Odd Lots - Zoltan Pozsar on What’s Going on in Rates Markets Right Now

Episode Date: September 9, 2021

There's a lot happening in the plumbing of the financial system. The Federal Reserve's reverse repo facility has seen huge takeup from financial market participants seeking to park excess cash. Meanwhile, the central bank has also announced the start of a new standing repo facility. And, of course, we're nearing the start of tapering, when the Fed will start to wind down its asset purchases. On this episode, we bring back Credit Suisse Strategist Zoltan Pozsar to talk about everything that's going on right now. He describes a system awash with dollars that no one wants, and walks us through what that means for broader markets.See omnystudio.com/listener for privacy information.

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My co-host, Joe Wisenthal, is away this week. I am recording this on September 1st, which means it is the start of a new quarter. And whenever we have the start of a new quarter, it's usually a time to start reflecting on what's happening in money markets. And there has been a lot happening in money markets. so far this year. So, you know, just today we have 82 participants placing $1.19 trillion at the Fed's reverse repurchase agreement facility, the reverse repo facility. And I have to say, the U.S. financial system right now is kind of a wash in liquidity, and it has been for some time. And that's causing problems for banks who have to handle all these deposits, problems for money market funds, and of course, problems for the Fed. So all this liquidity means that money market rates have basically been pressured lower all year, so much so that the Fed has actually had to tweak some of its facilities, including the reverse repo facility back in June to prevent those rates from going even lower. And more recently, it surprised the market by,

introducing a standing repo facility. So we have had a lot of requests to talk about this on all thoughts and no surprise we've had requests to speak to one person in particular, repeat all thoughts guest. We're going to be talking to Zoltan Pozar, of course, the global head of short-term interest rates over at Credit Suisse. Zoltan, welcome to the show again. Thank you very much for having me back. So I'm trying to think where to start, but maybe you could begin by describing the general state of liquidity and money markets at the moment. Like when I say the financial system is a wash in liquidity, what exactly do we mean? What is the general state?

The general state is things that haven't happened before are now happening. So again, let's perhaps start with prosperity basis. This is something that we are used to as being very negative. You know, there is always an excess demand for dollars. And that excess demand for dollars is gone. The cross-courancy basis is pretty much closed. You have some jurisdictions, smaller countries, but the cross-currency basis is even positive.

Mexico, South Africa, in China. You know, these are quite unusual things. LIBOR is dormant. I mean, the basis is the OIAS is three. basis for it's very tight. Repo and bill yields are very low. But this, what this is a reflection of is naturally just, you know, too much cash in the system relative to the demand for this money. You know, I think, unfortunately, I think we are in a period where things are going to be very different for quite some time relative to how things were over the past five years. I think over the past five

years, we've had sort of a golden era for stir traders because we've had so many, so many spread moves in the money markets, you know, the LIBOR basis or the cross-currency basis has done. You know, the repo markets acted out in the past. But if you think about why liquidity was tight as opposed to abundant, there are basically three reasons. You know, the Fed stopped QE in 2015, and then the ECB and the BOJ were just starting. So we were in this. position where there was an excess supply of euro and yen, people didn't know what to do with so they spotted for dollars. So that drove, that specialness to the dollar in the FX stock market. Then we had Basel 3 that was getting rolled out. And so nobody understood that, right?

So you had this relative shortage of dollars combined with an ever-growing shortage of balance sheet for various parts of Basel getting rolled out, LCR, SLR, SLR, the G-SIP scores. You know, the bank themselves had to learn how to manage these ratios, the market learned how to trade these ratios. And then we had these little idiosyncratic things like money fund reform, corporate tax reform. So these were always banking these rent. Some of the most experienced third traders would tell you that they've never traded as much front and basis in their career. Some of those careers spent 30 years as they did between 2015 and 2019. So then you fast forward to today, we now have so much liquidity.

And this is particularly a case for the US dollar that the Fed is doing QE faster than the BOJ or the ECB. So there's just an ample supply of US dollars. Regulations are not getting tighter. If anything, they are getting easier. The Fed has become a dealer of last resort. We have the swap lines.

