Submitted by Taps Coogan on the 11th of July 2019 to The Sounding Line.

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Luke Gromen, founder and president of Forest for the Trees, recently spoke with MACRO Voices’ Erik Townstead about his theory that the Fed will cut interest rates because the private sector no longer has sufficient liquidity to fund the national debt at current interest rates, not because of the slowing economy. He notes that the Interest on Excess Reserves Rate (IOER) is still several basis points above the effective Fed Funds rate, which implies a shortage of liquidity in the banking system.

Some excerpts from Luke Gromen:

“I thought the reaction to last week’s better-than-expected jobs number was very interesting… I thought most investors are focused on the wrong number, at least as it relates to (a) Fed rate cut and the percentage chances of what the Fed will do.. Virtually no one paid attention to what I thought was the most important number last week… the spread of the Fed Funds rate (FFR) over the Interest on Excess Reserves (IOER) has re-widened back to the highs… at six basis points, which is back to the ten year highs that prompted the Fed to cut the IOER rate at that point. What (that) is telling us is that the global dollar shortage has begun getting more acute in the US banking system again, that the so-called excess reserves held at the Fed are not excess at all… Critically, this is happening despite the fact that the US debt ceiling means that US treasury is not sucking up dollar liquidity with new treasury bill issuance (temporarily), and is actually adding to dollar liquidity by running down their cash balances, which actually results in a mini-QE of sorts… The underlying dollar shortage is severe and intensifying.”

“…When you look at what’s pulling dollar liquidity out of the banking system, it’s an over simplification, but why would I put large amounts of cash in a bank earning virtually zero when I can put that cash into a government money market fund buying treasuries and earning 2% plus taking essentially the same risk?”

The excess reserve figures published by the Fed refer to the bank reserves in excess of basic monetary reserve requirements, but not necessarily the reserves required by monetary authorities in other countries, reserves needed based on stress testing results, and reserves needed to meet a variety of other banking regulations that have emerged since the financial crisis. The degree to which bank reserves are truly in excess of all of the various other reserve requirements is largely unknown. Arguably, the only way to know that the overall banking system’s excess reserves are dwindling is that it would cause the Fed Funds Rate to rise above the IOER. That has been the case since March.

As Mr. Gromen notes, huge quantities of short term US treasury debt at competitive rates are sucking liquidity out of the reserve system. There may not be much liquidity left, which could start to push up interest rates for the treasury market and the banking system. To avoid that, the Fed must cut the Fed Funds rate and re-liquefy the banking system. To the extent that more accomodative policy is bullish for risk assets, this is likely to be another case of ‘bad news is good news.’ The swelling national debt and tightening liquidity will drive more accomodative policy that will drive more liquidity into risk assets. At least that’s the theory.

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