What the Fed's Big Balance Sheet Unwind Means for Markets

you can go on. Okay, So the FED started quantitative tightening.

We're recording this in late June, and weirdly, it kind of went by without that much fanfare, Like there were a few news articles about the FED firing the starting gun on quantitative tightening and the unwind of its very very large balance sheet, but there was so much going on at the same time, you know, there was that surprise seventy five basis point interest rate hike, and then lots of talk about inflation and things like that that it feels like it didn't get as much attention as

it probably should have. Most of the attention is paid to the rate obviously, you know, queue when it was first unveiled or when Ben Berneki did QUI two, which was the real QUEI during the Great financial crazies, I got so much attention, but there still seems to be a lot of ambiguity about a how it works, what it does, what it accomplishes, and then in terms of like the degree to which unwinding the balance sheet is or is not an additional form of policy, tightening is

something that I just feel like is at best, like still deeply misunderstood. It is kind of crazy that even after years and years of quantitative easing, there's still a discussion about what the impact is and how it actually works. I mean, I remember people still arguing about whether or not it pushes up asset prices and things like that.

And there are people out there right now who are arguing that the reason markets have fallen might not actually have to do that much with inflation concerns and worries over a looming recession, but could just be because liquidity is starting to exit the system. No, No, I mean, it's totally it's totally valid. You know, it's worth noting that we have had, you know, markets boomed even though there was no longer a further expansion of the balance sheet.

You know, we started to rally in early nineteen again even as the balance sheet shrank for a while, going into some of the tensions, but it really is wild, as you say, like how little we know and how little even I mean, I think even the FED knows about like quanted measuring the effects of changes to the

size of the balance sheet. Well, there is also an argument to be made that the QUEI that we seen over the past couple of years is stylistically and quantitatively different than the ones we've seen prior, and so the exit is going to be different too. So we are going to dig into all of these um very big and technical questions and I'm happy to say we really do have the perfect person to discuss this. We're going to be speaking with someone who's been on the podcast before, Joe,

but I think you were actually away for that effort. Yeah, so I'm thrilled to have him back. We're going to be speaking with Joseph Wang. He used to work at the New York Fed on the Open Markets desk, conducting repo operations, basically being deep in the weeds of money markets, and now he runs a blog called fed Guy, which is really a must read if you're interested in monetary policy and in all of these big questions about how it actually works. So, Joseph, thank you so much for

coming back on ad thoughts. Tracy, Hey, Joe, thanks so much for your biding. Yet it's a pleasure to be here. Yeah, So maybe just to begin with, could you give us the bra outline of how quantitative tightening or the QUEI that we've seen over the past couple of years. You know, as I alluded to, it's different to the QUI that we've seen in the past. So I guess the question

is how different is it this time? Like? What makes this particular exit different to previous periods of quantitative tightening that we've seen. Sure, so I think this time QUT is a different first and the level, and I think there's changes in the financial in the structure of the financial system that make a bit more difficult. So this time around, QUI looks like it's going to ramp up

to about nine billion dollars a month now. In contrast, the last time around when we did this, the maximum that we ever did was fifty billion dollars a month. So in terms of pace, it's a much much more aggress pace. We're doing nine billion a month, can kind of contrast last time the maximum we did was fifty billion a month. So the way that this works through the system, I think Bradley speaking, I think of QT as having two mechanisms. One is that it increases the

supply of treasuries into the market. That's one, and that's kind of how the FET thinks of it. It. By increasing or increasing the supply of treasuries, you are pushing the term premium higher, so it puts upward pressure on interest rates. And the second mechanism has to do with draining liquidity out of the system. So these two mechanisms are related but also operate in separate ways, And they also have a lot of moving parts into how they

actually can play out. And these moving parts aren't completely within the FET's control. So because of this, QT can play out in a range of outcomes. You can have very benign QT, where it really is just washing paint dry as Railie and what mentioned before, or you can

have QT that's more aggressive and very disruptive. Now, based on what I see in the current configuration of the financial system, considers so many moving parts, it seems what's happening right now is compared to last time, QT, this time is going to be a lot more disruptive. I guess I can talk about why from the So I'll go by the first mechanism, the increase in trgury supply, and then I'll talk about why draining liquidy this time

will also be more disruptive. So when QT increases the supply of treasuries into the private sector, the Fed doesn't actually get to decide what tenors that reach the market. That's a decision by the U S. Tresury techne. Overall, what happens is that um when the feed is doing QT, it's it's receiving repayments for the tresury that it owes that that it owns. So the U S Trsury issues new debt and takes that money and repays the ft.