We have the standing people facility before banks. We have the standing people facility before for foreign central banks. So this is a very different environment. And then in the midst of this, a lot of liquidity, a lot of balance sheets, a lot of excess cash in the system, there's also not as much activity in the world economy that needs to get financed. So if you just think about why foreign banks elsewhere borrow dollars is because they need to finance trade flows or whatnot. So debt demand is dormant. I think capital flows are a bit more domestic.

you know, the FX hedge those are not as dominant as they. The relative value hedge funds are kind of checked out at the moment because there's not a lot of opportunities. And so, you know, there's, and, you know, the best reflection of all this excess cash, as you mentioned, is all this $1.2 trillion dollars of cash that's sitting in the reverse repo facility, which you literally want to think about as money, the system doesn't need either because it doesn't have the balance sheet for it or because there's no use or out for that money. All right, this brings me to my next question, because I think a lot of people, when they hear that the system is a wash and liquidity, there's all this excess cash, a lot of people wouldn't necessarily think that's a bad thing.

And yet, you know, clearly this is something that the Fed, at least, has been responding to. I mentioned that it tweaked the reverse repo facility and then it started the standing repo facilities. What exactly is the problem here? Well, I wouldn't say that it's a problem. I think that the way all this is clearing in the system is actually quite beautiful and kind of hassle and problem-free. I think you're the only person that would describe this as beautiful. Well, look, I think it's beautiful because the Fed designed the system basically. So, you know, I mean, you put reserves in, you know, the central bank has a balance sheet and then someone has to hold the liabilities of the central bank.

And we have a beautiful mechanism where, you know, this money is going to flow through the path of risk resistance to whoever has the balance. And so that's what we are seeing. And again, you know, the reverse repo facility, you literally want to think about there as foam on the runway. So it doesn't matter how big a plane you're going to eventually crash on the runway. There's a lot of foam there. So the impact is not going to be painful. So what do I mean by that? You know, people talk about, let's find, let's find some, some, you know, spread opportunity we can trade in the money.

Maybe there's going to be a run on tether. And then, you know, the tether is going to have to sell, you know, $60 billion of commercial paper, something like that. I mean, you know, there are these ideas floating out there because we don't really have a lot of ideas to trade. So what would happen in such a scenario? Nothing. I mean, a money fund complex that has $1.2 trillion stashed away at the reverse people, they're earning five basis points. Whatever dislocation you go ahead in the CP market from someone having to sell $6 billion

commercial paper, hypothetically, is going to be scooped up and they will be asking for more opportunities like that. So this is just extra cash that will be there to get deployed, to harvest whatever spread. We have an FX swaps or or or live or so so that's a lot now people often bring up you know this is a problem for the banks but again this is not really a problem for the banks because you know the banks now have again and I think it's quite beautiful a mechanism whereby if in the morning they have cash coming in that they don't have the balance you for they can just push that cash away in the afternoon you know and so that money

that comes in in the morning and swells the bank's balance sheets. If you push it away into the money funds and our money funds can place it at the reverse repo facility, you know, this is a mechanism that enables the system to kind of clear and get around balance sheet bottlenecks. And, you know, the reverse triple facility has no limits. I mean, it's $80 billion per counterparty. We are, you know, some distance away still from some accounts maxing out the counterparty limit. but the Fed indicated that they can base that kind of party cap to a much higher number.

So really, there's no limits to, you know, this system is well designed. It's well built. It's working and it's doing what it's supposed to do. And frankly, I think, you know, all this money that's going into money funds and ultimately is getting deployed in the reverse repo facility, you want to think about it two ways. You know, there's two things happening. Number one, we have massive bill paydowns that are happening at the moment because that's something we don't need to talk about. But, you know, there's these bill paydowns. And so money funds are losing a current asset that they have in their existing book of business.

