Shark Tracker and the Sex Police

Fair warning: This post has absolutely nothing to do with anything except what I do when I goof off from covering finance. Feel free to skip it.

Holiday doldrums: I've been working on a brief overview of the most recent BIS Quarterly Review (that's Bank for International Settlements - sort of a global central bank and international financial regulatory organization) but I'm having trouble making myself finish it. The review is 81 pages of excellent, but rather dry analysis, of statistics and global trends in financial markets, bank business models, foreign currency reserves, and undiversifiable risks arising from securitizations. It's not actually as boring as it sounds (yes it is) but it's time consuming to pull out the interesting bits and connect them to potential future market moves. Which is the reason I exist. Until I can get that organized, here are a couple of time wasters that you may find entertaining if you're stuck on the trading floor this week, while everyone who makes more money than you is on the beach in St. Bart's or skiing in Aspen.

Great white sharks roaming the mid-Atlantic: Like most sane, rational people (who read Jaws as a child and spends way too much time watching the Discovery Channel), I have a pronounced fear of sharks. Specifically, being bitten in half below the waist (haha) by a great white shark while floating walrus-like in the swells off the beach. Or in Lake Michigan (you don't know).

My exaggerated fears led to a life-long, land-based interest in these magnificent animals. OCEARCH has been researching and tagging great white sharks and other apex predators to provide protection for the sharks, and education for the public and other scientists about these deeply mysterious creatures. Thanks to these incredible (and incredibly brave) researchers, I also have a new appreciation for just how often they are probably cruising the surf nearby, not eating me.

Courtesy of Shark Tracker, above is the 2-year tracking history of Mary Lee, a 16 ft, 3,500 lb great white shark who spends most of her time cruising the beaches of the mid-Atlantic, with the occasional vacation to Bermuda. If you want a sincere appreciation for just how big a 16 ft great white is, take a look at the pictures of Mary Lee being tagged on the site.

There are a lot of sport and commercial fishermen among my family and friends, and their encounters with or sightings of great whites have been exceptionally rare, but awe inspiring. Personally I hope to never see one in it's natural habitat or kept in captivity, but I applaud the scientists at OCEARCH and elsewhere who continue to respectfully learn more about them an share that knowledge with us.

Nostalgia on New Year's Eve: There are a lot of stupid things you can do in your 20s, and I endeavored to do most of them. The more reckless of these pursuits required spending a lot of time at bars, listening to local bands. When I was in Chapel Hill in the 90s, one of the best of these was the Sex Police. Alternative angst was not their style: the Sex Police were raucous, ridiculous, energetic and had a horn section.

They are reuniting for New Year's Eve show at the Cat's Cradle. Although I doubt I will find myself there in body, I will be there in spirits.

Hope everyone has a safe and happy turn into 2015. Then back to business as usual.

Bank Buying of Treasuries Helped Drive Yields Lower in 2014

Update: This is a follow-up on our Federal Reserve flow of funds post from Tuesday, December 9th, since data was updated on Thursday, December 11th. Please see that post, The Rest of the World Still the Dominant Treasury Investor for background.

The 2014 rally. Treasuries have persistently rallied throughout 2014 (see chart) despite:

1. Improving economic data in the US; and
2. The Fed winding down its own Treasury purchases that were part of QE, as of the end of October.

The 30yT has rallied almost 125 bp YTD from just under 4.00% to 2.75%, and the 10yT yield has dropped by 90 bp from 3.00% to 2.10%. In fact, as we head into the end of 2014 the rally has accelerated while the two lynchpins of the economy - employment and consumer spending - are showing signs of perhaps blockbuster strength.

Global demand for Treasuries remains high due to dollar strength and economic weakness outside US. We revisit the flow of funds data to see what sectors have been large marginal buyers of Treasuries this year. It is an obvious conclusion from the charts below of quarterly flows (seasonally adjusted annualized rates) that the "rest of the world" has long been the largest marginal buyer and holder of Treasuries. The "rest of the world" is a catch-all for foreign demand; in the Treasury universe it is dominated by demand from foreign central banks and other foreign official accounts.

