Month: November 2018

Amid expectations of a nothingburger FOMC statement, The Fed delivered, leaving rates unchanged and signaling “further gradual rate increases ahead.”

However, they did note, as expected, a slight downgrade on business investment to “moderated from its rapid pace earlier in the year,” but positively noted that household spending “has continued to grow strongly.”

Inflation expectations remain “little changed, on balance,” inflation near 2% target.

Risks to the outlook still “appear roughly balanced.”

There were no changes to communications policy, the appropriate size of a normalized balance sheet, technical issues related to interest on excess reserves (no change to IOER) or the extent to which the fed funds rate may need to overshoot neutral in the current cycle.

*  *  *

Gold was the best-performer since The Fed hiked rates in September and stocks the worst…

And although most economists forecast ‘zero’ chance of a rate-hike today, Fed Funds imply a modest 13% chance the Fed would surprise – they didn’t.

Most eyes were on the statement looking for any cracks in the hawkish incessant rate-hike-trajectory put forward by Jay Powell as the market remains convinced The Fed is wrong…

Financial Conditions have tightened dramatically since the September rate-hike… in fact the biggest tightening of conditions since the first hike in Dec 2015…

Before today’s statement, markets implied around a 78% chance of a Dec rate-hike (and a conditional-on-December-hike 47% chance of a hike in March), after the statement, that XXXXXXXXXX.

*  *  *

Here is what Goldman was expecting – very little change to the statement…

Full redline of FOMC Statement:

President Trump will not be happy…

 

 

 

 

 

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Authored by Lance Roberts via RealInvestmentAdvice.com,

In last Tuesday’s technical update, I discussed why a rally last week was highly probable from a psychological, technical, fundamental, and seasonal perspective. However, the key message of that discussion was simply:

“There remains an ongoing bullish bias which continues to cling to the belief this is ‘just a correction’ in an ongoing bull market. However, there are ample indications the decade-long bull market has come to its inevitable conclusion.”

On Saturday, I explained why we “sold the rally” the preceding Friday morning:

“The combination of both the extreme oversold and deviated conditions contributed to a bounce which hit our ‘target neighborhood’ of 2740-2750 on Friday morning.

In accordance with our portfolio management strategy, when the markets reached our target zone yesterday morning we executed sells of positions that have been under-performing both the market and other holdings within our portfolios. As we have stated many times previously, one of the primary tenants of portfolio management is to ‘sell losers.“

Currently, there is a rising risk of further corrective actions as the previous tailwinds supporting the bull market have begun to shift to headwinds.

Stock Buybacks

We have discussed previously the short-term effect of the tax cut legislation last December on share buybacks. To wit:

“The problem is that the tax plan may not provide the benefits as hoped. While President Trump suggests the plan will return ‘trillions’ of dollars locked up overseas to create jobs, the reality, according to Goldman Sachs, is likely closer to $250 billion that will primarily go to share buybacks, dividends, and executive compensation.”

That turned out to be a fairly accurate analysis as repatriation of dollars was roughly $300 billion, rather than the “trillions” as promised, in Q1. Importantly, that number is dropping sharply in Q2 as the incentive is being quickly absorbed. Via Zerohedge:

“After an initial record surge in the amount of US corporate cash repatriated from offshore jurisdictions (if only for accounting purposes, as the bulk of said cash was already largely invested in domestic securities via offshore entities) following Trump’s tax law overhaul and tax repatriation holiday, the movement of foreign cash has slowed sharply.”

Of course, as I have stated repeatedly over the last year, there is little incentive for companies to raise operating costs (wages, CapEx, etc) which erodes “earnings per share.” Therefore, the best “use of funds” has been share buybacks. As shown in the chart below, the surge in announced share buybacks surged after Q1 as dollars were repatriated which led to a subsequent surge in share count reductions.

This buyback activity has been a major source of support for the bull market through the first half of this year and, as we will discuss in a moment, was also the primary contributor to EPS boosts along with the lowered corporate tax rate.

“Because, as many strategists have noted over the past year, with JPMorgan’s Nikolaos Panigirtzoglou doing so most recently in his latest Flows and Liquidity report over the weekend, US repatriation flow are a key leading indicator for US stock buybacks.