And then they have cash coming in and they need to place it somewhere else. And that's the RRP facility. So that's just the rotation within these money fund portfolios. The other is new money that's going into the money funds. and that new money is the money that the large banks are pushing away because they don't have the balance sheet for that. And so there is something very, very interesting happen, which is that at any given point in time when a bank gets a new deposit, especially under COVID, it's either a new deposit because

there is QE happening and as well, you know, when QE have deposits get created in the banking system, but those are low-quality deposits. Because I'm an institution sold a bond to the Fed and got that's institutional hot money that doesn't really have a lot of value from the perspective of the bank. So the banks are pushing that stuff away. And then there's also still a lot of stimulus happening. Unemployment insurance checks are going out. We have COVID payments.

We have all sorts of payments that the government is still making to the households. Those are the good deposits. So if you have a banking system that is balance-shed constraint, then the largest banks are valetian in the U.S. You know, this is also a mechanism that enables these banks to take all these deposits as they are coming in and then at the end of the day, make

a choice as to this is good quality, this is bad quality. So the good quality I want to make room for on my balance and I want to retain it. And it's bad stuff, I just want to push away into a money fund because there's absolutely no value from a liquidity perspective. And so

it's actually a facility that helps the banks to cherry of deposits they won't hold. And so it works. It works. And, you know, we often think about the RRP facility as the floor underpinning the basement of money market rates. And it's a floor to money market rates too. So I think it's big, but it's doing as it's supposed to do.

And frankly, absolutely no difference between, you know, Treasury's cash payments being at one and a half trillion or the reverse repeliority being at $1.5 trillion. It's the same thing. It's just there's different mechanism through which the system holds in cash. On April 4th, 2023, around two in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg podcasts, this is Foundering, the Killing of Bob Lee.

beginning April 16. So if the reverse repo facility is successful in the sense that, you know, it's setting the floor on interest rates and it's soaking up this excess liquidity in the system, why did the Fed feel the need to start paying interest on it? So, you know, interest used to be zero. And then in June, the Fed raised it to five basis points. And here, I think I should note that this is actually a cost. call that you got wrong, right? You weren't expecting them to raise that interest. So what's going on there? And what's your take on that? Yes, that's a call. That's a call I got wrong. Look, I think I would say it's an extreme aversion to negative interest rates in the US, which I basically, which I basically misread. You know, the interest on the reverse reposition was raised to five basis points because, I mean, look, the backdrop for this is,

If you're the Fed, you have two groups you talk to all the time, the banks and the money fund. So the banks are telling you, I can't take any more deposits because I'm full. You know, I have an SLR. I have an SLR constraint. You know, the reserves haven't been exempted from the SLR. I'm not going to take. Then the money funds are telling you, well, I'm not going to take the money either because, you know, the RRP is earning zero. I have certain fixed costs or variable costs that are a function of my assets under management. So I need to be able to make a buck, you know, if I take new money.

You know, my argument was basically you can, a money fund can ultimately charge, charge the end investors a fee for taking their money. I think it would be the end of the world. Because at the end of the day, the Fed cares about the constellation of the, of the overnight rates that it's looking at, which are all interbank rates. you know, Fed funds, Euro dollars, Sofer, repo, all that stuff. But, you know, the Fed shouldn't really care about the rate to end investors, right? There's a big difference between rates to end investors and interbank rates.

That was my prior. And so, as you said, I was wrong, but what did we learn from this episode of being wrong? I think what we've learned is that, you know, the Fed cares not only about these interbank rates, but the Fed also cares about rates to end investors. They are averse to even bill yields going negative in episodes other than a massive crisis, you know, last March. They don't want money fund yields to be negative. They don't want deposit rates in a banking system to be negative.