That's what happens. So it's the U S. Treasury that gets decide what are the new what are the tenors of the new treasuries that the market absorbs. Now, you can do this in a way that's very market neutral. So let's say the U S. Tregury issues a lot of short data debt, Treasury builds now, the market can absorb these treasury bills very easily. If you think back to the first quarter of the tresury issued two trillion dollars in bills in the market just lapped that up easily.

So in a sense, it's because bills are so cash like, it's they don't really have any interest rate impact. But what the U. S. Treasury is doing this time around, it's actually cutting bill issuance, so because it had received a lot of tax payments in April above its expectations. So all the q T increase in supply over the next few months is going to be in coupons, and coupons are more difficult for the market to absorb, so it's probably going to place more upward pressure on interest rates.

There are also a lot more mechanics behind this that that make it the same around more disruptive. So, for example, we're having a big change in who the Marshall wires are in this market. Well, actually, I'll sit back a bit and say, so the increases imply this time around is much higher than it was last time around. I think it's useful to think about treasury rates in terms of supply and demand. So in terms of supply, the

sime around the amount. Taking into account of QT the estimates for the increase in supply to the private sector, it's going to be about one point five trillion dollars a year, so for the next three years. Now, just for context, pre COVID, the amount of supply that was going into the market was about five dred billion dollars a year, and so the pace of the supply is just so so much higher than than it was the

last time we did this. And that is happening in the context of from the say demand side, from the buyer side, where the Marshall buyer is changing and the market structure doesn't seem very strong. The Marshall buyer for treasuries before COVID was actually the hedge fund the hedge funds.

So what the hedgemunds were doing they were buying let's say, hundreds of boons haves and treasuries several hundred billions and treasuries, but they were buying it as part of a basis trade, so they actually didn't really care about things like growth and inflation. It was really about the spread between the cast treasuries in the future. So there were the marginal buyers. Post COVID, it was all about the FED and the

commercial banks. The commercial banks, because of regulation, they have to own a lot of liquid assets and they were buying tremendously. So those players are not in the market anymore. And there were also players who are much more agnostic to things like where the interest rates were because they have to buy them as part of a pair's trade

or for regulation. Those people are out, and you're having to a situation where we're looking for the new Marshal buyer, and that new Marshall buyer is probably going to be more sensitive to things like inflation rates. And you know as well as we see and this happening in UH inflation, it's it's not clear what that is, nor what defense policy rate will be going forward, So there's gonna be

some volatility there. M And one more thing, and you can see chair Power and mentioned this again, Trojery market liquidity is not pretty good. So when we have this tremendous increase in supply changing demand amidst very low Tridrey market liquidity. So just just for some context, so every day in the trojury market, we do about six hundred billion dollars in cash cash transactions, and we have about a twenty three trillion dollar trojury market for the private sector.

So if you rewind the clock twenty years ago, we

had about seven trillion dollars in net market. About treasuries daily volumes are about four hundred billion, So today the total treasuries volumes have more than triple toe trillion, but the liquidity daily liquidity is only a little bit higher, from four hundred billion to six hundred billion, So you can have in a sense, you can think about let's say the stadium getting a lot bigger, but the doors are not really increasing, and that's a big reason why

we see these huge moves and treasury utes recently. I think a few weeks ago, we sell the tenure, just jump twenty five basis points, we sell the treasury market break in March, and we've had flash crashes in the past, so it's kind of there's this storm brewing from my perspective, where you have enormous issuance, you have a weak market structure, and you also have a demand side for treasuries that

that's becoming a little uncertain. So uh, that's just with the treasury please no, So I want to explore like the liquidity side a little bit more. And one of the things that we talked about in a recent episode.

