Goldman- Excess Reserves Irrelevant and the FED does not need to execute Reverse Repos with Non-Primary Dealers


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Hopefully, when Goldman talks, people listen:
Clarification from author Franesco Cafagna: Views expressed in this piece are his own and are not necessarily reflect the view of Goldman Sachs

1. Do excess reserves really matter and does the FED really need to drain them?

The short answer is: I don’t think so. The total amount of reserves currently in the banking system is the sum of all Required Reserves (including a certain amount that banks hold for precautionary reasons) and Excess Reserves. The FED HAS to provide the banking system with the amount of Required Reserves it needs otherwise rates spike higher (potentially to infinity if the discount window or other forms of “marginal lending facilities” did not exist): the amount required is the result of banks’ individual credit decisions (how many loans they make) and the FED’s job is to estimate that amount and provide it to the system. But the FED does not control this number. When it comes to Excess Reserves, lots of people worry about the potential long-term inflationary impact they may have. The truth is that they don’t matter because they bear no weight in banks’ credit decisions (how many new loans they make). They simply appear on banks’ balance sheets as an Asset that gets “invested” every night in the form of a deposit that they leave at the FED and on which they currently get a 25bps remuneration. If the FED decided to drain excess reserves via Reverse Repo the impact on the system as a whole would be zero because the system as a whole is “self contained”. To understand this let’s think of the most extreme case: the FED drains all excess reserves via one giant Overnight Reverse Repo executed with all the
banks in the banking system. At a macro level all that’s happened is that each bank has changed its Excess Reserve asset (which is effectively an O/N asset) into and O/N Reverse Repo and the two are virtually identical. Another way to think of this is that Excess Reserves are ALREADY being drained every night because banks leave them on their account at the FED every night. The only thing that will change is the liquidity profile of banks IF the FED decided to execute Reverse Repos longer than 1 day: in that case a 1-day assets (excess reserve) would be transformed into a longer asset (Reverse Repo longer than 1 day). Whilst this may affect individual institutions, the system as a whole is unaffected because this amount “extra cash” in the system (excess reserves) is NOT being used for anything. It just sits at the FED every night. So effectively it’s being “drained” already every night. So all this talk about excess reserves and their potential inflationary impact seems misplaced: they are just irrelevant and the FED simply does not need to drain them because they are “self-drained” every night anyway.

2. Does the FED really need to execute Reverse Repos with Non-Primary dealers?

This item has gained press coverage following the Fed’s release of the last Fomc minutes in which it was clear that it debated the possibility of executing large scale reverse repo operations with non-primary dealers: the motivation behind this discussion is the perceived balance-sheet capacity constraint that the 16 Primary dealers might face (a Reverse Repo increases the assets of the broker-dealer entity facing the Fed). This statement by the Fed has created all kind of debate across the street with various dealers coming up with all kinds of estimates of the overall size that the Primary dealers can handle (with some estimates being as low as 100-150bn out of a total of over 800bn that the Fed might want to execute). Leaving aside the actual need to execute Reverse Repo in the first place (point 1 above) and assuming that the Fed will, in fact, choose to execute these operations because it has stated that they are part of the exit strategy policy, I think the alleged Primary Dealers’ balance sheet capacity constraint has been VASTLY exaggerated. It’s true that a Reverse Repo increases the assets of a broker-dealer entity, but this is an issue only for stand-alone broker-dealers (Jeffreys and alike). For Primary Dealers with big commercial banks operations (JPM, Citi, BOA) I don’t believe that this is an issue at all: since they are already sitting on big amounts of Excess Reserves and because 23A (which regulates the activity between a bank entity and its affiliates) does not impose any restriction on the amount of UST, Agencies and Agencies MBS repos that a bank can execute with an affiliate broker-dealer entity, this means that the JPMs of the world could potentially execute reverse repo operations with the Fed up to the amount of excess reserves they are already sitting on without increasing their balance sheet by 1 single cent: it would simply be a transformation of an asset (excess reserves of the bank entity) into another (reverse repo of the broker-dealer entity). So, in my view, the conclusion has to be that the Primary Dealers can in fact absorb a much bigger amount of Reverse Repo than originally thought even by the Fed itself and that realistically the only other counterparties that the Fed might engage directly for these kind of operations are the GSEs: but in this case the reason would not be balance sheet driven but would be driven by the distortion that the GSEs’ participation in the fed funds mkt creates (call me if you would like to discuss this further).

