Fire Jay Powell Immediately: The Overwhelming Proof For The Collateral Case

The Federal Reserve conducts reverse repo operations (RRP) daily and has for more than half a decade. These are very different from the “liquidity” operations the central bank has been deploying since last year’s rumble in the repo market; the latter merely mimic a repo transaction and are intended to push bank reserves the Fed creates on the spot out into the Primary Dealer network.

reverse repo, as the name implies, is the reverse of that transaction. Its purpose, therefore, is not bank reserve-type liquidity but to establish a floor for depository institutions. Those who are cash-rich have the option of “lending” that cash to the Fed receiving in return SOMA holdings as collateral.

Given that option, who in their right mind would ever lend into money markets at a rate less than the RRP? That’s the floor. As far as risk goes, you’re never going to do better than lending cash to the central bank on pristine collateral.

This goes for money markets and money equivalents alike. A 4-week T-bill, for instance, is a money equivalent in this sense. Why would anyone lend to the US government at a return less than what they would get at the RRP? These are near equivalent transactions; in the former you are left holding a 4-week bill while in the latter you’ve received government debt as collateral.

And if the RRP is set to zero, as it is now, you’d have to be crazy to hold anything at a negative yield. Especially short-term bills. Why bother paying the federal government to borrow from you when, if you have the cash, you can just go over the to Fed and at least park that cash safely collateralized at zero.

Negative bill yields are further clarifying and demonstrating the usefulness of those instruments beyond any investment or carry trade function. They have a separate utility that is, at times, of enormous value. Financial counterparties during those times are willing to pay a penalty, either the negative yield or the opportunity cost of not using the RRP, this week both, in order to secure and hold on to bills.

I’m obviously talking about collateral for use in repo markets. T-bills are the most pristine of pristine collateral; always on-the-run therefore liquid beyond anything else, and containing very little interest rate let alone credit risk because of their short-term nature. It doesn’t get any better as far as any repo counterparty will ever be concerned.

Negative yields below the RRP cannot be anything else. And it’s just the starting point for the collateral case.

Before getting to the rest, we’ve documented the string of evidence pointing in that direction for longer than I care to remember. May 29, 2018, the “strong worldwide demand for safe assets” that first flattened and then ran over the yield curve, inverting and twisting that thing into a grotesque shape the implications of which only a central banker could misinterpret.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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