So they basically just raised the RRP rate to five base points. I think the money funds got an asset that is sufficient for them to, which yields enough for them to be able to cover their costs, to even charge a fee to the investors and for the end investor to end up with a positive deal. So I think the short answer is there's that extreme aversion to negative interest. It's just something we don't do in the U.S. I'm kind of amused that so many people complain about the Fed manipulating interest rates. And meanwhile, the Fed is concerned about private actors manipulating interest rates.

it's downwards to a negative level. So one of the reasons Joe and I love having you on the show, Zoltan, is because you do this research that is incredibly granular where you talk about, you know, the individual incentives for each bank, why they do the things that they do. You just touch on it, you know, with the Federal Reserve, the idea that the Fed is absolutely loathe to have negative rates in the headlines, basically. Can you walk us through exactly? how banks are thinking about various forms of cash-like instruments at the moment. So, you know, when we say the system is a wash in liquidity, that liquidity kind of comes in different format. So, you know, you can have U.S. Treasuries, you can have agency MBS, you can have excess reserves

that banks get from the Fed. And I'm wondering, like, how are banks thinking about that mix at the moment? Well, it's a, it's a simple, it's a simple answer. At various points over the past five years, you know, these liquidity portfolios are always, are always being up. So, you know, whatever is the EODEST, that's what the banks do with that liquidity. Look, sometimes, you know, they land into the repo market because it yields better than on reserves at the Fed. Interest on reserves is always the, is the starting point, of course. Sometimes you lend in the FX swap market because yields are much better there.

And in both of these cases, the opportunity set is pretty bad. I mean, you know, repo is well below IOR. As I said, you know, the relative value hedge fund community is kind of checked out at the moment because there's not a lot of, you know, bond-based opportunities to put on and to the fund. So the repo market is very quiet.

The FX swap market, similarly, when you look at, you know, the very front end points in the FX swap market where these banks are active, Tom next, spot next points. Implied yields are just the basis point above IEOER. I mean, we've never seen things this tight since possible. It was rolled out. So this is, this is, again, what we started the conversation with. It's too much, too much liquidity, not enough demand for this cash. Sometimes, you know, the FX swap market and the repo market also each other. And so the FX spot market can pull the repo rates up.

But so money markets, again, are dormant. So if you're a bank portfolio, you cannot really do anything. But go out and when you go out the curve, you will be looking at other HQA, which is, which is mortgages and treasuries. And then, you know, you can buy these treasuries, which offer a spread over R.I.S. And you can buy it outright. You can buy it, buy it an asset spot.

But basically treasury securities are the frontier. And when you look at the bank HQLA portfolios, you will see that they have added a lot of treasury securities under the pandemic. And so good for the U.S. government because they have a lot of paper that they need to issue. But that's basically where the money is going at the moment. I think it would also be interesting to kind of dig into some. bank-by-bank examples of happening in this department because, you know, when we talk about banks, it sounds like it's plural, right? Because there's a lot of banks. But actually what's

happening is that there's only two banks, really, that have done all the heavy lifting in terms of in terms of buying all these treasuries. And that those two banks are J.P. Morgan and Bank of America. These are two of the most important creditors to the U.S. government at the moment, other than other than the federal force. But these are two banks that approach their bond buying strategy completely differently. And what I will say now is some of the things that have been said at these banks' earnings calls. And so it's not an inside B or anything like that.

The Bank of America's management has mentioned the number of times on their earnings calls that they are happy with the fact that they have called the bottom in rates during the third quarter of 2020, they have been slowing all their access liquidity into the mortgage markets ever since. So they have this programmatic buying of Treasury securities, and they are always in the market regardless of a yield level, simply because that's a bank that has a management philosophy where, look, there is no loan demands, but these deposits keep coming in. So we're a bank. So if the deposits are coming in, but there's no loan demand, we have to do. something with this excess cash, so we just buy securities. If households and corporations don't borrow

what the government does, we're just underwrite that. JPMorgan is a bit more different because they always have strong views about rates. And so Jamie Diamond's letter to shareholder, he basically said, yields are moving higher. Inflation is coming. The Fed is going to have to chase down this inflation. So yields are going higher. So we will hold off on spending all this 500 billion dollars of reserves that we have fed until yields will higher. And so, you know, they didn't spend any of this money. Bank of America has been in programmatic buying. I guess the question from here going forward is, was J.P. Morgan going to adapt to a world where, and this is a good segue into the standing repo facility and this idea of dealer of last resort, you know, in my writings,

and I think I mentioned this on this call, too, before, J.P. Morgan was always, the lender of next to less resort of the system, right? Because before the Fed would stop in, they had always the most amount of reserves in the system. So whether it was the FX swap market that was acting out, or the repo market, you know, it was JP Morgan lending into it on the margin. There was value.