You know, like treasuries and reserves are not that different from a sort of like economic perspective, Right, So, Okay, you talk about there's a huge increase into the market of these treasuries that the FED will be getting rid of reducing, but on the other hand, it's also diminishing the reserves the liability side of the balance sheet, and so on some level there's an evenness to it. And

economically they're not radically different, they are somewhat different. Explain further the effect on liquidity from swapping two assets that are not that different. Yeah, that's a really good question. So I think there's a couple of things to this. One is that reserves can only be held by commercial banks, so occurrence, So reserves are basically deposits at the FED, and only commercial banks probably speaking, can have deposits at the at the FED. So from a commercial banks standpoint, Joe,

you're you're right, it's it's very equivalent. I mean, there's more interest rate risk in a treasury, for example, but for a commercial banks standpoint, I can have reserves in my liquidity portfolio, or I can have treasuries. And what they've been doing for the past couple of years is they're making that choice to say that I want to have treasuries rather than reserves, since treasuries are using much more than interest on reserves. But that's not the decision

faced by people who are not banks. So for example, you and me, we have deposits at a commercial bank. We don't we're not eligible to hold reserves at the FED. So when the FED is doing QT, from from our perspective, the deposits in the system are declining. So when the FED does QT, it reduces reserve assets at commercial bank which are often backed by deposit liabilities. So it's this two tiered monetary system we have where non banks have deposits at banks and banks sold deposits at the FED.

So from our perspective, we're losing bank deposits, which are you know, carry credit risk and don't earn idle R. So the substitution is it's not perfect. But I think more broadly, the point though, is it seems like right now what's happening is that treasury start becoming less cash. Like you can see this in the lack of flight to safety in market volatility, bonds are selling off and

stocks are selling off. So when we have high inflation and we have a lot of rate volatility, it seems like the market is not rushing to treasuries as safety. They're rushing through just cash. And so that that makes it I think this asset swap that that you talked about, which is broadly what QUE is not as perfect substitutes for each other. So I just want to touch on on one consequence of the dynamic you just described before we go more into q T and the mechanics there.

But we've spoken about this before, I think last year, but the implication that banks aren't necessarily buying treasuries but because they think that, you know, interest rates are going to go up or down, but they're buying them because they have to buy treasuries to satisfy liquidity coverage ratios and regulatory requirements and things like that, and treasuries are sort of the best option of the assets that are available to do that. So what does that actually mean

when it comes to treasury yields? Like when we look at a treasury yield, now, how much information is that actually giving us about investors, expectations for the future direction of the economy and things like that. When I look at tragedy yields, I don't actually think there's a lot of information content. And I don't think so because as you as you know to Treasury Tracy, there's a lot

of people who buy treasuries for different reasons. So you do have investors who, let's say, look at growth and inflation and look at yields and make a judgment. But treasuries are very special in the financial system and that they are considered a high quality asset, a credit risk free asset, and under a range of regulations people have to buy them just because the regulations tell them too.

And banks, for example, they have to hold high quality liquid assets, as you mentioned, under things like the liquidity coverage ratio. What qualifies as high quality looquoid assets a very very narrow range of assets, treasuries being one of them, and so they have to buy some of that. But it's not just them. Um, if you look at let's say, government sponsored emprises like Fannie may or Freddie Mac, they also have similar regulations that they have to buy high

quality liquid assets. Or if you look abroad, if you are a foreign reserve manager, if you're managing the foreign reserves of let's say Japan or China or some other countries, you can't really buy just equities or anything like that. You usually other than the substational make usually you're very very conservative, and so you can only buy things like treasuries. So there's a there's a lot of demand for treasuries

that that's just not that UH driven by fundamentals. And of course you can have hedge funds who are just buying it as part of a basis trade where they care about the spread between the trusuries and something else rather than the absolute level of the trusuries as measured by UH. It's the economic fundamentals. So it's it's really hard to to look at from my perspective, to look

at price and infer economic conditions. So thinking about, you know, in terms of like the mechanics or the implications of quantitative tightening, why don't we start off with a sort of kind of basic question. But it's like, why does the Fed feel an impulse to reduce the size of its balance sheet because it has the rate channel it can hike rate it has it's been hiking fairly aggressively

seventy seventy five at the last meeting. Where does the urgency or just even the impulse come from to decreased holdings? I think from the FETs perspective, it's it's a lot like you and Tracy suggested earlier in the show, the FETE doesn't really understand what exactly happens, and so they want to do with something that they understand they think

