The Fed is Losing Control of Repo Markets (Again)

Another day, another significant borrowing from the Federal Reserve's repo facility. This has gotten to be a regular occurrence and concurrent with money rates rising due to the cash squeeze I told you about yesterday. Starting to see a lot of similarities to 2019. That's going to have the Fed not only cutting rates, but talking about ending their balance sheet runoff, even if Steve doesn't necessarily agree with me right now. But that's what's happening with central banks. More importantly, what's going on with actual banks? U.S. depository institutions are continuing to pile up Treasury and agency bonds in their securities holdings, combined now just under $2 trillion. And for context, that total was just $1.75 trillion back in January, around when the current bull steepening phase really did get started. On the other side, the risky side, bank lending to shadow banks, or excuse me, non-depository financial institutions, that lending has slowed way down. This, rather than the Fed's balance sheet runoff and the reduction in bank reserves, is more likely the reason why we're getting all these signals surrounding cash tightness in the money marketplace. And one reason we know it isn't the Fed, one of the many reasons we know it isn't the Fed, is because we see basically the same thing unfolding in Europe. European depositories have pulled back their lending to non-depositories at the same time, continuing to stockpile major amounts of European government bonds. While the stock market continues to soar on trade deals, the macroeconomy, the real macroeconomy, continues to rewrite the vastly more important and relevant credit market conditions that are spilling over into what is already a modest yet escalating bout of illiquidity. So much so that even the Federal Reserve is going to have to take a second look and to do something that it does not want to have to do. But in the end, as Steve and I talked about yesterday, it doesn't really matter. What does is that this keeps happening and why it's happening. So after skipping Friday, this week starts out with the same way that it did last week, with more financials lining up to borrow some reserve from the Federal Reserve via its repo window. And remember, the standing repo facility is what Jay Powell came up with after the repo mess in 2019, and it's really supposed to be a version of the discount window or what they call primary credit. But where last Monday there was only $2 billion drawn from the Fed, today there was $8.4 billion, the most in any non-quarter end day since 2020. $3 billion of it was used on Treasury collateral and the remaining $5.4 billion was with MBS put up. That's the most on MBS collateral since the Thursday before last when Zions and Western Alliance came up, though those came up later in the day after the repo borrowing had already been arranged. And then going back the day before that, October 15th, the repo facility has seen action in all but three of those nine trading days since then. And the only other non-quarter end that we saw any repo facility usage was September 15th, which looks more and more relevant to the trend, even if it's the ultimate seasonal bottleneck. The idea behind this repo facility is that firms which aren't able to borrow at or near market rates have an alternative option to fund their positions, which theoretically should help keep money rates from jumping, which is the purpose here. Or at the very least, money dealers can borrow from the Fed and then re-lend the reserves in private repo markets to help do the same thing, keep money rates in line. Not surprisingly, it's not working. Back on October 15th and 16th, as repo facility usage was then at its highest, the benchmark SOFR rate surged to 4.29% and 4.30% respectively. Those rates were well above the upper limit the FOMC has set for the federal funds market. And while the Fed doesn't target specifically repo rates, they target federal funds, they know from experience in 2019, as I showed you in a video last week, when repo is a mess, that can spill over across money markets, including the market for specifically federal funds, and lead to volatility there and everywhere else, which does directly impact the Federal Reserve's money rate policies. So SOFR last week then dipped after those initial two days, getting back to 4.16% and closer to where it really should be before rising again to 4.24%, both Thursday and Friday last week. So given the use of the repo facility earlier today, the SOFR benchmark rate is almost certainly going to be above that and therefore above the Fed's Fed funds upper limit. So as you can see before recently, the SOFR benchmark was typically down toward the middle part of the Fed funds range. While there hasn't been the kind of obvious surge in repo rates that has spilled over into Fed funds just yet, the longer this goes on, the more likely something like this becomes. And that more than anything is why at the FOMC meeting this week, officials are going to at the very least discuss ending QT, if not vote for it straight away on Wednesday. Before we go on with our video today, let me ask you a question. What if your gold could actually pay you every single month in more gold? That's what today's video sponsor, Monetary Metals, lets you do. And here's how it works. You still own the gold. It's still in your name. It's fully insured. But instead of just sitting there doing nothing, it actually starts working for you. Monetary Metals has built a system that turns idle gold into productive gold, earning real yield paid in physical gold, not dollars. No selling, no trading, no converting. You keep your gold and every month you get more of it. 