no loan transactions are likely. It should prevent rates from temporarily becoming negative. (Kurtz says this has happened in Europe). It should also assure continuing functioning of money market funds.
  • FAQs: Overnight Fixed-Rate Reverse Repurchase Agreement Operational Exercise (Federal Reserve Bank of New York) The Fed has clearly explained the reverse repo operation here. A reverse repurchase agreement, also called a "reverse repo" or "RRP", is an open market operation in which the Desk (The Open Market Trading Desk, operating under the authorization and direction of the FOMC - Federal Open Market Committee) sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The Desk receives cash from the counterparty and then returns cash at the specified time in the future. "The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty."

This opens the Fed short-term transaction market beyond the realm of primary dealers and the much larger community of all member banks to include any financial institutions the Fed wishes to include. The Fed says that the reason for developing this new interest rate control mechanism is to improve the FOMC "ability to manage short-term interest rates, regardless of the size of the Federal Reserve's balance sheet".

  • The diminishing usefulness of the Fed Funds rate (Walter Kurtz, Sober Look) We are returning to this article (it was discussed several articles back.) By opening up access of the shadow banking system (financial system firms that are not Fed members) to access the reverse repo operations run through the New Fed trading desk, the Fed has raised the amount of transaction run at interest rates that it sets.

reverse-repo-fed-2013-jun-2014-ma

The total of interbank loans plus reverse repos averaged around $320 billion in 1Q 2014 (interbank loans were around $120 billion, see graph three articles back). This brings the short-term assets subject to the Fed controlled rate back to the level it was before the Great Financial crisis and compensates for the nearly 5σ deviation discussed with that previous item. But this may not be the only action ongoing at present which can increase the Fed's leverage over interest rates. See the final article in today's 'behind the wall' list for how foreign banks are involved.

  • The Logic Behind The Fed's Overnight Reverse Repo Facility: Not Taking, But Adding Liquidity (Tyler Durden, Zero Hedge) This article introduces some other aspects of the FRFA (full-allotment overnight reverse repurchase agreement facility). One of these is liquidity and thus the concern about stable operations of money market funds mentioned a few articles back. Much emphasis in this artcle is given to the hogging of Treasury securities by the Fed. (They now own about 1/3 of the amount "held by the public", leaving only 2/3 for the rest of the public.) This reduction of the amount held by the larger public community (beyond the Fed) and has created liquidity issues. So another aspect of FRFA is to "alleviate collateral pressures for "high-quality assets". In other words to support short-term liquidity.
  • Why is the Fed under-testing the overnight reverse repo facility? (Mayur Sontakke, Market Realist) This article explains the Fed strategy to prevent over-encouragement "of a shadow banking system and how the FRFA (full-allotment overnight reverse repurchase agreement facility) will reduce the risk of financial crisis during times of high stress by (1) greatly expanding risk-free asset availability while (2) using circuit breakers (such as caps) to prevent impacting money markets negatively. Econintersect: As all discussants have noted, this is a facility under evaluation. The parametric limits of operation are still to be tested. That leaves this discussion rather in a state of limbo. But that doesn't deter critics: See the next two articles.
  • Total Inadequacy Of The Fed's New Tools (Skeptical Investor, Seeking Alpha) This author says the new tools available to the Fed (1) interest paid on excess reserves and (2)reverse repo operations are "totally inadequate" to deal with an "inflation shock".
  • Reverse repos are just a way the Fed soaks up cash from financial institutions.
  • The Fed is the "borrower," swapping its Treasuries for banks' cash.
  • Reverse repos drain money from the financial system.
  • This is similar to an article from earlier in the year which was discussed here some months ago. See next article for a longer discussion which comes to a conclusion which disagrees with Conrad's third bullet above.

    Stuber's logic may be confusing. He says the average per day for reverse repos by the Fed is $80.577 billion and he gives that exact same amount as the amount of liquidity withdrawn for the entire month. Since the Fed is selling and then rebuying the securities in a reverse repo, Econintersect would argue that only the difference between sell and higher buy is actually added to the system and nothing is withdrawn even for a full banking day.

    (Note: There are actually 49 repos in Stuber's table so his average should have been slightly higher, $82.22 billion.)

    There is an "overnight" (or weekend) liquidity removal for the financial system agents buying the securities from the Fed's SOMA (System Open Market Account, dealing in assets on the Fed's balance sheet) with a repo agreement to sell them back the next day (or after weekend) to the Fed. The Fed is actually creating reduced overnight liquidity by the total amount of reverse repos it assumes at any specific time and is adding a permanent level of liquidity equal to the sell-buy back spread paid to the same financial institutions. The financial institutions are buying a very small higher level of long-term liquidity (and financial system balance sheet asset increase) in return for a very much larger short-term (overnight) reduction in liquidity.

    The $4.029 trillion total is merely a cumulative currency "float" for the transactions, with a current "float" never exceeding $130.74 billion at any time (and averaging about $57 billion per day for the 71 days starting 02 January 2014 and ending 13 March 2014). Thus the amount of long-term liquidity added is the buy-sell differential per day (0.03% from the table provided by Stuber), which totals $57 billion x 71 days x 0.0003 = $1.21 billion.

    (Note: This rate per day is probably on the low side so the liquidity added may well be up to as much as $2 billion or slightly more. Some of the per day rates in this time period were less than 0.02% per day, but others were found as high as 0.05% per day.)

    This in no way sterilizes (counteracts) the $150+/- billion QE liquidity injection over the same 2+ months. The net effect is a small increase in total financial system liquidity over the total period and a small improvement in positive cash flows for financial system participants. There are overnight reductions in liquidity averaging $82 billion counting only banking days or $57 billion counting calendar days. These are all reversed the next banking day.

    The Fed claims the reverse repo operations are a tool to improve the ability to "manage short-term interest rates".

    Stuber claims the actions by the Fed are in a desperate attempt to stem a decline in the value of the dollar and shows the following chart:

    dollar-index-9-mos-stuber-sa-2014-mar-14

    • The Fed to pay foreign banks to keep the Fed Funds market alive (Walter Kurtz, Sober Look) Kurtz says that the Fed's intention to depend on the Fed Funds rate to be central in the upcoming normalization of interest rates (rather than the reverse repo program) has some problems. (See articles above.) Basically, there is not enough interbank lending to provide sufficient liquidity (previous article) and that has led to a dependency on foreign banks for sufficient Fed Funds demand for interest rate operations. The process involves the US federal home-loan banks (FHLBanks) who do not receive interest on excess reserves at the Fed. The FHLBanks can make overnight (O/N) loans to foreign banks who then add to their excess reserves at the Fed. This creates a 16 basis point rate of gain for the foreign banks as shown in the flow chart below. Kurtz points out that this significant source of overnight loan activity will vanish if the Fed Funds rate increases and the interest for excess reserves does not (an increase is very likely). (BTW, Kurtz points out that foreign banks can work with the 16 bp rate because they are not subject to FDIC insurance which is sufficient to make such a tactic unprofitable for U.S. banks.) Kurtz concludes:
    The whole policy of targeting the Fed Funds rate now depends on a handful of foreign banks' willingness to participate in this game - just as we approach the first rate hike in years. Is this really the Fed's best monetary policy tool going forward?

    foreign-banks-Fed-arbitrage-sober-2014-aud-02


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