And the problem for stock market bulls, is that recent data are consistent with this idea that offshore cash repatriation is slowing considerably and by implication, so are buybacks.”

As I have repeatedly argued:

“Going forward the ability to increase margins will become more difficult as higher labor costs, rising energy prices, higher interest costs, tariffs, and a stronger dollar weigh on bottom line profitability. More importantly, the dramatic surge in earnings growth in the first two quarters will dissipate quickly as year-over-year comparisons become more problematic.”

As expected, the buyback activity is slowing as rising interest rates, and the one-time benefit of repatriation, reduces the “profitability” of expending capital on share repurchases.

Earnings

Another tailwind quickly turning lower is reported earnings per share. As I discussed in our analysis of earnings for the second quarter:

“The risk to current estimates going forward remain higher rates, tighter monetary accommodation, and trade wars. As I wrote recently, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”) but an ongoing trade war could effectively wipe out the entire benefit of the tax cut bill. For the end of 2019, forward reported estimates have declined by roughly $9.00 per share.”

Just since that writing, the estimates have deteriorated further as the ongoing “trade war” has now begun to drag future estimates lower. In just 2-months, the estimates for the end of 2019 have fallen by almost $4 per share.

But looking forward, year over year comparisons are going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.

As I stated previously, the deterioration in earnings is something worth watching closely. While earnings “beat lowered estimates,” it is important to keep earnings trends in perspective. The deterioration in earnings in due to the late stage of the economic cycle, tariffs, a stronger dollar, and rising labor costs is notable and should not be readily dismissed.

It is important to remember the bump in earnings growth will only last for one year at which point the analysis will return to more normalized year-over-year comparisons. While anything is certainly possible, the risk of disappointment is extremely high.

Fed Balance Sheet

Another big tailwind for the market over the last decade, of course, has been the ongoing “emergency measures” by the Federal Reserve, as well as Global Central Banks, of liquidity infusions supported by artificially suppressed interest rates. As shown in the chart below, the Federal Reserve has previously provided the underlying “Fed Put”which has repeatedly encouraged investors to take on increasing levels of equity risk.

However, with the Fed now on a rate hiking campaign, while simultaneously reducing their balance sheet, the previous level of liquidity support is being reversed. As shown in the chart below of weekly changes, the reduction in the balance sheet has increased the volatility of the market as the support for equities has been reduced.

While it is currently believed that Central Bankers now have everything “under control,” the reality is they likely don’t. It is far more likely one of following two conclusions is more accurate.

1. The Fed is absolutely aware the economy is closer to the next recession than not. They also know that hiking interest rates in the current environment will likely accelerate the next downturn. However, the “lesser of two evils” is to face the recession with the Fed funds rate as far from zero as possible, or;

2. The Fed believes the economic data is indeed trending stronger and are overly confident in their ability to guide the U.S. economy into a “Goldilocks” type scenario where they can control inflationary pressures and growth rates to sustain a lasting economic cycle. 

With the Fed continuing to tighten monetary policy, the screws are being twisted further on both households and speculative-grade corporate debt. It appears the markets have already begun to anticipate more defaults and are repricing risk accordingly.

Government Spending

Lastly, government spending has been very supportive to the markets in particular over the last few quarters as economic growth has picked up. However, that “sugar-high” was created by 3-massive Hurricanes in 2017 which has required billions in monetary stimulus which created jobs in manufacturing and construction and led to a temporary economic lift. We saw the same following the Hurricanes in 2012 as well.

These “sugar highs” are temporary in nature. The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth. Over the long-term, debt leads to economic suppression. Currently, the deficit is rapidly approaching $1 Trillion, and will exceed that level in 2019, which will require further increases in the national debt.

There is a limited ability to issue debt to pay for excess spending. The problem with running a $1 Trillion deficit during an economic expansion is that it reduces the effectiveness of that tool during the next recession.

Conclusion

The tailwinds that existed for the market over the last couple of years from tax cuts, to natural disasters, to support from Central Banks have now all run their course.

The backdrop of the market currently is vastly different than it was during the “taper tantrum” in 2015-2016, or during the corrections following the end of QE1 and QE2.  In those previous cases, the Federal Reserve was directly injecting liquidity and managing expectations of long-term accommodative support. Valuations had been through a fairly significant reversion, and expectations had been extinguished.