There was a lot of value in having all this access cash because, you know, as Warren Buffett would say, you know, cash has option value. So if you're a bank portfolio, especially if you're JPMorgan and your heart of the financial system, you need to have that cash to be able to kind of lend into these money market institutions. Right now, that opportunity set is extremely poor. I mean, the only thing, the only thing that gets people excited in turn, which is pretty depressing, by the way, so all year there's nothing to do when there's the year and turn.

You have to kind of handicap that. So that opportunity that is poor. Deals were supposed to go higher, but they didn't. They went lower. You know, we have a taper announcement. Yields didn't do anything on the back of that. So I think it would be very interesting to see during the second half of the year how this posture at this bank is going to change going forward because if yours are not moving higher, they're basically giving up a lot of net interest income that other banks are earned.

And so it was just very interesting. You know, there is this theory out there that bank to math, for treasuries to satisfy the liquidity requirements has been one of the factors, you know, maybe even a very important factor in keeping yields very low. And, you know, this was sort of a mystery in markets over the summer and in the spring. Why are treasury yields so low when it looked like the U.S. economy was actually recovering? How big a factor do you think bank demand has been when it comes to yields? It's not in the numbers. I mean, you just don't. see, you just don't see any kind of level shift in, in banks buying more treasury. So,

you know, we will have the cold reports out in a couple of weeks, but I doubt that there any big increase in bank buying because you know this from the VPAJ number. So you just, you just don't see any of that. I mean, you know, the one thing I would point to is, you know, some of the, there's two things. You know, it's always about flows and technical, so to speak. And then there is the narrative. I mean, you know, the Delta variant got a little out of hand, you know, articles about that kind of started to percolate roughly when yields have started to rally. So I think I think a lot of this is part to the virus in the Delta variant, but also TGA balances were coming down, right? So all this cash was coming into the system. And when

large amounts of money are coming into the system, there's always some leakage because, you know, people think about DGA comes down so there's fewer bills gold that money goes to RRB. Yes, most of it, but some of it leads. And so someone who was in bills probably went into an aggregate bond fund and aggregate bond fund had to kind of deploy that money coming in. And so there was some bid for fixed income. So I think it's a combination of those two, but it's definitely not been the bank portfolios that caused that caused the rally. It was certainly not JP Morgan because they were kind of waiting for the others, the other things happened. You know, so.

Okay, well, let's talk about the standing repo facility then. You know, when the Fed announced that there were a lot of different interpretations over what exactly it's meant to be doing. So, you know, on the one hand, some people were saying it's supposed to prevent more blowups in the repo market. But then there were some other people who were saying it's basically paving the way for the end of QE and allowing the Fed to start the taper. So how are you viewing it? Yes. So the latter one was the view that I, that I subscribe to as well. Look, we don't need a

standing repo facility now. There's so much money in the system that we won't need it for the next five years in the aggregate sense. So the standing repo facility, I think, is going to be, I would say we are already to see the impact. I mean, you have two standing group officers. It's one for three, actually, if you want to think about it. It's actually one is there for the dealers that should be able to replace funding they need to remediate. It's been the buy. And the cash providers, if the cash providers pull away from the dealers, the Fed is going to step in.

And so the dealers don't buy it. Standing repo facility is just a term, but again, I tend to think about these in terms of types of entities that have existed. So there's the dealers. Then there will be the bank portfolios, large and small that can apply. And then you have the FEMA repo facility, which is the same for foreign central banks. So that's one Lego block, so to speak. I also want to say the same day that the Fed announced the standing repo facility, the G30 also issued a report. part of which was basically recommending that we also need a standing repopsic

but we need to make this available to anyone who owns Treasury collateral. And so there was always these two views about who should we make, who should get access to these standing repo facility. And so I always thought, you know, the issue with opening up for everyone is that, you know, it's just a very broad system, right? So, you know, if it's hedge funds too, how do you draw the line? You let in the little ones and the big ones. If it's asset managers, again, how do you design the criteria for access and haircuts and whatnot?