they understand well, like the overnight rate. So it seems from what I hear, they want to get out of this Balanciet stuff and go to something that they feel like they're more comfortable with, which is raising the over night rate. And you know, as you said, as you mentioned, you have disagreements within the FED as to what exactly QUI does. How you have people who would be like, oh, you know, he doesn't really do anything, just solving one

asked for another. And you have people in the market who look at KUI and just max long because QWI makes the market go higher. So I think there's a there's just not very clear what it actually does, and they don't want to be doing things that they don't really understand. What do you think it does? Can you sort of describe for us what draining liquidity would look like in the current period versus draining liquidity from say or nineteen, because I think that might help us sort

of understand the differences here and the difference in the mechanism. Sure, so when the FED drains liquidity out of the financial system, it doesn't actually have control where the liquidity comes out of. It can come out of the banking system, which you would drain reserves and deposits, or it can come out of the RAP, which which just decrease the RAP size. Now the RAP, as you see right now, it's very large.

It's two two point two trillion. The the RP you can think of as just the true excess liquidity in the final nancial system. There's all this money that people have nowhere else to invest in, and so they just leave it on deposit at the FED at the end

received the IRP rate. So when you do q T, if money is coming out of the IRP, you're it's going to be a very benign because you're taking money out that really nobody wants, or you could take it out of the banking system, which conceivably someone somewhere is reliant upon that that that liquidity. The FED beforehand doesn't actually know what will happen if you listen to fit

precedents tak over the past few months. They just look at the RAP and they think that there's a lot of excess liquidity in the system, and so they can they can we can just do aggressive QT, no problem. But if you notice what's happening right now is that the RP is not declining, it will probably go much higher in my view, right so I have to say, we're recording this right before quarter end, so right before the end of June, and there is a very high

chance that it could shoot up. I think in May it went above something like two trillion dollars, which was a record at the time, but we could get another record before this episode actually publishes. Yeah, when I used to round the rap, we were very surprised for like five billion. Now that that's that's too low. Um, what happens. So the reason is that you have all this liquidity. Um, how it gets strained ultimately depends on who buys the

newly issued treasuries and how they finance it. If the treasuries are purchased by people who are levered investors, then a drain it's the RP. For example, if you are a hedge fund and you buy the newly issued our treasuries with repo loan, then the cash from that repole loan ultimately comes from the RAP. A money market fund will withdraw money from the RP and lend it in

repo to the hedge fund investor. Money fund investors can only lend, can only make specific investments, very narrow one of them is repo, so that's basically the only that in increased bill issuance, but broadly speaking, that would be

how you get the RP lower. On the other hand, if the people who buy the newly issue treasuries are let's say cash investors who are buying it with deposits they held out commercial banks, then what you will see is that liquidity will be drained out of the banking system. So that means that what's being drained is not necessarily liquidity that's held in the RAP that no one wants that's access, but liquidity in the banking system that maybe

someone somewhere is relying on. Now beforehand, it's hard to see where the where the liquidity will be drained, but the way that I look at this is I just look at what's actually been happening the past few months. So the past few months, when the Treasury has been issuing coupon debt, the people who have been buying it have been people who are holding money at a commercial bank.

So you can see that what the increases over the past few months, the amount of reserves in the commercial banking system is declining, but the amount of in the RP is not declining. So just how the financial system is currently configured that there doesn't seem like there's going to be any increased demand for leverage treasury investing. So going forward, what you can actually see is that the draining from QT comes out of the commercial banking system,

whereas the RAP continues to increase. This, in a sense, is kind of like a double tightening effect because when the RAP goes higher, it's also draining liquidity out of the banking system. So this is why it seems on this side of the equation. From my perspective, draining liquidity

can also be disruptive. You're not draining liquidity out of the RAP, which would be painless for the financial system, You're draining it out of the banking system, and the RAP is also suching liquidity out of the banking system. Let me ask you another kind of slightly bigger picture question, But you talked about the balance sheet remains a tool that the FED is, you know, it's hard to quantify its effects, perhaps it's a little bit uncomfortable using it

and so forth. And it seems to me that you know, you're thinking about the difference between post Grade Financial Crisis and post COVID that QUEI was sort of used differently, and so post Great Financial Crisis, the FED it to hit the zero lower bound and felt it needed to ease further, and so it brought assets, whereas my sense of sort of march was that there was a big l and specifically of this liquidity effect and of this uh you know, wanting to sort of credit easing and