Duration extension by foreign central banks. It is important to note that in the 2Q and 3Q of 2014, foreign buyers actually sold or ran-off nearly $300 bn in Treasury bills and bought close to $800 bn of longer-term Treasury securities, for net buying of ~$500 bn. (This breakdown is available in the complete FoF data, though we don't show it above.) That duration extension no doubt had a sizable impact on the level of rates across the curve.

US banks increase Treasury buying to satisfy regulatory requirements. The other, arguably more important trend in 2014, has been the pick-up in Treasury demand from US banks and other depository institutions. Net buying by US banks initially jumped higher in 4Q 2013 and has remained strong, rising again in 3Q 2014. This buying is the result of new regulatory rules and standards for banks - most embedded in Basel III - that have been announced and are gradually being phased-in. The most important of these are the liquidity coverage ratio and liquidity risk monitoring tools, both of which "encourage" banks to significantly increase their holdings of so-called "high quality liquid assets," of which the safest of these is Treasuries.

It has long been speculated by myself and others that, over time, the increased Treasury buying by banks due to regulatory requirements would put sustained downward pressure on rates. That has clearly materialized in 2014. I don't know how close banks are to satisfying the new liquidity requirements, though there are several groups that track and estimate such measures (The Clearing House and the BIS are two such organizations). I will try to find estimates from them and post later this week.

A flat scenario for 2015? One takeaway here is that, at least on the part of banks, the outright level of Treasuries that they hold has been increased dramatically over the past year - from $276 bn to $442 bn - (see chart above) and this will be sustained. Once banks reach the appropriate liquidity thresholds, the growth in the level and flows is likely to moderate, but as securities mature they will need to be replaced, so the overall net flows from banks will probably be positive going forward, keeping some overall pressure on Treasury yields.

Foreign buying of Treasuries over the longer-term is no doubt the biggest swing factor. Although foreign official accounts are generally buy and hold, any pull back in Treasury buying on the margins - due to either a strengthening global economy or diversification away from US dollar assets - will be felt in Treasury yields. Although it's possible that there could be a moderation of foreign and bank demand in 2015, we suspect it will persist at least for the next two to three quarters.

Would the Fed invert the curve? In our minds (ok, my mind) that leaves the following open question: what if the 10yT yield hits a ceiling at ~2.50% as the Fed begins to raise rates in 2015? Does that effectively cap the path of short term interest rates for this cycle given that it may stop the Fed from deliberately inverting the yield curve? Is it possible that the path of short term rates rises from 0.25% to 2.00% and stops there? I suppose that really depends upon what happens with inflation in the US and globally, but it seems to be getting more and more difficult to project inflation to rise substantially in the near term.


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Good Riddance to (most of) the Swaps Push-Out Rule

Congressional sausage making. Hopefully, by tomorrow evening (Friday, December 12th, 2014), both chambers of Congress will have successfully avoided yet another unpopular government shutdown by having passed the Consolidated and Further Continuing Appropriations Act, 2015. The CRomnibus (Congressional slang for "continuing resolution omnibus") spending bill will fund the government through September 30, 2015, the end of the 2015 fiscal year. This bill - like virtually all spending bills before it - is crammed with a variety of amendments reflecting diverse legislative priorities, ranging from big to petty and cutting across all swaths of the political spectrum, in order to secure enough votes for passage.

Pruning Dodd-Frank. One of the "big" inclusions in the bill - that is creating something of a populist furor in the media - is an amendment that would scale back section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as the "swaps push-out rule". Our favorite kemosabe, Senator Elizabeth Warren, is out proselytizing that scaling back the swaps push-out provision will allow "Wall Street to gamble with taxpayer money."

The swaps push-out rule. I suspect that you would rather poke pins in your own voodoo doll than read Section 716 of Dodd-Frank. Instead, we excerpt from one of many excellent legal summaries of the provision, this one from Cadwalader (edited for brevity):

One of the most contentious provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (the “Dodd-Frank Act”) is Section 716 – commonly referred to either as the “Lincoln Amendment” after its principal proponent, Senator Blanche Lincoln of Arkansas, or alternatively by its functional name, the “swaps push-out rule.” The Lincoln Amendment effectively forbids FDIC-insured institutions and other entities that have access to Federal Reserve credit facilities – including banks, thrifts, and U.S. branches of foreign banks – from acting as a “swap dealer” except in certain limited circumstances, thus requiring such institutions to “push out” most swap dealing activities into an affiliate that is not FDIC insured and that does not otherwise access Federal Reserve credit facilities.

