From Money Fund Report®: Credit Suisse strategist Zoltan Pozsar is recommending that the Federal Reserve play a wider role in the global markets as a way to address what he views as a crippled U.S. dollar-exchange market resulting from the effects of money-market-fund reform and Basel III. His Nov. 18 edition of Global Money Notes was titled "Exorbitant Privilege to Existential Trilemma." The "exorbitant privilege" is the U.S. government’s "ability to borrow in its own currency anywhere in the world thanks to a vast and deep Eurodollar market," an ability that is on the wane, he wrote.
Pozsar explained that "Prime funds’ loss of $1 trillion in assets under management amounts to the clamping of a major ‘artery’ whose role was to bridge the Eurodollar market’s marginal dollar needs." He continued, "These needs are now bridged through a smaller and increasingly tight ‘vein’ that’s the balance sheet of American banks under Basel III. The result is a Eurodollar market that’s structurally more expensive, less liquid and dominant than it used to be." As an example, he wrote that "Outflows from prime funds to date have reduced the volume of (overnight) Eurodollar trades from $250 billion to $90 billion." This, he maintains, has created an "existential trilemma," comprised of an impossible situation whereby the Fed is expected to constrain bank balance sheets, maintain a balanced Eurodollar exchange rate and implement monetary policy.
Pozsar’s assessment of reform-related prime fund outflows is that "they turned out to be far worse than expected" with just under 90 percent of assets under management exiting the sector. With that shift he wrote, "Large American banks and asset managers replaced prime money funds as the marginal lenders to foreign banks."
The fallout from money-fund reform is multifold. Pozsar asserted that on the "local level," it will make it more difficult for the Financial Stability Oversight Council’s Alternative Reference Rates Committee to come up with an alternative reference rate because "when the dust of reform settles the Overnight Bank Funding Rate will have lost most of its volume advantage over the fed funds rate, in our view." Globally, the repercussions include "increasingly negative cross-currency bases," and in turn, "tighter financial conditions for the rest of the world," producing "slower, not faster growth as foreign banks pass on higher costs to their customers, or worse: de-lever their books."
Prime Funds’ Resurgence Unlikely
At one point Pozsar expressed being puzzled that "no Fed official devoted a speech to the topic of prime money-fund reform and its local and global repercussions;" for him its importance cannot be understated. Before money-fund reform, he observed, "prime funds represented a $1 trillion pool of ‘omnipresent’ liquidity that was sliced and diced according to foreign banks’ needs. Investors in prime funds rolled their o/n balances every day which foreign banks could tap for custom terms and sizes any day – it was the way a marginal funding market is supposed to trade." With money-fund reform, "This omnipresent pool is no more."
He was not optimistic about the resurgence of prime funds either. Yields hampered by liquidity requirements and the possibility of redemption gates and liquidity fees were cited as reasons for his dim view. Another contributor to this trend is the higher payout on checking accounts at banks.
In addition to the exodus of assets from prime funds, Pozsar asked readers to "Consider the image of American banks absorbing these flows through hamstrung balance sheets…what you see is an elephant inside a snake."
Were prime funds to rebound, then these market constraints could be seen as cyclical, but in Pozsar’s view that is not the case. These changes are "structural," he argued, and their attendant strains call for the one bank that could grease the skids: That is "none other than the Federal Reserve Bank of New York."
Instead of being a "lender of last resort," Pozsar envisions the Federal Reserve as acting as a "dealer of last resort." It would use its swap lines to serve as a "backstop to prices when dealers hit their balance-sheet constraints and have no room left to make markets at reasonable spreads." This change would address the conundrum comprised of private market-makers pushing up against balance sheets and a strengthening dollar, "forcing the Fed to stay on hold" with regard to interest-rate hikes.
Pozsar explained how this role would fit in the wider markets. "In a way, quantitative Eurodollar easing is the missing piece in a mosaic where the European Central Bank and the Bank of Japan continue on with QE at an aggressive pace, and investors in their jurisdictions are filling their duration gaps with higher-yielding U.S. dollar assets on a hedged basis. But the private provision of (currency) swaps to hedge these flows can’t possibly keep pace with the public creation of euros and yen on a massive scale."
In short, he stated that "Barring the scrapping of Basel III or the blanket exemption of reserves from the supplementary leverage ratio, quantitative Eurodollar easing for the world – the fixed price, full allotment broadcast of Eurodollars globally through the dollar swap lines – is the solution we need."
Psychologically, he discussed that how the Fed window is viewed would have to be altered. "In English, this means that long-held notions of stigma would have to be expunged from the market’s conscience." When bank quotes are "more expensive" there should be a default to the Fed "with no further thought," maintained Pozsar.
Fed Consideration: Not Unlikely
He addressed the likelihood of this occurring. "It’s not unlikely," Pozsar said. "We know from the July FOMC minutes that the Fed is actively looking into ‘approaches to reducing perceived stigma associated with borrowing at the discount window’ and is conscious that ‘the dollar is the principal reserve currency and that money transmission in the U.S. occurs through globally-connected funding markets.’"