backstop credit market specifically via asset purchases. I guess you know, the question I've wondered is did they sort of backdoor themselves into using a tool that it actually never really wanted that because it had this unusual situation, they didn't really want to have to go back to QUEI, but they sort of were forced to. And it's stuck around longer because they had this sort of different need when COVID hit, I think you're you're right that they used

to QUEI differently in COVID. So POSTDFC, it was largely used as a tool to lower longer dated interest rates. So the Fed hit the zero bound, they wanted to continue to ease by putting downward pressure on longer date interest rates. So in order to do that, it bought a lot of treasuries now tasks for to March, it was a little bit different because the treasury market broke. So what that meant was that people who wanted to

sell their shoulders for cash cannot do that. So on a global scale, treasuries are kind of where people keep their dollars. It's kind of like a huge bank, so to speak. So for example, if you and I we go to the bank and we want to get our cash out because we need cash, we expect to be able to get that. But if the bank says, sorry, I don't have any cash, then you know, we panic. There's a there's a run on that bank. And that's

what happened in March. The trosury market. Everyone wanted to sell their trogrees for cash, realized that they could not actually sell their trajury for cash. In a sense, there was a run on the market, and they started selling everything else they could to get cash. The FEDS saw that, and they wanted to help that by basically backstoppying the troldan market, becoming a liquidity privator of last resort, and they purchased let's say, about trillion dollars of tresuries in

one month. That's how KEE came back in. But it stayed far, far far beyond uh, the liquidity event at that stage. I think it morphed back into easing financial conditions as you suggested, which I take to meet the original QUWI motivation of putting down red pressure on interest rates. So that's how I think about that. I agree it probably was not super necessary after after for the length

of time that they kept it. You know, you mentioned the treasury market blow up in and again this is something that we've been talking about quite a lot recently

on other episodes. We also had the repo blow up from and I think the response to that was the creation of the Standing Repo Facility the s r F, which basically allowed banks to exchange treasuries for dollars, And so I'm wondering, does the existence of something like that doesn't make it less possible that we're going to get some sort of major blow up or are there limits to what the SRF can do in the current environment. So last time around, QT basically contributed to the blow

up of the report market, as you noted. So I don't I don't think that's going to happen this sun around. But so I mean, we we never have the same thing blow up. Usually I think stress will be in somewhere else. And I think too to understand why I think the stress would be somewhere else, it's helpful to revisit what actually happened. Why did QT caused the report

market to blow up? In for some context, in twenty UM, heading into let's say, say September, when the report market blew up, there was a tremendous demand for report financing. The amount of repot demand for report financing increased by a few hundred billion in the in the months leading up to September twenty nineteen. And those are all the hedge funds doing the doing their basis trades, and that pushed report rates um steadily higher and ultimately above interest

on reserves. So the banks saw the saw that report rates were above interest on reserves, and they note that lending in treasury back repo from a regulatory standpoint, is equivalent to holding reserves at the FED. So they figured that they can earn some extra return by shifting the composition of their liquidity portfolio to fewer reserves and more repot and so heading into September, the banks became the marginal lender in the report market to the tune of

hundreds of billions of dollars. So QT was playing in the background, and what QT was doing it was withdrawing the amount of UH excess cash the banks out the reserves. So as we had from a demand side, continued demand for report financing, and on the supply side, thanks being the marginal lenders in the market, their extra cash bell declining because of QT. Eventually the market hid an air

pocket where report rates spiked higher uncontrollably. Another way to think about this is that the markets that benefited from KWI cash were hurt by QT and the major beneficiary in QWI cash last time around, as report we don't have that problem at all. The sign because report rates are much lower than io R. Banks are not lending in report. What they have been lending in, as I mentioned earlier, is in treasuries and agency nbs to the tune of well put five trillion dollars the past couple

of years. So we have this dynamic. We have a similar dynamic playing out, but just not in the report market. The semiround tremendous demand, continued demand for financing by the U S trusury met by the marginal lender in the market,

the commercial banks having less cash to lend. So if there is another blow up because of the q T, it's very likely to be in my view, in the treasury market, since the same dynamic is playing out, And what that could eventually mean is some kind of let's say, liquidity backstop for the treasury market rather than for the report, which I think is probably very logical given what the FED is already doing. Uh if you room call. As he noted Tracy, when the report market blew up, FED

stepped in with an emergency liquidity facility for report. When the ethics spot lines blow up, the FED has their FICX swot lines. When the commercial paper market blows up, they have their you know they have their tools for that. In the past, when the treasury market blew up, it's they just did qui, which is a very blunt instrument.