Inasmuch as maintenance of FDIC insurance is a requirement for all national banks, all federal thrifts, all state Member banks, and all (if not virtually all) state non-Member banks and state thrifts, Section 716 effectively precludes a bank or thrift from being a “swap dealer” after the effective date of the Lincoln Amendment.

There are some broad exemptions. Businesses and/or trading desks of the following swap products are exempt from the push-out rule:

• Interest rate and foreign currency swaps;
• Swaps involving bank eligible assets, such as agency MBS, marketable corporate grade debt, loans and precious metals;
• Swaps used in bank hedging activities and other risk mitigation.

So what swap businesses are actually prohibited at a bank under the rule? Generally speaking, banks are prohibited from engaging in swaps related to commodities, equities and credit (with a notable exception of investment-grade credit default swaps that are centrally cleared). These swaps businesses must be pushed out to a separately capitalized entity.

Why is the push-out rule controversial? You're going to love this, I promise.

1. Its inclusion in Dodd-Frank was opposed by virtually every banking regulator, the Treasury, and other financial regulatory bigwigs (see: Volcker, Paul) from the time it was initially proposed (in April of 2010). It didn't even have the support of the majority of Democrats. So, how did it get in the bill? 
2. It was put into the bill as a blatant and ultimately unsuccessful attempt to save Blanche Lincoln's (D-AK) senate seat. 

Let's address the regulatory resistance first. Excerpts from a Harvard Law School Forum post authored by lawyers at Davis Polk & Wardwell, titled Transition Period for Swaps Pushout Rule (edited for brevity, formatting added to improve the funny):

The Swaps Pushout Rule has been one of the most controversial provisions of the Dodd-Frank Act. It was opposed by the heads of all three federal banking agencies as well as Paul Volcker. Both Federal Reserve Chairman Ben Bernanke and former FDIC Chairman Sheila Bair said it would increase systemic risk, rather than reduce it. The Swaps Pushout Rule has not improved with age. Indeed, one of the key lessons from the preparation of resolution plans under Title I of the Dodd-Frank Act, and recent simulations of the resolution of a systemically important financial institution under Title II of the Dodd-Frank Act, is that pushing swaps out of insured banks into non-bank affiliates creates an impediment to the orderly resolution of banking groups.

When swaps are held within an insured bank, their value can be preserved for the benefit of the bank’s creditors (including the FDIC’s Deposit Insurance Fund) and the stability of the financial system because the FDIC has the statutory power and incentive to transfer the swaps to a creditworthy third party or bridge bank within one business day after the original bank’s failure, overriding any otherwise applicable rights of counterparties to terminate the swaps. In contrast, counterparties have the right to immediately terminate swaps held within a non-bank affiliate under the Bankruptcy Code, and bankruptcy courts have no power or incentive to override those rights by transferring the contracts to a creditworthy third party or bridge company. Selective termination of swaps by a bankrupt entity’s counterparties typically results in the sort of value destruction and severe market disruption that occurred in the Lehman bankruptcy. As a result, there have been numerous efforts since the enactment of the Swaps Pushout Rule in July 2010 to repeal or significantly modify it.

Editor's update: Sheila Bair has recently reversed her opinion and now thinks that the push-out rule should be kept in its entirety. You can read her opinions here. 

The Treasury also refused to endorse the push-out provision at the time, though current Treasury Secretary Jack Lew has stated that Congress should allow the SEC to finish the rulemaking process before it attempts to dismantle it. 

Swaps push-out as political pandering. It's tough to remember back to the spring of 2010. We were all running around with our financial hair on fire. Dodd-Frank was being constructed, Congressional voting was imminent, but no one knew for certain what was going to be included. Blanche Lincoln's proposal was one of several that was hotly debated in the press.

Excerpts from a May 15, 2010 article (in that notorious bastion of conservative journalism, the New York Times), In Tough Stance, Democrat Finds Few Allies (edited for brevity, formatting added):

The chairman of the Federal Reserve opposes it. The country’s chief banking regulator dislikes it. The secretary of the Treasury has been unsupportive, at best, and Paul A. Volcker — no one’s idea of a best friend to Wall Street — calls it unnecessary. 

