Joseph Wang: Fed Likely To Have To Expand Balance Sheet To Avoid Losing Control Over Repo Market
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Podcast Summary
In this episode of Monetary Matters, host Jack Farley sits down with Joseph Wang, former New York Fed senior trader and author at FedGuy.com, to analyze the Federal Reserve's October meeting and significant balance sheet policy changes. (01:06) The discussion centers on the Fed's announcement to end quantitative tightening (QT) on December 1st, effectively halting their $2.3 trillion balance sheet reduction that began in 2022. Wang explains how stress in repo markets, with rates trading 10-15 basis points above Federal Reserve rates, forced this decision as money market funds have exhausted their excess liquidity and commercial banks are now the marginal lenders in repo markets. (07:00) The conversation explores how the massive $2 trillion fiscal deficit is driving insatiable demand for repo financing, primarily from hedge funds executing basis trades, creating what Wang calls "balance sheet dominance" where fiscal policy constrains Fed monetary policy.
Main themes:
- Federal Reserve's loss of control over balance sheet policy due to massive fiscal deficits requiring repo financing
Speakers
Joseph Wang
Joseph Wang is a former senior trader for the New York Federal Reserve who now writes at FedGuy.com, providing expert analysis on monetary policy and financial markets. During his tenure at the New York Fed, Wang was directly involved in the central bank's monetary operations and gained deep insights into money markets, repo operations, and Federal Reserve policy implementation. He is recognized as a leading voice on central bank balance sheet operations and repo market dynamics.
Jack Farley
Jack Farley is the host of Monetary Matters podcast, focusing on Federal Reserve policy, monetary economics, and financial markets. He conducts in-depth interviews with experts on central banking, economic policy, and market dynamics, bringing complex financial topics to a broader audience with clear, insightful discussions.
Key Takeaways
The Federal Reserve Has Lost Control of Its Balance Sheet Policy
Wang argues that the Fed's balance sheet policy is now driven by fiscal policy rather than monetary policy objectives. (26:24) With a $2 trillion fiscal deficit requiring financing through repo markets, the Fed must continuously add liquidity to maintain control over short-term interest rates. This creates a scenario where "by targeting rates, you lose control over quantities" - meaning the Fed cannot shrink its balance sheet while maintaining rate control. This represents a fundamental shift from traditional monetary policy where the central bank had autonomy over both interest rates and balance sheet size. The practical implication is that the Fed will likely need to expand its balance sheet again soon, potentially adding hundreds of billions in treasury bill purchases to meet repo market demand.
Repo Market Stress Signals Liquidity Scarcity
Current repo market conditions show clear signs of stress that prompted the Fed's QT decision. (02:39) SOFR rates are trading 10-15 basis points above Federal Reserve rates, and even the federal funds rate is 3-5 basis points above target - unusual for what should be the most controlled rate in the system. (19:00) This stress occurs despite being mid-quarter (no window dressing effects) and represents a fundamental supply-demand imbalance. The reverse repo facility has been drained to near zero, forcing money market funds to lend directly to hedge funds and commercial banks, who have limited capacity. Wang expects this stress to worsen, potentially requiring emergency Fed intervention through expanded balance sheet operations.
Hedge Fund Basis Trades Are Financing the US Deficit
A significant portion of US Treasury debt issuance is now financed through highly leveraged hedge fund operations in repo markets. (17:30) Hedge funds buy cash treasuries and sell treasury futures in basis trades, borrowing in repo markets at leverage ratios of 100-400 times. (26:26) This financing mechanism has grown secured overnight financing volumes from $1 trillion in 2022 to $3 trillion currently. These trades work because treasury futures are overvalued relative to cash treasuries, as mutual funds prefer futures for treasury exposure rather than dealing with repo financing directly. This creates a structural dependency where fiscal deficits directly translate to repo market demand, constraining Fed policy flexibility.
Fed Independence May Be Diminishing, But It's Not Necessarily Catastrophic
Wang challenges conventional wisdom about central bank independence, arguing that it may not be essential for price stability. (54:00) He points out that countries have maintained low inflation without independent central banks, citing China as an example, while independent central banks have presided over significant inflation periods. (56:00) The key insight is that inflation has multiple drivers beyond interest rates - including supply chains, fiscal policy, and global labor markets. Democratic accountability through elections also provides inflation discipline, as evidenced by recent election outcomes influenced by inflation concerns. Wang argues that modern central banks have become so powerful (controlling housing markets through mortgage purchases, determining credit allocation) that some democratic oversight may be appropriate.
Commercial Banking Is Becoming Increasingly De-Risked Through Shadow Banking
A fundamental shift is occurring in commercial lending where banks increasingly lend to non-bank financial institutions rather than directly to companies. (66:04) Wang notes that 9-10% of bank loans now go to non-bank financial institutions like private credit funds and business development companies. This creates an additional layer between banks and ultimate credit risk - banks lend to sophisticated private credit managers who then lend to companies. (67:54) While this makes the banking system safer by transferring risk to entities that won't receive government bailouts, it also creates a large shadow banking sector that regulators have limited visibility into. This evolution makes the Fed's job easier in terms of banking stability but more complex in terms of credit transmission mechanisms.
Statistics & Facts
- The Federal Reserve's balance sheet has shrunk from $8.9 trillion to approximately $6.5 trillion since 2022, representing a $2.2-2.3 trillion reduction in liquidity. (13:39) This massive quantitative tightening process will end on December 1st as announced by Chair Powell.
- Secured overnight financing volumes have exploded from $1 trillion in 2022 to $3 trillion currently, representing the dramatic growth in leveraged repo financing. (26:26) Wang attributes this growth primarily to hedge funds financing treasury purchases through repo markets.
- The US fiscal deficit is running at approximately $2 trillion annually, with Wang noting that much of this deficit financing flows through repo markets via leveraged hedge fund operations. (25:31) This creates structural demand for repo financing that constrains Federal Reserve policy options.