A more calibrated instrument would probably be some kind of emergency backstop willing to buy treasuries that you know, a set interest rate set above the market as a liquidity backstop. There is a standing report facility right exactly that provides emergency liquidity. If you have treasuries, you can repull that for cash. So it provides emergency cash. It doesn't have doesn't put a ceiling on rates in case the trajey market blows up because it's selling in theory, why is

that not sufficient to avoid a blow up? If any holder, if a holder of treasuries can know that there is this there's window or the desk out there that will swap at any time treasuries for cash, why doesn't they add short circuit the sort of run dynamics in the first place. Exactly, So that has to do with a balance sheet constraints, and I'll explain that a little bit

more so. When the people who have access to the FEDS report facility are the primary dealers, So if you want to have liquidity flow from the standard report facility to the market, it has to go through the primary dealers. And how that would play out is the primary dealer would borrow from the FED, let's say a hundred dollars from the FED, and then let's say, on the asset side, lend out that hundred dollars, so it expands the balance

sheet of a primary dealer. Primary dealers are basically like the pipes to which money flows from UH the FED or money market fled cash investors into the broader market PREGFC. There is not a lot of limit to how why these pipes could be post GFC, because I'm all the number of regulations the pipes actually have kind of a

fixed size. So for example, if there's a tremendous need for liquidity, a primary Julie cannot borrow like a hundred billion dollars from the FED and just lend it out to the market because they would hit these regulatory constraints. From a high level, pre GFC, the dealers were doing about three trillion dollars in repo. Now that's you know

pre GFC lets in two thousand and seven. Today they're doing about one point five trillion so you know, everything in the market has gone much bigger, but yet the repo, the amount of repo primary dealers do has gone smaller by half. And that's those are the pipes of the financial system becoming more constrained. And also why we had these blow ups in March. Dealers, even though at the time they also had access to this repo facility that FED had their balance sheets, the pipes were simply not

wide enough to to accommodate all that. So um, they could there are regulatory things they can do to tweak that, and I think there's work being done on that side. Um, but at the moment it's not complete yet. So what would cause the FED to pause QT? Like, what would be the catalyst for it to step back and go, wait a second, we're doing this set too rapid a pace, or we're doing too much too soon and basically reconsider.

So I think thinking is that eventually the FED would become well hike or do qut and eventually something will blow up and they'll have to to reverse. I actually think that's that's totally accurate in what happened in the past. But I think what's happening now is that the FED actually has enough tools so that they don't have to stop. So if you think about broadly speaking, the FETE has basically become a one mandate bank. For the moment, the power was telling you that it's it's can can a

bit to price stability is unconditional. He's telling you that full employment is conditional price ability. So the only thing that happens that matters for him right now is is inflation. And so he's going to be very aggressive in his monetary tightening, and that means of course not stopping QUT and not stopping grade hikes. He can do that now because the FED has rolled out so many new facilities such that wide sectors of the economy can be supported

even if something breaks. The FED during March pioneered facilities to make the blender of last resort for wide range of markets and for ride range of sectors. For example, their back stopping the municipal bond market through their Municipal Licuity facility lasts him around, and the corporate bond market through the Corporate credit facility and Becauceivably they could also

have new treasury facilities as well. So I think eventually something will break, because it always breaks but it doesn't mean that they'll stop, just means that they could use their facilities to further extend their tidying. These facilities, in my view, greatly extend the possibility of of how restrictive Monterrey policy can be simply because the remove liquidity risk. Wait, sorry,

can you just explain that a little further. You're saying these new facilities, the facilities that were pioneered in these new facilities that were pioneered in Mary, the explicit backstopping of the credit markets, the MUNI facility, which was obviously extraordinary and sort of you know, this brand new thing explained, How do you see them potentially being used? Because I