By Franesco Cafagna


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gold supply comments


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Nadler: The gold market is made up of five pillars. On the supply side, you have mine supply, scrap gold supply and occasionally central bank sales or purchases (that’s kind of a swing factor). On the demand side, you have fabrication demand for jewelry and so on, and investment demand, which is a cyclical, emotional phenomenon—people go into stages of panic, fear, greed, and bubbles are formed, and so on.

On the supply side, lately you’ve started to hear people say supply is running into oblivion, that it’s “peak gold.” Well, the reality is that GFMS’ latest computations (which run through midyear) show an actual 7 percent increase in mine output, of 1,212 tons. Miners went on hiatus only because the credit crunch prevented those who had found all this gold from actually coming to market with it.

Crigger: Sounds like we won’t be hitting “peak gold” anytime soon.

Nadler: No. Maybe we’re not finding huge discoveries like we used to, but some $40 billion has been sunk into the ground to find new gold, and nobody goes out and spends $40 billion figuring it’s wasted money and nothing else will be found. And miners are eager to find new gold, because the average cost of production is in the low-$400s. So at $1,000/oz, it’s a party.

So now that some of that gold is starting to show in the pipeline, we better have eager takers for it all, because when you look at incremental mine additions over the next five to six years, we could have as much as 400 tons’ worth of additional mined supply coming into the market year-on-year. That’s significant—that’s almost 25 percent higher yearly output in mining than people thought was coming.


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Valance Weekly Economic Chart Book


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Valance Weekly Economic Chart Book

A bit disorganized, but these are my impressions as of month end.
(Look for the usual couple of days or so of month end allocations driving the technicals.)

I don’t see much to get encouraged about on almost all of these charts.

In general, demand was trending lower since maybe mid 2006, took a sharp dip in mid 2008 with the great Mike Masters Inventory Liquidation that ended in late Dec 2008, after which the rate of decline stopped accelerating (second derivative change), and now were are, for the most part, back on the ‘trend line’ of the slow decline in demand that started in mid 2006.

Personal income looks very weak, hurt by falling interest income as previously discussed. The clunker lift has reversed, and housing remains very week with no real signs of recovery yet. (about 2% of GDP was clunkers and inventories)

The deficit got large enough due to the automatic stabilizers around year end, market functioning returned as the Fed eventually accepted enough different kinds of collateral from its banks to adequately fund them. (should have been lending unsecured to its member banks all along, etc.)

But while the Obama fiscal package added some demand, and GDP stabilized, the zero interest rate policy continued to shift savings incomes to widening bank net interest margins, and the Fed’s $2 T portfolio began draining another maybe 60 billion a year in private sector interest income. Additionally, interest rates on tsy secs have declined sharply with the Fed rate cuts. (While I fully support a zero rate policy I also recognize the need to sustain demand with a payroll tax holiday, per capita revenue sharing, and an $8/hr fed funded job for anyone willing and able to work.)

And now with productivity higher than real GDP growth, employment continues to fall, though at a lower rate, and capacity utilization in general remains at very low levels. Prices remain very weak, apart from gold, which could be a bubble driven by the misconception that the Fed’s ‘quantitative easing’ policy is inflationary. In fact, it’s nothing but an asset shift that modestly reduces term interest rates at the cost of draining billions in interest income from the private sector.

If gold does turn out to have been a bubble and collapse, it could be highly demoralizing as it would reveal the Fed does not have the tools to ‘reflate’ at will. Dollar shorts could start covering, further taking away the bid from stocks (also as previously discussed). And if the Saudis have left the prices to their refiners below current levels, crude and products will fall as well.

All major foreign govts. seem to be continuing to favor export led growth, which will also keep US domestic demand in check.

And, in general, it looks like most of the world is looking to tighten up fiscal policy, believing in the like of the ‘debt trap’ and also that monetary policy is expansionary and inflationary.


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