None of that support exists currently.

There is a reasonably high possibility, the bull market that started in 2009 has ended. However, we will likely not know for certain until we get into 2019, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.

We have already taken steps to reduce equity risk and will do more on rallies that fail to re-establish the previous bullish trends in the market. If I am right, the more conservative stance will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

If I am wrong, and the bull market resumes, we simply remove hedges and reallocate equity exposure. As I stated previously:

“There is little risk, in managing risk.” 

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Sometimes in bed, she recalls, he would be “shaking me and grabbing my face” while demanding that she repeat such things as “I’m a little whore.” She says that he also told her, “If you ever left me, I’d kill you.” –The New Yorker

Disgraced former New York Attorney General Eric Schniederman won’t face charges after the prosecutor assigned to the case decided to close it following an “exhaustive review.” 

Nassau County District Attorney Madeline Singas announced her decision Thursday after interviewing four women who had romantic relationships or encounters with him – concluding that “legal impediments, including statutes of limitations, preclude criminal prosecution.”

After establishing himself as a prominent fixture in the #MeToo movement, Schniederman resigned following a report in The New Yorker in which four women accused him of choking, hitting, and threatening them during brutal, alcohol-fueled sexual assaults. 

Two of Schneiderman’s accusers did not reveal their identities, while the other two, Michelle Manning Barish and Tanya Selvaratnam, have come forward in full. All four accuse the New York Attorney General of heinous and abusive sexual assaults – along with threats, mental abuse, and stealing prescription medication.

All have been reluctant to speak out, fearing reprisal. But two of the women, Michelle Manning Barish and Tanya Selvaratnam, have talked to The New Yorker on the record, because they feel that doing so could protect other women. They allege that he repeatedly hit them, often after drinking, frequently in bed and never with their consent. Manning Barish and Selvaratnam categorize the abuse he inflicted on them as “assault.” They did not report their allegations to the police at the time, but both say that they eventually sought medical attention after having been slapped hard across the ear and face, and also choked. Selvaratnam says that Schneiderman warned her he could have her followed and her phones tapped, and both say that he threatened to kill them if they broke up with him. (Schneiderman’s spokesperson said that he “never made any of these threats.”) –The New Yorker

One of the anonymous accusers said Schneiderman told “repeatedly subjected her to nonconsensual physical violence,” but was too afraid to come forward. The fourth woman – a prominent New York attorney, says that Schneiderman slapped her across the face and left a mark after she rebuffed his advances.

The other Schneiderman accuser who revealed her name, Tanya Selvaratnam – a feminist author, actor and film producer, says that she met Schneiderman at the 2016 Democratic National Convention. After they began dating, “it was a fairy tale that became a nightmare,” as Selvaratnam says Schneiderman began physically abusing her in bed, and that it got worse over time. 

“The slaps started after we’d gotten to know each other,” she recalls. “It was at first as if he were testing me. Then it got stronger and harder.” Selvaratnam says, “It wasn’t consensual. This wasn’t sexual playacting. This was abusive, demeaning, threatening behavior.”

When Schneiderman was violent, he often made sexual demands. “He was obsessed with having a threesome, and said it was my job to find a woman,” she says. “He said he’d have nothing to look forward to if I didn’t, and would hit me until I agreed.” (She had no intention of having a threesome.) She recalls, “Sometimes, he’d tell me to call him Master, and he’d slap me until I did.” Selvaratnam, who was born in Sri Lanka, has dark skin, and she recalls that “he started calling me his ‘brown slave’ and demanding that I repeat that I was ‘his property.’ ”

Then, the abuse got worse… 

Schneiderman “not only slapped her across the face, often four or five times, back and forth, with his open hand; he also spat at her and choked her. “He was cutting off my ability to breathe,” she says. Eventually, she says, “we could rarely have sex without him beating me.“

In her view, Schneiderman “is a misogynist and a sexual sadist.” She says that she often asked him to stop hurting her, and tried to push him away. At other times, she gave in, rationalizing that she could tolerate the violence if it happened only once a week or so during sex. But “the emotional and verbal abuse started increasing,” she says, and “the belittling and demeaning of me carried over into our nonsexual encounters.” He told her to get plastic surgery to remove scars on her torso that had resulted from an operation to remove cancerous tumors. He criticized her hair and said that she should get breast implants and buy different clothes. He mocked some of her friends as “ditzes,” and, when these women attended a birthday celebration for her, he demanded that she leave just as the cake was arriving. “I began to feel like I was in Hell,” she says.