feel like these facilities have largely been forgotten about. No one ever talks about either one of those these days, exactly exactly, so they've all forgotten and they're not commissioned right now. So what I'm saying is that if q T or if FED rc TIKES actually breaks something in the market, the FED does not have to stop. It does not have to stop because it can continue to keep the financial markets coming along so it can repair, it can can continue to tighten in pursuit of its

inflation goal. While sort of more strategically repairing potential breaks in the financial market exactly, Joe, Okay. Interesting because again, the FED has become lender of last resort to such a wide wide range of market participants, from the corporations, from the to the municipals, and indirectly to small businesses

through the banking system through their mainstream lending facility. So it's basically such so significantly expanded their footprint that there's less reliance on the transmission of monetary policy through the market, and you can kind of, uh, well, it's not ideal, but you can kind of indirectly reach it through these programs such that even if something breaks, it doesn't actually mean they have to back down, lower rates and continue QB,

especially if inflation is too high. What's your bet on what could break if you had to, if you had to wager something right now, like, what would it be? Where's the biggest area of weakness. I still believe the trophy market is the highest risk. That's first, because as I mentioned the report, breakup dynamics that we saw in the prior QUTY are playing out in the trophy market.

Have tremendous supply coming up the few years, the demand, it doesn't seem like it's there because the marginal investor is disappearing and we have very weak, low liquidity, weak market structure, and just watching the trophy market over the past few weeks seems like it's becoming more volatile. So I think that's probably the place that that is most

likely to break this time around. So one of the things you know, as you were talking about in the beginning, it can be sort of hard to well, it can be hard to predict what's going to break. It can also be hard to predict where the liquidity is going to get drained out of the system first. Like all of these things, it doesn't seem like it's a hard science,

and anticipating it is. This sort of fundamentally why the FED is so uncomfortable quantifying the tightening effect of balance sheet policy, because you know, it's sort of easy to see, like the transmission mechanism of a rate increase. It's like your high rates and rates go up, and then you see it in mortgages and car loans and that titan is the housing market. It's somewhat straightforward, I think, whereas if there's so much uncertainty about where is the liquidity

going to come from or be pulled from? It seems that makes it inherently a much tougher tool to quantify and calibrate. I agree completely with that, and I don't actually know if the FED under understands this. If you hear, I think there's work from the ft that's also been mentioned from by Governor Waller that you know, let's say two trillon dollars of QUEI is a QT is equal

to like fifty basis points. I suspect that's probably not true, and it will be something that they wish they didn't say, because the thing is, there's so many moving parts to this. There's so many ways that it can go. It's not something that can fit it in an equation. Now, if you want to approach the world as if you are a giant equation, you need to have relationships that are consistent and don't change. And this is very much true

in physics. If I drop rock here, uh, you know, my points per second square goes down, saying if I dropped it in London, or if I dropped it a hundred years ago. That works well for things that don't change. But if you're looking at the financial markets, The relationships are always changing their different regimes, and there are different actors and different regulatory changes, so you just really can't

know what will happen. In the estimate, I think is is just not very useful, and so with in that sense,

it's kind of good that they get out of this. Yeah, this is a related question, But what's the future of the FED and its relationship with financial markets in the sense that you know, as you've been describing now for the past at least the past ten years, you know, more than a decade since two thousand eight, Whenever something goes wrong, the FED comes up with some sort of new program to enable it to keep pursuing its policy

goals or keep doing what it was doing. Is that just how it's going to be for the foreseeable future? You know, something goes wrong, the FED comes up with a new program, it gets added, Eventually it becomes the new normal. Eventually something else goes wrong and there's a new program, and so on and so forth. Or is there going to be a larger shift or break in this pattern at some point? I think going forward, I think the inventible outcome is probably a reversal of the

Fedatricia Court. Simply because the FED itself is becoming so much more involved in the markets, it's going to need to have more accountability. It's it's going it's it's essentially becoming lend of lasted work to everyone in the system. But also because of changes in the structure of the economy such that the FED probably can't carry out its task the same way that it was able to say at its inception. And this has to do with how the public sector is just the bigger part of the economy.

