Fed May Have To Drain As Much As $1 Trillion In Liquidity To Push Rates 25 bps Higher

It's 2:00:01 pm and the Fed has just announced it will hike rates by 25 bps while using very dovish language to convey that just like "tapering was not tightening" in 2013, so "tightening isn't really tightening", and unleashing a massive buying order.

So far so good. But the real question is what does this mean for post-kneejerk market dynamics, and the one most important variable of all:�liquidity.

The all too crucial, and�overdue, answer to this question will be delivered when the Fed releases its "implementation note" concurrently with the FOMC statement which should explain all the nuances of just how the Fed will adjust the IOER-Reverse Repo piping that will be crucial to pull of the rate hike in practice, something which has been stumping�

Two weeks ago,�we cited repo-market expert E.D. Skyrm�who calculated that moving general collateral higher by 25bps would require the Fed draining up to $800 billion in liquidity:

"In 2013 on my website, I calculated that QE2 moved Repo rates, on average, 2.7 basis points for every $100B in QE. So, one very rough estimate moved GC 8 basis points and the other 2.7 basis points per hundred billion.�In order to move GC 25 basis points higher, in a very rough estimate, the Fed needs to drain between $310B and $800B in liquidity."

That may be conservative.

According to Citigroup's latest estimate, the liquidity drain could be substantially greater. Here is the take of Jabaz Mathai

There will be a separate document from the NY Fed with details around the operational aspects of the liftoff.�Of primary interest will be the size of the overnight reverse repo facility�that the Fed will put in place to pull short rates higher. We don’t think it will be unlimited, but a size large enough that will keep short rates from falling below the 25bp floor –�and the size could be as high as $1tn.

Putting this liquidity drain in context, the�entire�QE2 injected "only" $600 billion in liquidity in the span of many months, suggesting that as of tomorrow, the Fed may drain as much as 166% of its entire second quantitative easing operation overnight.

Whether that liquidity is inert and can be easily released by banks, and more importantly, non-banks without resulting in any additional risk tremors is the first $640 billion question that the Fed is facing. The second, third and fourth? Assuming a linear relationship and another 3 rate hikes until the end of 2014, this means that by the time short term rates hit 1%, the Fed may have soaked up as much $4 trillion in liquidity. Here one thing is certain: a $1 trillion drain may not have a material impact when starting from a $2.6 trillion excess reserve base. $4 trillion, however, will leave a mark (the Fed's entire balance sheet is $4.5 trillion) especially once the market starts to discount just how the rate hike plumbing takes place.

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Will The Fed Hike Rates This Week?

The Only 'Data' That Matters

This is the real "data" that The Fed is "dependent" on...

As Deutsche Bank notes,�The Fed is “right” to be raising rates. If they had done it earlier all the problems they now have to face, they wouldn’t have had to.�If they do it later, those same problems will be even worse. Of course had they done it earlier there may well have been other problems. Like for example, no growth and a much higher unemployment rate. But that’s all water under the bridge. Fact is this Fed is ready to go. And markets know it!

But, what would it take for the Fed not to hike this coming meeting?

We think SPX through 1860.

Right through the 1900s, the Fed is likely to be complacent that this is normal market volatility.Pre-Prom nerves, if you will. It took the SPX just seven trading days to drop from 2102 to 1867 in August, an average of over 30 points a day. It could do the same but the pace would have to be closer to double. Possible but one wouldn’t make that a central forecast.�More likely, the debate will quickly shift to how quickly the Fed stops tightening.

It appears, we have discussed previously,� that�the logic of the median dots is to raise rates to dampen a would be credit bubble (and 'disable' the record leverage that low risk premia have allowed).�It’s hard to know how far rates have to rise for that outcome but we suspect it's more than one hike and less than what our adjusted Taylor rule model for terminal funds suggests, which is around 2.5 percent. Plus or minus 1 percent therefore seems a reasonable first proxy,�which would have the Fed hiking say through to September, 2016.

And then what...

It looks like the market is already pricing in the next inevitable round of QE.

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Submitted by Martin Armstrong via ArmstrongEconomics.com,

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PROF. THOMAS COLEMAN & LARRY SIEGEL: The Hidden Cost of Zero Interest Rate Policies – $1 TRILLION or 5% per Year Taken From US Savers

FRA’s Co-Founder Gordon T. Long interview Thomas Coleman and Larry Siegel on their paper, The Hidden Cost of Zero Real Interest Rates. Thomas Coleman is the executive director of the center of economic policy at the University of Chicago Harris School of Public Policy and has spent most of his career in the financial industry mainly in research, trading and model development for derivatives and trading other fixed income derivatives. Larry Siegel is the research director at the research foundation of the CFA institute and also the senior advisor at Ounavarra Capital. He is also an author and public speaker.

$1 TRILLION or 5% per Year Taken From US Savers

On financial repression Larry describes it as the use of market prices, in particular interest rate to transfer resources from party A to party B in this case from savers to government. According to him the government can then borrow at rates that are extraordinarily low and not a reflection of the true value of the money to the lenders.

On the paper, Thomas explains that there are 3 highlights. The First is detailed from a historical perspective. He says that from looking at history we can see that nominal rates are low by historical standards. According to him what really matters are real interest rates. He mentions that when taking into account nominal interest rate and inflation we currently have real interest rates as minus one percent. This means that the real value of saving in a zero rate deposit would be a loss in value at about one percent a year.

“Financial repression is a disastrous ongoing strategy”.

Thomas mentions that one of the costs of a negative real interest policy is that negative real rates potentially distort decision making. He explains that the real interest rate is the price that determines how much we consume or how much we want to consume, the price of consumption today versus consumption in the future and how such a policy disrupts such decisions. Thomas stresses that it is the real interest rates that matter and that one of the reasons nominal rates has gone down below zero especially in Europe is because inflation has trended lower.

“Businesses decide whether to undertake a project based on whether the return they expect to make on the project is greater than the cost of capital. If you force the apparent cost of capital low enough through a low interest rate policy a lot of projects will look good and profitable that aren’t if you applied a normal cost of capital to that product so this motivates businesses and consumers to do a lot of things they shouldn’t be doing”.� –Larry

On trying to understand the wealth transfer from savers to borrowers, Thomas likens it to an implicit tax. He says that it is more than just a transfer from households to government but also from one set of households to another, from older to younger there by reinforcing the idea that negative real interest rates are potentially a distortion to� the price of consumptions today and consumptions tomorrow and also what we save today versus spend today. The troubling thing with all this according to him is the potential distortions that arise as a result of a negative real interest policy.

Abstract written by Chukwuma Uwaga –�[email protected]

PAPER: ��The Hidden Cost of Zero Interest Rate Policies

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