And so that's cumbersome. Then if you think about what the Fed did, it's actually a beautiful middle ground because, you know, the dealers, of course, they always deal with. Bank portfolios and foreign central banks, what are. I mean, they are half the buy side. If you think about the buy side from a dealer's perspective, you know, it's the insurance companies, it's the asset managers, it's the hedge funds, and the bank portfolio in the foreign central banks. So basically, two very important actors from the buy side got access to the standing

group of facility, which means that in the next crisis, and there will be an ex-crisis because there's always are, that there always are, you know, they will be able to go to the Fed to turn bonds into liquidity, whether you're a foreign central bank or a bank portfolio. And that's going to be a massive help for everyone else in the system because the dealers won't have to deal with these accounts because they can go to the Fed directly. And so everybody else

is going to have more balance sheet that the dealers can provide to them. So this is how the contours of the next crisis is going to play out. observation number one. Observation number two, you know, why now? Look, I think anyone that if you're a foreign central bank, now you need $60 billion less in liquidity because you know that the Fed will give it to you now. So if you think about the typical FX manager, it has some

liquid assets in the money markets and it has some longer term securities and treasuries and mortgage. That money market bit is basically, you know, you just leave money on the table because that's your liquidity insurance. That's the money that you can spend on short order if something unexpected happen. You can now allocate 60 billion less to those types of instruments, because if and when that liquidity event, the Fed is going to be able to provide to you that liquidity on demand for a fixed price. And, you know, these liquidity events always less like a week or two weeks or a maybe at most, and then the flows changed. But, you know, it's a nice, it's a nice tool to have. And you can also know that, you know, the Fed is not going to be opportunistic. You know, it might not

be the case if you want to raise the liquidity in the market because you will be dealers. Dealers can charge you a price. If you're doing this, the work can get out. You know, it's, it's not supposed to, but, you know, people always talk. It's like, well, one account is read. One account is selling. I would also say that, you know, this repo facility, even though it's going to be more expensive than the market, because it's priced a little bit wider than the market design, there will be an anonymity premium that foreign central banks are willing to pay up for because they can just raise their, is their liquidity anonymously. You know, if you remember China selling, you know, back 2015, 2016, all those treasuries and

and it costs some backuping dealer inventories and spot spreads around. I would even say that those episodes probably are going to be less painful going forward because you can just go to the Fed. And so instead of selling those treasuries, can just finance them, get those dollars to do your interventions in the local currency market. So I think this is going to smooth things. I would also say since the standing repo facility was announced, we've had a 10-year auction and a five-year auction,

and a five-year auction that has gone extremely well, especially the 10-year auction. And we've seen the foreign participation at those auctions, which is a record participation by foreign official accounts. So I think here's a liquidity tool, and the foreign central banks are saying thank you, and they are underwriting the deficits to the result. And if you think about five large central banks, each allocating $60 billion experts, treasuries, that's, that's $300 billion, I don't know, half a paper or something like that. So, you know, foreign central banks, I think over time, they will change their behavior,

hold a little less liquidity, and lend a little longer to the U.S. government, because the other arm of the U.S. government is going to fund their liquidity. So that's fun. The bank portfolios will be able to apply starting October 1st for access to this facility. And, you know, the bank portfolios, I think this is not going to be as big a deal for the big banks like JPMorgan and Bank of America because they are a league of their own. But, you know, there is 20, 30 or so regional banks, smaller banks that also will qualify. And I think it's an overlook fact that a lot of these smaller banks also have a lot of access reserves that they accumulate. over the past years.

I think that number, I don't have it on top of my head, but it's something like $400 billion. They can also spend some of this liquidity on treasury securities and mortgages because they know that the Fed is there at 25 basis points. Chances are I will never need that equity, right?