For example, if you think back hundred years ago, the government was a very small part of the economy, and the FED, with its mandate of controlling inflation, it can simply adjust interest rates, and private actors respond to that. It works much better. If you are a private sector actor, you care about the price of money, and if industrates are higher, you moderate your economic activity and af ingistration

or lower. You know, maybe you spend more um. But the structure of the economy has changed so much over the past hundred years such that there's a greater part of the economy that's basically the public sector, and the public sector doesn't really care about interest rates. So when the FED hikes. When the FED cuts, that doesn't really affect their economic activity. Their economic activity has to be

effected through the legislative process. So as this trend continues, as one, a greater part of the economy becomes insensitive to the FEDS interest rates, thus making the FED less effective in controlling rates. And two, as a FED becomes much more involved as lender of last resort to a wide range of the market, essentially becoming more in the allocation of credit business, which I think is probably something that more probably belongs to, if not the private sector,

at least someone that has public mandate. So it seems we're heading towards the world. It will make more sense or more coordination between Fed and Treasury to achieve these goals simply because the FED is doing more stuff that is physical policy alike, and also it has less ability to influence economic outcomes. All right, Joseph, it was so good having you back on odd Lots. Thank you so much, really appreciate it. Thank you so much for inviting me.

I love odd Lots and I really appreciate the opportunity. Thanks Tracy, and thanks Joe, thank you. It's great, great chat. So Joe, I thought that was incredibly interesting and really good to get into the weeds of some of this. And also, I mean, one thing that is becoming clear from recent episodes is that lots of people seem to be saying that liquidity in the treasury market has deteriorated for various reasons and that there are some vulnerabilities there.

But Joseph's mentioned of the idea of treasury is becoming less like cash um or less cash like in the way they are traded and in their position in the financial system. That would actually be a sea change for markets. I think it's weird because, I mean, clearly, with the existence of the standing repo facility, the FEDS goal is to make it more explicitly cash like. I mean, that's

the idea right there. Similar it's always been somewhat money like and similar to cash and okay, and now they have this formal standing repo facility so that at least the primary dealers can swap them into cash at any time, even when it is not an emergency. So the fact that like liquidity is still deteriorating, the fact that you know, we have had all these issues, uh, you know, raises it to his point. There's clearly still a lot of

unfinished business. Yeah. The other thing that kind of struck me from that conversation was his description of how when the r r P. I don't think we ever actually said what the r r P stands for, but it's

the reverse repurchase facility. But when the r RP goes up, it doesn't necessarily mean that liquidity in the overall system is going up, which I think there are still a lot of people out there that look at the r r P at two trillion dollars or whatever and they go like, oh, liquidity slashing around the system by everything I'm thinking. I'm thinking in particular of a certain sub credit where the r r P is a really big

talking point. But Joseph's point that actually the RRP going up means liquidity might not be going out of the banking system and so you know, financial conditions are tightening, that's worth remembering. And just to his is broader point which he hit a few different ways, like the sort of relationship between quantitative tightening and where liquidity can come out of the market at any given time and to some degree, you know, the unpredictability of it, the faith

it's different under different regimes. I think that may be like the clearest explanation of like why the FED and nobody else really even like talks about the tightening effects of QT, in part because like it's just not nearly as straightforward or predictable. So the idea of like putting a number on it or saying like, okay, QT is like worth this many rate cuts or sorry raid hikes or whatever, like it seems way harder to judge. Yeah, no, I actually just keep the balance sheet big and forget

about it. Seems like it cousable. That's that's if I were there, like, let's just yeah, it's just too much of a headache. Figure it's future and whatever. I just keep it there. That would be that was well, I mean we were on the phone. That would be my vote. You know what everyone can pain for Joe for FED share Uh, you know, a simplified FED, simplified open market operations. That's Joe's that's Joe's campaign platform. Balancie. It only goes in one direction when I'm on the bed, only get

We never do the opposite, you know what. I think that might actually be a very successful talking point. Okay, let's leave it there before we say anything else sounds good. Let's leave it there. Okay, this has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe Why Isn't Though. You can follow me on Twitter at the Stalwart. Follow our guest Joseph Wange on Twitter. He's

at fed Guy twelve. Follow our producer Kermen Rodriguez at Kermen armand, and check out all of the Bloomberg podcasts on Twitter under the handle at podcasts. Thanks for listening year to