Submitted by Taps Coogan on the 25th of September 2019 to The Sounding Line.

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Chris Whalen, Whalen Global Advisors chairman, recently spoke with CNBC about the ongoing overshoots in the overnight funding markets and the importance of the Fed defending their pegs.

Some excerpts from Chis Whalen:

“The Fed, for the last year or more, has been shrinking their balance sheet, which had the effect of shrinking banking deposits. So, the market was getting tight. We saw this all of this year. We saw this in December in spades (during the market selloff)… There’s been a lot of discussion inside the Fed for well over a year about complimenting the shrinkage of the balance sheet with a program that would let them put liquidity into the market when needed. But, they haven’t acted on it. They’re at least a year late. Dudley (and) Williams at the Fed at New York are wrong when they said that they didn’t miss this. I think it is key for investors and also the public at large, is the Fed really serious for the target for Fed Funds at 1.75-2.00%? Because if they are, they have got to defend that 2% upper bound. They have to be ready to add enough cash, not reserves but cash, to make that market clear. Even today…, they could have done more…”

“Remember, when they departed and starting purchasing trillions of dollars of securities (after the Global Financial Crisis), they created this super-asset called excess reserves that don’t have to be hedged and they trade at par everyday. So banks tended to want to hold those and not treasuries and agencies. They distorted the market. So now that we’ve been reducing the balance sheet, the Fed hasn’t realized, until today or last week, that they needed to manage liquidity. When you are brutally reducing the amount of bank deposits, which is what we are talking about, every time one of those reserves got redeemed at the Fed, the Treasury had to go issue a bond.”

“If (the Fed) says the upper bound is 2%, they’ve got to defend 2% and this morning we were trading over 2% for GCF (General Collateralized Financing). This is a medium term problem. If they don’t commit to the Street before October 5th, which is their current guidance, that they are going to continue this through the end of the year, then we could repeat last December.”

If record government and corporate bond issuance continues, as it almost certainly will, the funding problem in the overnight markets is going to keep getting worse. Unless the Fed wants to be doing tens of billions of dollar of repos on a daily or weekly basis forever. they are going to need to start growing the balance sheet again. They will probably try to avoid calling it ‘QE’ when they do so, but at the end of the day, they will be adding billions of dollars of liquidity into financial markets with two rate cuts already behind us, bonds and equities near all time high valuations, unemployment at 50 year lows, and core CPI at its highest level since 2008 (2.38% year-over-year). If that doesn’t give inflation a boost, nothing will.

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