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Matt Winkler
Matt Winkler
Articles (145) 

Why the Year-End Turn Could Trigger QE4

Credit Suisse published a paper arguing that QE4 could start within the next two weeks. Otherwise, we could see dislocations in short-term interest rates as banks scramble for year-end liquidity

December 12, 2019 | About:

Financial crises have a way of bringing obscure concepts to the fore. Before September 2008, the term “mortgage-backed security” was reserved for finance gurus and blithely ignored by the general public. Then 2008 happened and the inner workings of the mortgage market were suddenly revealed to all and became a big part of the lives of the average American. Back in the 1980s, it was savings and loans that rose from obscurity to the mainstream.

This time, the public is being introduced to the strange inner workings of money markets. Ever since the overnight lending market blew up in September, the financial news media has been covering it consistently. In a Dec. 9 note to investors, Zoltan Pozsar, the managing director for investment strategy and research at Credit Suisse (NYSE:CS), that coverage may soon be expanded, since this formerly obscure market could get even more topsy turvy by the end of the year with another dislocation unless the Federal Reserve restarts the fourth round of quantitative easing. 

Pozsar’s tone at times verged on alarmist, saying that if the problem is not dealt with as soon as possible, “the world would stop spinning.” Not literally, of course, but such a strong phrase is generally reserved for end of the world preppers, not analysts high up in the ranks of a major international bank. His reasoning is that as financial institutions gear up for the year-end turn with excess reserves for all intents and purposes no longer available, there could be an especially high demand for reserves and little supply.

Why the sudden surge in demand by Dec. 31? Demand peaks at year-end because in 2011, banks became incentivized to lower their G-SIB scores so as not to incur capital surcharges by the end of the year. G-SIB stands for global systemically important bank, and the higher that score, the higher the surcharge. Scores are proportional to risk, so in order to lower the score, banks need to exchange high-risk assets for low- or even no-risk assets. Reserves, of course, are the quintessential no-risk asset, so demand for those becomes especially high.

The implications here are a bit paradoxical because the higher stocks go, the higher G-SIB scores go for banks, equities being risk assets as a part of bank capital. So the higher stocks climb into the end of the year, the higher the demand for reserves becomes, and the greater the chances of a money market dislocation if the Fed doesn’t step in. According to Pozsar, this could lead to a slingshot scenario where higher stock prices lead to trouble in money markets, which in turn leads to stock liquidations and a broad selloff to raise reserves.

Last year’s turn didn’t see any dislocations, the analyst readily admits, but excess reserves were also about $180 billion higher back then and stocks were already in a deep selloff, alleviating much of the pressure on short-term lending that may have otherwise materialized. This time, equities are at all-time highs and still climbing, and excess reserves have already reached a bottom as of September.

The financial maze here is a bit too arcane to know for certain if Pozsar is correct in his convictions, but if he is, investors should have at least a few days to prepare. If there is going to be the sort of money market stress at the 2020 turn as he expects, we should start to see signs by next week as the scramble for reserves begins.

In Pozsar's words:

"If the equity market rallies and auctions go poorly, G-SIB scores will keep going higher and the risk that funding market pressures from managing G-SIB scores will show up starting the last two weeks of the year and will last longer than just the spot turn are rising."

Disclosure: No positions.

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