Their antipathy is directed at a proposal from Senator Blanche Lincoln Democrat of Arkansas. She wants banks to get rid of their lucrative derivatives operations because they played an outsize role in the financial debacle. And when Wall Street needed a rescue, Mrs. Lincoln says, taxpayers should not have had to bail out bankers’ bad bets.

But just how far Democrats will pull back from an outright prohibition is unclear. Mrs. Lincoln is in a vicious primary campaign. Her opponent has tried to portray her as a Washington insider cozy with Wall Street and big business. If Mrs. Lincoln is seen as having given ground to bankers on derivatives, she could lose her job — and Democrats might well lose the seat to a Republican this fall.

In the month since Mrs. Lincoln offered her proposal, Democrats have played a waiting game. But in that time, opposition has grown and bank lobbyists have fought her plan, what they call the “push out” provision. 

Banks are betting that with the support of the prominent regulators, Democrats will have the political cover to oppose Mrs. Lincoln’s provision without appearing to give in to Wall Street. 

Mrs. Lincoln is adamant in her belief that banks should not be in the business. 

“Banks were never intended to perform these activities, which have been the single largest factor to these institutions growing so large that taxpayers had no choice but to bail them out in order to prevent total economic ruin,” she said this month. 

Editor's aside: I am tempted to parse the sentence above and refute the allegations in it as factually incorrect, misleading, and resorting to the usual chicken-little style hyperbole of politicians, but (a) the argument was 4+ years ago; and (b) she lost the general election in 2010 in a landslide.

The nation’s chief banker disagrees. In a letter last week to several senators, Ben S. Bernanke, chairman of the Federal Reserve, said that “forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities.” 

 Below is an arbitrary calendar of events, after the above article appeared in the New York Times on May 15, 2010.

• Arkansas Democratic primary, May 18, 2010: US Senator Blanche Lincoln (Democrat) 44.5%, Lieutenant Governor  Bill Halter (Democrat) 42.5%, DC Morrison  (Democrat)12.3%

• Arkansas Democratic primary run-off, June 8, 2010: Blanche Lincoln 52%, Bill Halter 48%.

• Dodd-Frank legislative text finalized, June 25, 2010: The Senate-House conference agrees on final legislative text of the Dodd-Frank bill, including Section 716, the "swap push-out provision" as proposed by Blanche Lincoln. 

• General election, November 2, 2010: John Boozman (Republican) 57.9%, Blanche Lincoln 36.9%

Tailoring the swaps push-out rule in CRomnibus. This is actually pretty straightforward. The House is proposing to shrink the swaps push-out rule so it will not apply to equity and commodity swaps. Airlines that want to hedge their jet fuel exposure can do so at reasonable cost at any bank with a relevant swaps desk. So what is still pushed out? From a House of Representatives write-up:

The section would continue to apply to structured finance swaps that are based on an asset-backed security. Retaining coverage of structured finance swaps based on asset-backed securities was intended to address concerns surrounding the well-known derivatives activity of American International Group (AIG) based on mortgage-backed securities which directly contributed to the company's precipitous decline and Federal bailout in the fall of 2008. 

For the record: AIG? NOT A BANK. Problem with their "security based structured finance swaps"? They were based on subprime mortgage securities. It was never the "swaps" at "banks" that were the problem; it was that the underlying collateral was bursting into flames. Congress should have listened to the regulators, because they were right. (I know, I can't believe I said it either.)

We're done here. 

The Rest of the World Still the Dominant Treasury Investors

The data. The Federal Reserve releases its quarterly flow of funds report on Thursday. Officially titled "Z.1 Financial Accounts of the United States - Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts," the 175 page report is mind-numbing in a way only government produced documents can be. For those willing to sift through the information - or better yet, hire some economists (or archeologists) to do it for you - the report contains a wealth of high level information about the quarterly flows of financial securities and period end balance sheets of households, businesses, investors and governments.

Why it's important, but not market moving. The downside of the flow of funds report is that by the time it's published the analysis is very backward-looking. Thursday's report will update the data through 3Q 2014. The Treasury information in particular is reconstructed in part from the TICs data, so much of that information has already been made available*. Therefore any market moves that were driven over a quarter by changes in flows of, say, Treasuries, agencies, or corporate securities by a particular financial group - e.g. banks, pension funds, foreign central banks - have already taken place. Also, the data doesn't give a maturity bucketing breakdown of security buying or holdings by different investors - though it does in many cases separate Treasury bills from other Treasury securities - so the flow information it provides is "big picture".

