The Collateral Shortage Will Get Worse

Recently, Credit Suisse’s banking expert Zoltan Pozsar suggested the Federal Reserve’s Overnight Reverse Repurchase Program (RRP) will see over a trillion dollars flooding in over the next couple of months as the collateral shortage worsens. In what appears to be a collateral game of “hot potato, the Fed is trying to encourage those with pristine collateral to willingly part with it as the large commercial banks desperately need it.

With over $28 trillion in debt, it is hard to believe there is an insufficient amount of debt to back a large amount of cash in customer deposits at the large commercial banks. Large commercial banks purchase short-term Treasury securities with customer deposits to create bank reserves but the commercial banks prefer short-term Treasuries, which there is an insufficient amount of.

Part of the problem has to do with the U.S. Treasury, which is not issuing the type of debt the commercial banks want, part of it has to do with the U.S. government spending down its cash, and part of it has to do with the Federal Reserve buying Treasuries through its Quantitative Easing program.

To alleviate the pressure building inside the financial system from the collateral shortage, the Fed is offering overnight collateral loans in exchange for cash. To encourage the use of its overnight RRP facility, the Fed is paying 0.05% interest on all the cash it receives. With Treasury Bill yields around or below 0.05%, this is an attractive option for money market funds and other funds with large amounts of cash.

The Fed is always beholden to the large commercial banks, who it seeks to protect at all costs. By encouraging the use of its overnight RRP, the Fed is simultaneously encouraging those with Treasury Bills to either sell them or allow them to mature.

As money market funds and other funds with large amounts of cash let their Treasury Bill holdings mature to park their cash at the Fed for a slightly higher yield, the large commercial banks can buy those matured Treasury Bills when they are reissued by the U.S. Treasury. In what appears to be a game of collateral “hot potato”, the Fed is encouraging those with pristine collateral to part with it to allow the large commercial banks to buy it.

While the Fed’s intentions remain unknown, it appears the Fed is attempting to stabilize the commercial banking system by providing the pristine collateral the banking system needs by stripping the collateral from those who have it. According to Pozsar’s estimates, a trillion or more of cash is expected to find a home with the Fed’s overnight RRP facility in the next couple of months.

The Fed may be hoping the overabundance of cash in the financial system will resolve itself as the economy reopens and as debt and rent moratoriums expire. While it appears the burgeoning use of the Fed’s overnight RRP facility is a problem, the Fed seems unconcerned that is it parking $700-800 billion in cash on a nightly basis.

So far the collateral shortage has not had any negative effects on the economy, financial system, or the risk appetite of investors. A surge in the use of the Fed’s overnight RRP does affect Treasury yields and the dollar.

Treasury yields tend to decline and the dollar tends to rise when cash is parked at the Fed’s overnight RRP facility. Usage of the overnight RRP facility has never seen levels as it is now, let alone the expected trillions more that Pozsar is predicting will be parked at the Fed.

In the months to come, presuming Pozsar’s estimates are correct and the relationship between the overnight RRP facility, Treasury yields, and the dollar holds, financial conditions are going to severely tighten. This suggests Treasury yields are likely to collapse which will send bond prices skyrocketing along with the dollar.

The unintended effect of a rising dollar is that a rising dollar is disinflationary and can be deflationary, which will quickly put an end to any fears of high inflation. Collapsing Treasury yields will also put an end to any calls for the Fed to begin tapering its Quantitative Easing program. Strangely, the Fed’s solution to the collateral shortage may also solve several of the Fed’s other problems in a way nobody sees coming, perhaps not even the Fed.