Selvaratnam also said Schneiderman routinely “drank heavily,” took sedatives, and pushed her to drink with him. 

“Drink your bourbon, Turnip” – his nickname for her. In the middle of the night, he staggered through the apartment, as if in a trance. “I’ve never seen anyone that messed up,” she recalls. “It was like sleeping next to a monster.” 

And then came the alleged threats…

“He had said he would have to kill me if we broke up, on multiple occasions. He also told me he could have me followed and could tap my phone,” said Selvaratnam.

Despite the allegations, Schneiderman won’t face prosecution. 

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Authored by Irina Slav via Oilprice.com,

If anyone needed any further proof that Africa is shaping up as the next major hot spot in oil and gas, this year’s edition of Africa Oil Week will provide it. The event launched amid higher oil prices and booming exploration activity across the continent with supermajors and independents both upbeat about their prospects there.

If we ignore the waywardness of oil prices, which served as the basis for Africa’s oil and gas recovery, and which can once again plunge local oil producers into recession should they drop, prospects are bright.

A PwC report on the state of the oil industry of Africa, released on the first day of the event, noted how local oil and gas field operators had adjusted to the lower-price environment and are now in a position to reap the benefits of higher international prices for oil while their costs remain low.

“Africa’s oil & gas companies have weathered the downturns and capitalised on the upswings focusing their efforts on new ways of working, reducing costs and utilising new technology,” one of the authors of the report, PwC Africa Oil & Gas Advisory Leader Chris Bredenhann said.

There is abundant evidence that the message captured in the PwC report reflects reality. None other than Exxon is looking to Africa for its next elephant find. The U.S. Geological Survey estimated that two years ago there were at least 41 billion untapped barrels of crude oil in sub-Saharan Africa alone. Exxon is focusing on western and southern Africa in its exploration work and has been amassing stakes in oil and gas prospect in Ghana, Mauritania, Namibia, and South Africa. The supermajor hopes to strike a discovery containing no less than a billion barrels of crude, also known as an elephant.

BP and Shell are also expanding in Africa. Shell earlier this year announced its first exploration rights acquisition in Mauritania. BP has partnered with Kosmos Energy on a gas project in Senegal. Also in Senegal, ConocoPhillips is partners in the giant SNE block, which might contain up to 1.5 billion barrels of crude.

Then there are the independents, some of them with a special focus on Africa, such as Tullow Oil and Cairn Energy.

“When you go for business development, trying to acquire licenses or make partnerships in West Africa, you can sense the competition,” Bloomberg quoted South African Sasol’s senior VP for exploration and production, Gilbert Yevi.

“It’s like a new California gold rush.”

The rush is far from contained to legacy oil producers such as Nigeria or Angola. On the contrary, there is a flurry of newcomers on the oil scene, from Uganda and Kenya to Madagascar, which shares a gas-rich basin with Mozambique and has proven oil reserves, which have remained largely untapped until now.

African governments have also sensed which way the wind is blowing. Sudan and South Sudan recently said they had settled their differences and will work together to bring South Sudanese oil to export markets via the single pipeline through Sudan. Ethiopia struck a deal with rebels active in a gas-rich province, improving greatly its chances of getting developed.

In short, Africa has got on the oil bandwagon, and as long as prices stay where they are or at least don’t fall by much, this wagon could go a long way.

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Last week, the DOJ filed the first round of criminal charges related to the massive international fraud that was the 1MDB scandal.

US prosecutors alleged that more than $4.5 billion was embezzled from the sovereign wealth fund, which was set up by the government of disgraced former Prime Minister Najib Razak, eventually leading the ransacked government fund to a default on nearly $2 billion of local currency bonds, briefly denting the value of the Malaysian ringgit. Holders of those bonds are still working on a restructuring deal with the fund.