*Sidebar: There are known and long-standing issues with the TICs data, which we won't rehash here. Government analysts have worked tirelessly over the years to improve the quality of the data, make the collection of it more timely and the data itself less subject to revision. This has in fact made the data much more relevant and useful. Despite those efforts, global reporting requirements of financial holdings are, to a great extent, voluntary. There is no system that currently exists where you can enter the cusip of a security and pull up a list of beneficial owners and how much par value they hold. "Yeah, but, the Treasury has to send payments to the bondholders, so they must be able to track who owns them." They can track the settlement details of security transactions, and the processing of the coupon or principal payments - but that tracks to the bank where the security is held, not to the owner of the account. So if the banks in Belgium hold $500 billion of Treasury securities in accounts for individuals, corporations and/or government entities all over the world, that $500 billion securities will still appear to be beneficially attributed to the country of Belgium in the TICs data because that is where the payments go. There is not (or not yet, anyway) comprehensive regulation - in the US or globally - that requires banks to turn over individual account information to the government. Of this you should be thankful.

Disclaimer to the sidebar: The above is based on my understanding of the Fedwire and Treasury payments processing systems. My understanding may be faulty or outdated, so please improve it and/or correct any mistakes, especially if you work for the Fed, the Treasury, or the FBI. (If you work for the IRS, just leave it.)

But it is useful for trend analysis and making projections. Despite the drawbacks, for our purposes the data is useful for analyzing broad financial market flows and investment trends. And one trend for at least the past decade has been that the rest of the world is the dominant financing partner of the US government. The chart below shows the amount of Treasury securities held by sector (in $ billions).

"Monetary authority" in the graph above refers to the Federal Reserve bank. Together, the US central bank and the "rest of the world" - which in the case is overwhelmingly foreign central banks - are now holding almost two-thirds of US government debt.

If we look at the quarterly flows (see the chart below), we see the same thing: that the rest of the world has most often been the dominant net buyer, while US investors - particularly households - have frequently been the dominant net sellers of Treasury securities.

Note that the quarterly flows above are seasonally adjusted annualized rates - which crudely means you need to divide by four to get the actual flows. I are a mathematician.

So what do we know. The Fed started tapering their Treasury purchases - you see that in the flows over the past two quarters as the blue bar gets smaller. Thursday's data should show Fed flows in Treasuries of zero in 3Q 2014. My guess is that you will see an increase in "rest of the world" buying, as the global economy slowed down and the dollar appreciated strongly against most other currencies in the 3Q (and continues to do so).

If I were going to make an argument for rates staying stubbornly low next year despite the Fed hiking, this is where I would start. As long as the major global economies are weak while the US is improving, there will be an overwhelmingly strong bid for Treasuries from the rest of the world.

Instead of making that argument - because you've all been inundated with "2015 Outlooks" from every sell-side and buy-side analyst on the street (and don't lie to me, I know you only read the bullet points) - what I plan to do is spend some time learning more about currencies, interest rate parity (which is apparently a great theory that seems to never actually work) and cross-asset correlations. Oh, and I will briefly update these charts on Thursday after the actual flow of funds report comes out.

Bravo to the Fed: the Repo Test is Working

Background: The previous post, Litmus Test for Monetary Policy Started Monday, reviews the rationale of the Fed's ongoing test of "just barely" raising the reverse repo program (RRP) rate to assess the impact on the front end of the curve.

Success: Other short term rates have risen in tandem this week with the Fed's upward pressure on RRP from 7 to 10 bp (see chart below). The Fed effective has notched from 9 bp to 12 bp; the general collateral Treasury repo rate has stayed elevated at ~20 bp; and perhaps most importantly, AA financial, non-financial and asset backed commercial paper rates have edged up from 3 to 7 bp to 9 to 12 bp (not shown on chart, data available here). This provides modest but important confidence that - when the Fed does begin to tighten policy sometime next year - raising the RRP rate will likely function as an effective transmission mechanism to other short-term secured and unsecured lending rates.

