Maybe the Fed took away too much liquidity and backdoor QE is coming?
The rise in the euro today is peculiar.
If anything, you would expect it to go in the other direction based on a rising Treasury yields, better risk sentiment, solid economic data and a smaller chance of Fed rate cuts.
Instead, the opposite is underway. Fed fund futures are now pricing in a 13% chance of a 50 bps cut, up from zero at the start of the week. One caveat is that those numbers might be skewed by the problems in the short term funding market.
...and that brings us to the main point.
Something has gone wrong in the repo market. It was probably a confluence of elevated corporate issuance, Treasury auction settlements and tax payments but it's still worrisome. The world was supposed to be awash in liquidity and suddenly no one can find dollars.
What if the Fed removed too much liquidity during the balance sheet runoff?
That's a scenario that desks (and likely the Fed) is considering. BMO sees three possibilities with a chance of all three coming tomorrow:
- Lowering IOER by 5 basis points
- A standing repo facility (rather than today's one off)
- Restarting balance sheet growth
The third one is backdoor QE (if not frontdoor QE). The announcement probably wouldn't be immediate but would be a pledge to keep the balance sheet growing at the same pace as liabilities with a restart coming in Q4. Currently, the balance sheet is about $3.6 trillion while reserve balances and reverse repos total about $2.0 trillion. This was thought to be a reasonable buffer but no one was sure and now it looks like it's too small.
So the risk tomorrow is that we see some kind of balance sheet hint or announcement. If that's the case, the market will give the dollar the QE treatment. Needless to say, that could lead to a 1-2% short-term move, depending on what happens with rates.