Meanwhile, former Goldman Sachs Southeast Asia Chief Tim Leissner has pleaded guilty to fraud charges and is expected to cooperate with authorities against other more-senior officials at the bank. One of his fellow bankers, Roger Ng, was arrested by Malaysian police and is expected to be extradited to the US, although as we reported this morning, Ng is fighting said extradition (for a full breakdown of the latest events, see this post).

What was perhaps even more curious about the DOJ complaint, was the reference of a “senior Goldman official” who was instrumental and involved in Goldman’s establishing of close ties with both 1MDB and the Razak government, ties which would eventually allow Goldman to issue $6 billion in three issue in bonds underwritten by Goldman which netted $600 million in fees for the bank.

And, as we added over the weekend, all of this is happening at a terrible time for Goldman” which recently underwent a leadership transition, with longtime former CEO Lloyd Blankfein handing the reins to John Solomon, who is best known for moonlighting as a DJ.

And as the breadth of the scandal – and the likelihood that the bank’s most senior employees may have looked the other way (though, to be sure, Blankfein has repeatedly denied having any knowledge of Goldman’s role) – becomes increasingly apparent, the timing of Blankfein’s exit is looking more and more suspect.

And now we now know why, because it now appears that our veiled reference that Blankfein may have been the unnamed senior Goldman official, was in fact accurate.

In a new report, Bloomberg writes that years before Goldman Sachs arranged bond deals now at the heart of globe-spanning corruption probes, “the firm’s then-CEO Lloyd Blankfein personally helped forge ties with Malaysia and its new sovereign wealth fund.”

But much more importantly, Blankfein was the unidentified “mystery” high-ranking Goldman Sachs executive referenced in U.S. court documents who attended a 2009 meeting with the former Malaysian prime minister, Bloomberg’s sources said. And what’s worse, the meeting was arranged with the help of men who are now tied to the subsequent plundering of the 1MDB fund, according to U.S. court documents unsealed last week.

The meeting at the Four Seasons hotel in New York was set up and attended by two key figures in the 1MDB scandal, Malaysian businessman Jho Low and former Goldman partner Tim Leissner, one person with direct knowledge of the matter said, asking not to be identified as the information isn’t public.

It was this high level gathering – which was also attended by then Goldman CEO Blankfein – that laid the groundwork for a relationship that would prove extremely profitable for the investment bank.

While a Goldman spokesman refused to comment to Bloomberg on Blankfein’s behalf, the bank has repeatedly said it knew nothing about any corruption, and simply believed proceeds of debt sales it underwrote “were for development projects” and then threw Leissner under the bus, accusing the former Goldman partner of withholding information from the firm.

In addition to Goldman, the meeting was also attended by the now infamous Jho Low, then a largely unknown banker whose meteoric rise had managed to cultivate relationships with senior Malaysian government officials, including then-Prime Minister Najib Razak. And while Low’s lavish spending habits were New York tabloid fodder around the time of the meeting, Bloomberg adds that starting about two months before the meeting, Leissner and another Goldman banker began a years-long effort to bring Low aboard as a client, a request that compliance workers at the firm consistently denied.

Was it Blankfein’s involvement that eventually greenlighted the bank’s lucrative relationship with 1MDB and Malaysia? The DOJ is reportedly looking into precisely this. That said, there’s no indication that Blankfein was aware of the internal assessments of Low, or knew the identities of all the people present at the meeting.

The documents filed by an FBI agent in June said that evidence supports Low was present at the meeting. The agenda for the November 2009 meeting was mapped out by Low and included a “debrief” with Najib and the “1MDB boys” after Goldman executives had left, the documents show.

At the same time, the meeting offered Blankfein a chance to speak with Najib in his first year as prime minister, and Najib’s visit to New York included meetings with other business leaders and U.S. investors. A month after the gathering, Malaysia’s securities commission announced that Goldman Sachs would set up fund management and corporate finance advisory operations in the nation.

Fast forward to last week when the U.S. accused Low of teaming up with the Goldman bankers to pilfer money from 1MDB, and more importantly, Leissner pleaded guilty to conspiring to launder money and violating the Foreign Corrupt Practices Act by paying bribes. Furthermore, Goldman’s earnings from the deals have also become a sore point with the new Malaysian government, which hopes to recoup some of the money.