Volatility in the Fed effective still likely but tolerable: One thing the Fed has not done is push the RRP rate high enough to fully induce the lowest bid cash lenders (some of the FHLBanks) to move all of their lending away from the Fed funds market. You can see in the second chart above the intraday high and low bids (the gray and orange lines) plotted with the Fed effective, which is the volume weighted average rate. The only way that the daily average can be that low - that close to the lower bound - is if the distribution is highly skewed towards the lowest lending rates. The worry - or eventual expectation, really - is that if the FHLBs were to significantly or completely reduce lending in the Fed funds market in favor of RRP or CP or another higher, short-term market, then it would push the Fed effective to set materially higher towards the intraday high of ~31 bp. That's actually not a big deal in reality, as the number of institutions that borrow in the intrabank market is very low, and functionally it changes nothing to have the fed effective rate reset without the presence of the FHLBs. Optically it would of course be shocking to those who don't follow this market closely (that is, practically everyone) but after a period of volatility, the Fed could no doubt convince the market to maintain its focus on the RRP and the interest on excess reserves (IOER) rates as opposed to the Fed effective.

Next steps - determining the spread between RRP and IOER: The Fed is maintaining the RRP rate at 10 bp through the end of next week, then is expected to drop it back down to 5 bp. I suspect the Fed will arrange another test early next year where it raises the RRP rate to 15 or 17 bp for a short period of time. This would give the Fed some information - to back up a lot of untested theory and educated modeling (guessing) by Fed researchers - of what may be a "normal," maintainable spread of RRP to IOER. Although it can seem pedantic, setting a “normal” spread between the two rates is more than an academic exercise. The RRP rate is a collateralized lending rate where – at least for now – mostly money market funds lend money to the Fed on a secured basis in exchange for Treasuries. This is the shadow banking system lending to the safest counterparty on the planet. The IOER rate is the Fed paying interest on cash reserves in the banking system - which it created through 3+ rounds of quantitative easing - to the depository institutions that hold those reserves. The Fed needs the secured lending rate in the shadow banking system to influence, but not be pari passu with, the unsecured interest / lending rate in the banking system. And for both of these avenues to effectively transmit the tightening policy throughout the market.

Guesses are that the two rates should be held anywhere from 5 to 20 bp apart. With the IOER currently at 25 bp, and it becoming the de facto "fed target rate" through the next tightening cycle, that would mean the Fed would set the RRP rate anywhere from 5 bp - where it is currently - to as high as 20 bp, as a lower bound before the FOMC begins to tighten monetary policy.

What could go wrong? The answer that almost everyone will give you is that inflation could ignite since the Fed will eventually be trying to tighten policy without draining the $2.7 trillion of extra liquidity in the banking system. The Fed will tell you that they can successfully tame any unwanted inflation by raising IOER rapidly, which discourages banks from lending money / providing easy credit at rates below where they can safely earn interest on those reserves. All of that is true, but not what worries me.

The Fed’s reverse repo program has now grown to about $150 bn in size. That is, each day the Fed takes in roughly $150 bn of cash from various lenders, predominantly money market funds, in exchange for $150 bn of Treasury collateral. At current operating size the RRP is now larger in total par value than the general collateral Treasury repo market as cleared each day at the Fixed Income Clearing Corporation (FICC) (chart above).  The Fed has recently capped the size of the RRP operations to $300 bn. Given the path the Fed has chosen, this was probably an inevitable necessary step, but it is contrary to their stated role of being the “lender of last resort”. Instead of influencing short-term rates, the Fed has now inserted itself as a major participant and provider of collateral into the short-term markets. Eventually there will be another financial crisis. Hopefully it will occur long after the Fed has stepped back from these large-scale operations, allowing them to successfully intervene as necessary and function in the role of liquidity backstop and not “liquidity market maker”. 

Litmus Test for Monetary Policy Started Monday

What if the Fed raised rates and the market didn't respond? Today through year-end is when the Fed and the market will get its first inkling of whether or not the Fed can successfully pressure short-term rates higher without draining $2.7 trillion of excess reserves in the banking system. This is a big deal. This is the first real test of whether or not raising the reverse repo program (RRP) rate will potentially be an effective conduit of monetary policy.