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As the central bank lets treasury and MBS assets and bought under the QE's runoff, that reduces the level of bank reserves, which we're supposed to believe is everything here. The truth is, as I showed in a recent deep dive analysis, the primary form of actual cash in the euro dollar world is money dealer balance sheet liabilities. They are the reason why before 2008, there were practically no bank reserves and the monetary system functioned perfectly well, certainly without the constant illiquidity deflationary conditions that we've been getting for years at a time since August of 2007. But the Fed has sold everyone on Fed bank reserves because that's what the Fed actually does. And this is what it does very well, not actual money in bank reserves, but selling the public on things. No one really understands what it is or what it does, and they certainly have zero idea how the monetary system actually works. So bank reserves are what everyone believes in, just as the Fed wants it. There's no evidence that the level of bank reserves plays any role in monetary tightening, let alone loosening. And this is another one, you do not have to take my word for it. In late 2022, as the Federal Reserve was then just starting up its QT process, it put out a circular which said, and I quote, with its return during the pandemic, QE seems to have become a more routine part of the Fed's crisis toolkit. But there is still debate among economists over how and how well it works. And when it comes to the reverse process of shrinking the Fed's balance sheet, typically referred to as quantitative tightening, QT, economists know even less. And you'd have to wonder how that can be after all these years of practicing QE and QT. And the reason why there is still debate about how and how well QE might work is simply because it doesn't. Proponents have been scrambling, trying to find smaller and smaller ways it might have done something that they can put into a study. And nowadays, those are usually just about made up term premiums on bond spreads. If bank reserves, especially printing trillions of them, were akin to money printing, there would be no discussion. There would be no argument. The results would be easily observable all over monetary conditions and the real economy. Instead, there is zero correlation with any real outcomes, particularly those that are promised like a resilient monetary system free from deflationary forces that we continue to observe almost constantly since they started with the bank reserves. Bank reserves are irrelevant, and they have been that way from the very beginning. So if QE doesn't show any results, why would anyone think QT somehow would matter? As the Fed itself says, they are just guessing. They're making it up as they go. They want it to mean something, but they don't really know for sure because there is no evidence that this is the case. What that means in this context is policymakers start lowering the level of bank reserves by allowing assets on their balance sheet to mature and not reinvesting the proceeds. That's called passive QT. The technical details don't really matter here. All QT really does is reduce the Fed's balance sheet, which is the entire point, not tightening, just reversing QE. If there was any kind of science behind it, legitimate science, Fed officials in 2022 would have said they're going to lower the level of bank reserves to a range around X because they know that a range around X is what the system actually needs. Notice that's not what happens. Instead, they just lower the level of reserves a little bit at a time until something happens. And then when something happens, they are further assumed that it happened because the lower level of bank reserves. So now that money rates are misbehaving here in October of 2025 and there's persistent use of the Fed's repo facility, that could be a sign the level of bank reserves is at a minimum. But here's the thing. If this had all happened three months ago, the Fed would have thought the level of bank reserves three months ago was that minimum. Or if this showed up three months later in January, the Fed would have kept going with QT the whole time and decided the minimum level of bank reserves was a lot less when they got to January. There's no science behind bank reserves or anything the Fed does. They just assume correlation might be causation and therefore react accordingly. Again, you don't have to take my word for it. When you actually look into this stuff and listen to what they're saying, what they're saying is we don't really know. We just kind of hope that it makes some kind of difference. In this case, QT has got to go because they don't know for sure whether or not it might actually make a difference. And if this cash squeeze and money markets keep going even after they terminate QT, they're going to have to say, well, the level of bank reserves, the minimum level of bank reserves must have been higher than we thought. So we'll have to raise the systemic level of reserves through a 2019 style not QE QE. They can't say that bank reserves are relevant. That would be admitting way too much. Instead, they say, well, it might have an impact and we can't possibly be sure. So we're going to have to, out of an abundance of caution, react in the way that we always react to the level of bank reserves, even though what's really happening in the monetary system is vastly more important and vastly more relevant. Meanwhile, in actual banking, meaning regulated banking, depository institutions have started to cut back and slow down their lending to shadow banks or non-depository financial institutions, as we're supposed to call them these days, because it doesn't sound nearly as scary and risky as shadow bank. Using the Fed's own data, the H8 statistics, banks were lending at a better than 10 percent quarter over quarter rate back in April. That was after a discontinuity in the figures, which means we don't have comparable totals before the start of this year. But that lending back around April wasn't risk taking either. It was mostly bailing out shadow banks and repo who had been stuck by the deflationary wave. Everybody blamed on trade wars. No, the fear was a legit setback in the economy was going to unleash losses in private credit portfolios of these shadow firms, which you'll note is what we are exactly seeing right here in September and October. It was the macro risk, not the tariff risk. And while the tariff risk might be diminished as all these trade deals get done, macro risk hasn't gone away. If anything, it's been increasingly confirmed, which is the entire reason