So if there's a spread in buying treasuries, you should just do that. So I think this is going to move the needle a lot in terms of, of making treasuries and collateral in general more attractive, more attractive than cash, which is, again, if you look at the side guise, that's precisely what we need. This is generating demand for treasury securities from two very important buyers. Yeah, this is something I wanted to ask you about because there was this concern around

who will actually buy Treasury securities and agency MBA. So, you know, mortgage bonds issued by the GSEs, when the Fed starts to taper QE. And you're suggesting that it's, I guess, a non-issue now because of the standing repo facility. Is that right? Yes. I think this is a, this is a, the question of who will buy is a very important question. In retrospect, who buys on the margin, it's always very simple, you know, like, but in real time, when you need to figure out who is going to buy in the next. that's what people get confused.

It's just kind of hard to big. But look, if we were to tell, here's a brief history of rates and funding markets over the past five years. And we always talk about the marginal buyer in this program because, you know, life is on the margin, everything in the market is on the margin. So who is the marginal buyer?

2015 to 2017, it was the Asian FX-Hed buyers, that were extremely important and docked for flows. So they were buying the treasuries, they were spucking again for dollars, Europeans were doing the same. And so that they were the marginal buyers. And then the cross-currence basis blew out, and then they had their trial by buyers.

Their demand kind of changed a little bit after that. Then you had a bond basis that opened up. The Fed started to high trades, the curve gradually flattened. So it was all the RV hedge funds. And they funded everything in the repo market. And then we had that repo market episode in September 2019. The Fed started to rebuild the liquidity buffer of the system with build purchases. And then it came.

And basically, you know, that was a moment where even though you were building up the liquidity buffer of the system and you were pulling back to this excess reserves regime, you didn't do it fast enough. and the pandemic forced your hand. And basically the Fed needed to take out all the RV hedge funds from these bond-based positions because they couldn't fund these positions. And then the bank portfolio stepped in, and they became the dominant buyers of Treasury. So this is a span of six years, you know,

for an FX hedge accounts funding in the FX stock market, relative value hedge funds funding in the repo market. And now we have, you know, the bank portfolios supported with a standing vehicle facility in case there is a need for it. And so who is going to buy going forward? I think the bank portfolios will be a very important part of the picture because that's where the excess cash is. We just basically broadened and incentivized a slightly broader set of banks and foreign central banks to do the same. that JP Morgan and Bank of America have been doing ever since the beginning of the pandemic. So I think we are basically buttering up and appealing to a certain buyer base

that's going to be doing the bidding of the government. And also keep in mind, you know, we are also in an environment where loan demand is very weak. And a bank needs to land. The bank has capital and that needs to be deployed. And so I think another very important thing to keep in mind is that when you think about the lending process, you know, a bank makes a loan, creates deposits. That's the kind of tradition. That's the way things supposed to work, I guess.

That's traditional. But the other version of this is a bank buys a treasury security and creates a deposit when they do that. And then the government is going to spend all that money. So if you think about this infrastructure bill, for example, you know, normally it's all the private sector building stuff. But when the private sector is building stuff, you know, some developer goes to a bank, you know, you want to build huds and yards. You go to a bank, you take out of finances. Okay.

And so the bank made a loan created a deposit and the developer of huds and yards is going to spend its old contractors. And so that's what that looks like on the balance sheet of the banking system. if it's the government doing infrastructure projects, they will borrow the money and they will send it to the little contractors to build whatever. So then all of a sudden, it's not loan deposits, but it's Treasury Securities and deposits. And probably we will see a lot more of this type of lending going forward

than we have seen this pure form of the old type of lending, which is all loan-based. You know, this is basically the future. I think the banks will be buying a lot more treasuries and a lot more mortgage-backed securities. And the fact that this repo facility is there to help in occasional liquidity hiccups without a stigma, I think it's going to be a huge incentive. It's always about incentives. You know, again, in retrospect, it's always simple, as I said over the past five years, who were the most important marginal buyers. I think going forward, it will be the banks.

And that means that it's also going to be a very stable form of funding the government because it's all going to be sticky deposits. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court.