The test. As of Monday, the Fed raised the overnight reverse repo rate to 10 bp, and will leave it there through mid-December. That means the Fed is willing to pay interest of 10 bps to investors of cash, and provide Treasury collateral in exchange to secure the overnight loan. These cash investors are predominantly money market funds, most GSEs and large institutional asset managers. The cap on the overnight RRP is $300 billion. Additionally, the term reverse repo program will run four operations in December that will span year-end, with a cap of $300 billion and a maximum bid rate of 10 bp. This is the highest rate that the overnight and term program have offered for RRP cash investors. Importantly, the 10 bp rate for secured cash investments with the Fed is above current unsecured fed effective (9 bp), overnight Libor (9 bp) and AA commercial paper rates (3 to 9 bp out to 30 days).

The propagation of monetary policy. For the Fed's new monetary policy target to be effective, it will need to pressure rates higher across the short-term spectrum. The counter-parties actively participating in the Fed's RRP have been so far heavily weighted towards money market funds. The transmission mechanism for tightening credit will need to transmit from these institutional lenders of secured credit in the so-called "shadow banking system" to the secured and unsecured inter-bank and non-financial markets - tri-party repo, fed funds, commercial paper, Libor, CDs.

"I thought the Fed hated the shadow banking system." That's what's called irony. It is now dependent upon that system - and the banking system to some extent as it raises IOER - to transmit its monetary policy throughout the short-term rates complex.

Why has the Fed shifted its monetary policy target from Fed funds to IOER and reverse repo? Cursory outline in bullet points. Don't expect any nuance.

• For years, if not decades, prior to the financial crisis, "excess reserves" - or extra cash/liquidity in the banking system above the reserve requirements - used to average $20 to $40 billion per day. 
• Required reserves are roughly analogous to a minimum daily balance required for a checking account. Most depository institutions in the US have a "checking account" with a Federal Reserve bank, where they are required to maintain a minimum reserve cash balance based on things like the total amount of their daily transaction volume, size of their depository base and so on. 
• Prior to the financial crisis, if a bank exceeded the daily reserve requirement in its account, it had "excess reserves." Unfortunately, this excess cash received no interest. 
• The excess reserves can be loaned overnight from one bank to another to meet the Fed's reserve requirements. Reserve requirements are no joke: "Thou shalt not bounce a check to the Fed." Banks that had extra cash would loan it overnight to another bank to earn interest, instead of leaving it in their own account earning nothing.
• The market for these interbank loans of reserves is known as the Federal funds market, and the average interest rate at which the loans take place is known as the Fed funds effective rate. 
• The Fed used to primarily conduct monetary policy by setting a target Fed funds rate, and either increasing or decreasing the amount of reserves in the banking system to keep the Fed effective close to the target rate.
• A direct result of the Fed's quantitative easing programs is that $2.7 trillion of excess reserves / cash / samolians / clams are now floating around in the banking system. Most banks have no need to borrow reserves. 
• Furthermore, the Fed began paying interest on excess reserves (IOER) equal to the target Fed funds rate - currently 25 bp - so no bank with excess reserves has an incentive to loan them out for less than that rate. 
• The amount of lending in the Fed funds market plummeted from ~$100 to $200 billion per day (that's a best estimate) pre-crisis, to as low as $20 to $30 billion per day. Moreover, the vast majority of the lending is no longer bank to bank, but government agency (GSE) to bank, because GSEs cannot earn IOER since they are not depository institutions. 
• Instead of trying to drain the (ocean with a teaspoon) excess liquidity out of the financial system in order to raise the fed funds rate, the Fed has begun targeting other non-bank specific short-term lending rates as a target when it begins to tighten monetary policy. 
• The rates the Fed is now targeting for conduction of monetary policy are the interest on excess reserves rate (IOER) and the lending rate for the reverse repo program (RRP). 

Is this going to work? We all better hope so. Last week the Fed raised the RRP rate to 7 bp and there was a decent response from the fed effective and repo. This is a somewhat bigger test, as it should have some impact on the CP markets, even if its small. The problem with money market funds and shadow banking in general is its very bucketed in what it can and cant invest in for risk purposes. Once it fills the "repo" bucket, the funds may be forced to lend money cheaper elsewhere, simply to avoid exceeding proscribed risk limits (that were, ha ha, often the result of new Fed and SEC regulations). So the transmission may only go so far. We will get some information and report back soon.