why the otherwise inflationist hawkish Fed is forced to dovishly cut rates, not that rate cuts are any more relevant to the world than bank reserves are. But with Tricolor, First Brand, Zions, Western Alliance, Primalend, and the very little noticed VoiceBridge, the growth rate in regulated bank lending to shadow banks has slid to around three to four percent per quarter, which as you'll note is down significantly from earlier in the year. Not only that, you can see where the slowdown really started to slow down, which is, yep, right at the start of July when the U.S. dollar exchange value sold out of sell America and started to drive upward. Now, it isn't a full-scale pullback, but then again, full-scale pullbacks don't realistically happen. Everything is a process which takes time, and right now there is a process of scaling down underway, which also corresponds with the other signs and signals of monetary tightening that we've been following, not just in repo rates in the Fed's repo facility. This isn't bank reserves, it's bank risk aversion. And of course, the other side of that, if you're risk averse, you're going to want to own a lot of safe and liquid instruments, meaning U.S. treasury bonds, notes, and bills, as well as agency bonds. As of the week of October 15th, the latest data that we have from the Fed, banks added another seven billion in total for those, bringing the aggregate system up to 1.96 trillion. That's a 12% increase from the end of January, and 5% during the third quarter and the first two weeks of the fourth quarter. So even as stocks have soared and trading deal frameworks keep getting framed for the media, banking sector continues to de-risk, especially where it comes to shadow banks, and de-risk where it comes to safety and liquidity. But it isn't just U.S. banks. We see the same exact thing, if not more so, taking place over in Europe. This is a global trend. It's not about the Fed and the Fed's bank reserves. It's about global risk aversion, because we know, we know there was a ton of stupid stuff going on in private credit, whether in euro denomination or U.S. dollars, and offshore and onshore, and everywhere, because everybody said governments had engineered a red-hot recovery that was going to stick around for years and years and even as Europe fell into forgot-how-to-grow recession, didn't matter. Eventually it was going to come out of it in a very short order, and when it did, everything would be just fine. So take on risk, do the deals, volume, volume, volume, and then this year, oh crap, maybe that was a mistake. So while U.S. banks have slowed their lending exposure to shadow firms over the past, you know, three plus months, European banks have reversed lending to their shadow banks. European bank loans to financial corporations other than MFIs, which is the UCB's classification for shadow banks, those had peaked back in June at 1.46 trillion euros. Though as you can see, the lending binge really started to roll over, not surprisingly, after April. Again, global macro risk, not Fed balance sheet runoff. So lending from European banks to European shadow banks, that dropped off outright in July and August, and then for September, only rebounded by a small amount. Banks are, and they have been, reassessing their exposures to riskier shadow banks, especially during the summer. The summer keeps coming up everywhere, and as we've seen in developments from U.S. dollar shadow banks, there is every reason why that would be the case. And like their American counterparts, European MFIs have also continued piling up government bonds. Another 38 billion euros were added in September after taking a slight pause in August. That brings the total for the year, the total increase for the year, to 318 billion euros, or 17%. So ask yourself, what makes more sense here? Risk-averse global banks that are getting even more concerned as the global economy continues to crack, and the logical consequences of that cracking now have gotten to be highly visible in shadow banks, and are even spilling out into repo functions. Or, the Fed's balance sheet runoff that not even the Fed really has any idea how it might impact monetary conditions, just happens to have hit a magical spot no one at the Fed could possibly know ahead of time, at the same exact time as everything else I just described. So the Fed's balance sheet runoff that they can't possibly describe to you ahead of time, that's the reason why we're seeing what we're seeing in repo markets? Or is it this mountain of evidence everywhere else that macroeconomic concerns are driving risk aversion in all of these different monetary capacities, and that's why we keep getting the persistent usage in the Fed's repo facility, and elevated rates in repo markets? The vastly more important questions relate to what happens from here, and I don't mean the end of QT or even the start of not QE, which we should probably continue to expect. Instead, global banks continue to behave and position defensively for what should be obvious reasons, but they aren't obvious because of the Fed, as well as, of course, the stock market. Nothing bad could possibly be unfolding with equity soaring under trade deals, and the promise of AI earnings that maybe show up in 2038. Banks certainly aren't infallible, but at least they're looking at all the relevant information. What we know is that something is causing illiquidity in U.S. dollar money markets to the point it's becoming an outright nuisance. And as the cockroaches uncover themselves with the spotlight finally being shined into the shadows, would that light really just say it was bank reserves? Shadow banks have been reckless for years under the cover of the strong and resilient economy. You take that away, and what's left is NDFIs who are in way over their heads, just as the shadows covering them recede along with the tide. As I mentioned, there are a lot of similarities with the repo mess in 2019, so I went over what really happened in 2019 and what those similarities really are in the video linked below. As always, thank you very much for joining me. Huge thank you, Eurodollar University members and subscribers, and until next time, take care.