As for the former Goldman CEO, as noted above, Blankfein who recently retired as the bank’s chief executive but still serves as chairman, said at a conference in New York last week that he’s not aware of senior managers missing red flags in the 1MDB dealings. Instead, he said, the matter was an issue of a few employees dodging bank controls and lying about it.

Of course, it would be naive to think that Leissner was able to pull enough strings on his own, not just at the bank, but also across the US state department, to allow billions in illicit funds to flow across US borders. As for Blankfein, if the DOJ is indeed looking at the bank CEO, then perhaps it should also look at the State Department, and the Secretary of State who presided at the time many of these alleged fraudulent schemes took place.

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That didn’t take long…

Just 24 hours after retaking control of Congress in the Midterms,  ABC News  is reporting that four senior members – House Judiciary Committee Ranking Member Jerrold Nadler (D-NY), Intelligence Committee Ranking Member Adam Schiff (D-CA), Oversight and Government Reform Committee Ranking Member Elijah Cummings (D-MD), and Senate Judiciary Committee Ranking Member Dianne Feinstein – sent letters to top Administration officials demanding the preservation of all documents and materials relevant to the work of the Office of the Special Counsel or the firing of Attorney General Jeff Sessions.

In their letters, the Members wrote:

“Committees of the United States Congress are conducting investigations parallel to those of the Special Counsel’s office, and preservation of records is critical to ensure that we are able to do our work without interference or delay.

Committees will also be investigating Attorney General Sessions’ departure. We therefore ask that you immediately provide us with all orders, notices, and guidance regarding preservation of information related to these matters and investigations.”

The letters were sent to numerous Trump administration officials including the White House Counsel Pat Cipollone, FBI Director Chris Wray, Director of National Intelligence Dan Coats, CIA Director Gina Haspel, Deputy U.S. Attorney for the Southern District of New York Robert Khuzami, Treasury Secretary Steven Mnuchin, NSA Director Paul Nakasone, IRS Commissioner Charles Rettig, and Acting Attorney General Matt Whitaker.

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Last week we reported that after some $34 billion in Treasury and MBS maturities on October 31, the Fed’s balance sheet had shrunk the most ever in one month since the start of the Fed’s quantitative tightening, as the Fed’s holdings of Treasurys, MBS and other assets declined to “just” $4.14 trillion, down 7% from their all time highs of $4.5 trillion one year ago.

And it is this decline that is now spooking Wall Street, with a Bloomberg report citing Fixed-income traders who are “telling the Federal Reserve that it might end up making a big policy mistake.”

While most pundits have been concerned about the Fed ongoing rate hikes and resulting tightening in financial conditions, as the Fed’s balance sheet unwind has picked up, “unexpected knock-on effects” have emerged in overnight lending markets such as IOER, Fed Funds and, of course LIBOR –which just hit a new decade high – where demand for short-term cash has been on the rise again after a sharp spike earlier in the year.

The argument is that the Fed’s balance sheet shrinkage is increasingly threatening financial stability, resulting in quotes such as this one from TD Securities rates strategist Priya Misra: “The Fed is in denial. If the Fed continues to let its balance-sheet runoff continue, then reserves will begin to become scarce.“

They will become even more scarce if the Fed continues unwinding its balance sheet at the current “cruise control” speed of $50BN per month. If the Fed maintains the current pace through the end of next year, its assets would fall to about $3.7 trillion from $4.1 trillion today (and a high of $4.5 trillion), resulting in even more distortions in overnight funding markets. 

Which, taken on its face, is bizarre: while the Fed’s excess reserves with banks currently amount to just over $1.7 trillion, this number was just $50 billion, give or take, before the crisis.

So, as Bloomberg wirtes, it’s curious to think that at current balance-sheet levels, “the U.S. banking system could be facing a problem of not having enough cash.”