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with me, June Grasso. Subscribe today wherever you get your podcast. So I'm a little bit concerned just from a very, like, self-interested financial journalist's perspective that you're laying out a financial system that seems quite smooth and seems like kind of unlikely to end up in a massive blow-up that, you know, someone like me can write lots of articles about. Which in some ways, you know, money markets and the repo market was always supposed to be a boring area of the financial system that just worked. But then it exploded in 2008.

And then we've had various explosions since then. Is there anything interesting coming up in repo that we should be watching out for? Like, you know, what should be getting us excited? Because you've described it as this beautiful system and very smooth in terms of functions. Yes. Well, as I said, it's quite depressing in money markets. And, you know, just like you would like to write about interesting things, you know, people want to put on trades about, you know, spread low-ups and whatnot. Yes, look, you're right. I mean, you know, the dealer of last resort was missing from the picture, institutional, you know, like that's why we had the September 2019 episode. the swap lines are now there,

the standing repo facilities there. And the Fed is doing this dealer of last resort thing on both sides of its balance sheet. So the Fed is keeping interest rates from going too low with the reverse repo facility. It's keeping repo rates from going too high and the FX swap market from blowing up with the spotlines. And so, yes, this is a very stable era of the system.

I would say that we are looking forward to. But I would also say that this was a five-year learning process of the Fed, right? Because what were the past five years about? The past five years were about, you know, we had financial reform. We had Basel III. Bank balance suits are less flexible, you know, all the things that happened over the past five years. And so the Fed was still thinking, I would say, that the great financial crisis was a one-off. And the things we had to do then, hopefully we will never have to do again.

And so here we are today where some of the things that the Fed did during your great financial crisis, some of the things that the Fed did last March, March 2020, they became institutionalized. and they are now standing facilities. So they are definitely going to take the edge off of funding markets. And so whether this is good or bad, what this means is that the frontier is shifting elsewhere, because whatever problems we will have is probably going to happen in some other jurisdiction. But I think dollar funding markets are going to be, much more stable, much more stable going forward.

Things will be very quiet until we get to a point where the banking system again is liability constraints because there's just so much cash in the system that, you know, the banks are not going to have any problem, funding problems to the foreseeable future. And, you know, as Ben Bernanke said at the end of the first three QE episodes, you know, the Fed's damage is very big and over time, the economy and the banking system is going to grow into this big balance shift. I think in a similar vein, it's probably going to take a few more in Treasury securities and a few more trillion assets before all this access cash gets soaked up. But again, once that tight equity environment arrives, I think the belts and suspenders

around how we are going to deal with that tightness are indeed just going to make things less spectacular and the spread of the while will be less spectacular than they were, it's been 2015 and the beginning of the pandemic. I think it's an end of an era. Yeah, it sounds like a much more boring system awaits us, a less spectacular system. Zoltan, it's great having you on, as always.

Thank you so much. Okay, thanks for, thanks for having it. So I don't have that much to add to what Zoltan just said. And of course, it's always weird doing this when I'm basically talking to myself. But I do think the end of an era idea is an interesting one. And it does feel like we've seen a sort of step change in the repo market, given that we now have these two facilities. As Alton said, you have the reverse repo facility that is putting a floor under rates. And then you have the standing facility that's basically putting a ceiling on rates. And it just feels like

I don't know, the system is going to be much more constrained or much more controlled, much more steady going forward. So I guess we'll have to wait and see what happens. You know, with a new system, there's always the chance that you do see new risks develop. So maybe there's something out there that no one has seen yet. And we will get a chance to write something about it one day. Okay. This has been another episode of the Oddlots podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. Joe isn't here, but of course you can follow him on Twitter at The Stowart. You can also follow our producer, Laura Carlson, at Laura M. Carlson. And you can follow Bloomberg's head of podcast, Francesca Levy, at Francesca Today. Thanks for listening. Hi, I'm PJ Vote. My podcast Search Engine has a new two-part series for you. Of all the new technologies coming out of AI, the most tributtal. transformative one might be driverless cars. They're already on the road in 10 American cities,

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