Still, there is a reason why even with trillions in reserves parked at the Fed, banks are finding themselves liquidity-constrained and it has to do with regulation. as Bloomberg explains, the argument essentially goes like this:

post-crisis rules enacted to curb risk-taking, like Dodd-Frank and Basel III, have prompted banks to use much of those same reserves — upwards of $2 trillion worth — to meet the more stringent requirements. It’s those forces that are, in effect, creating the scarcity of reserves that has banks — mainly the smaller ones at this point — scrambling for short-term dollar funding. Since the Fed started shrinking its assets, reserves have fallen by more than a half-trillion dollars, according to Fed data from Barclays.

In other words, it’s not so much the market, as regulatory requirements that are behind what is the latest funding squeeze:

“The current backdrop is one that is dominated by the regulatory landscape,” said Jonathan Cohn, the head of interest-rate trading strategy at Credit Suisse. He estimates excess high-quality liquid assets (which include reserves) at the eight U.S. globally systemically important banks have fallen by more than 15 percent since the Fed began its unwind. “Banks are in a decent position right now, but over time this will begin to weigh” on them.

One place where this argument can be seen in real time is the market for fed funds, where a rising level of stress has been observed in the past year, and specifically the IOER, or interest on excess reserves rate, which together with the Fed’s Reverse Repo Rate on the bottom, defines the corridor in which the Fed Funds rate is expected to move.

The issue is that since the start of 2018, the Fed Funds rate has drifted ever higher to the top of this range and is effectively on top of the IOER. In response, in June, the Fed tweaked IOER so that it is now slightly below the upper target. (Before, IOER and the upper band were the one and the same.) The change emerged after domestic banks doubled their share of daily demand for fed funds in the second quarter from the start of the year, according to Bank of America.

And, as noted above, since the start of the Fed’s QT, “the effective rate has started to creep higher. Last month, it even bumped up against IOER for the first time since 2009 and the rates have been in line with one another almost every day for the past couple of weeks.”

While some have linked the drift to the Fed’s balance sheet unwind and resulting reserve scarcity, the Fed disagrees.

Minutes from the Fed’s September meeting showed that officials saw new T-bill sales, rising yields and higher repo rates as the catalyst for the recent upswing. Simon Potter, head of the markets group at the New York Fed, was more emphatic, saying the rise in the fed funds rate “is not a sufficient condition for reserve scarcity.”

That said, there has been a slight shift in Potter’s language in recent months, stating in August that he sees “no evidence that we are at, or close to” reserve scarcity, and a few weeks later that he “[doesn’t] believe we’ve reached” that point. Whether this implicitly suggests we’re now potentially close to a kink point in the demand curve for reserves is undoubtedly a core uncertainty for Treasury markets.

It is also why analysts predict another tweak to IOER either this month or next, which is when traders project the Fed will raise its target rate even as many increasingly expect the Fed to soon stop shrinking its balance sheet. TD’s Misra estimates it will by December 2019, though she wouldn’t be surprised if the runoff ended sooner.

BMO’s Ian Lyngen, head of US rates, echoes this view, although he warns that any move to “taper the tapering”, or end the quantitative tightening program, would result in even more rate hikes which will become the “last tightening tool”:

We’re increasingly hearing chatter that the Fed’s balance sheet runoff could end as early as next year – a risk the market isn’t focused on at this stage. In the event that such a shift is the function of funding stresses in the very front end of the market as reserves are drained, it would be accompanied by increased conviction on the part of the Fed to hike rates – effectively the last tightening tool.

Meanwhile, as the Fed refuses to address what to many bond traders has become the potential catalyst for a “$4 trillion policy mistake”, Michael Cloherty, head of U.S. rate strategy at RBC Capital Markets, is worried.

He says the biggest risk is the Fed turns a blind eye to the pressures on bank reserves and triggers huge swings in short-term rates with its balance-sheet runoff.

“At some point, all of the reserves outstanding will be locked up by all the people who need it” to meet all the regulatory mandates, which may lead to a “scramble” for short-term cash, Cloherty said. “If the Fed keeps shrinking its balance sheet until it sees signs of stress, the question will be, “How ugly is that stress?’ I think it will be quite ugly.”

Perhaps he is right, but the bigger question is how did regulators get things so wrong that some $1.7 trillion more in bank reserves than existed before the financial crisis is now grounds for concerns about a potential liquidity scramble, and the next logical question: how long before the Fed is forced to think not only about ending quantitative tightening, but launch the next round of quantitative easing?

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