https://plus.credit-suisse.com/r/V7rztG2AD-WEsDHH

That about sums it up. 5 bps is too generous; it will upset the state of “singularity”. Like heat-seeking missiles, money market investors move hundreds of billions, making sharp, 90º turns hunting for even a basis point of yield at the zero bound – at 5 bps, money funds have an incentive to trade out of all their Treasury bills and park cash at the RRP facility. Bills yield less than 5 bps out to 6 months, and money funds have over $2 trillion of bills. They got an the incentive to sell, and others have the incentive to buy: institutions whose deposits have been “tolerated” by banks until now earning zero interest have an incentive to harvest the 0-5 bps range the bill curve has to offer. Putting your cash at a basis point in bills is better than deposits at zero. So the sterilization of reserves begins, and so the o/n RRP facility turns from a largely passive tool that provided an interest rate floor to the deposits that large banks have been pushing away, into an active tool that “sucks” the deposits away that banks decided to retain.

Think about the extreme: most of the “Covid-19” deposits currently with banks go into the bill market where rates are better. Money funds sell bills to institutional investors that currently keep their cash at banks, and money funds swap bills for o/n RRPs. This process is not overnight. It will take a few weeks. Cash-rich banks can handle the outflows, but some bond-heavy banks cannot.

Next you notice that some banks are borrowing advances from FHLBs, and cash-rich banks stop lending in the FX swap market as the RRP facility pulled reserves away from them and the Fed has to re-start the FX swap lines to offset.

Libor-OIS will have to widen from here, unless the Fed lowers the o/n RRP rate!

It’s either quantities or prices. In 2019 the Fed chose prices over quantities, which backfired. In February, it chose quantities over prices, which worked well.

Yesterday, the Fed turned “unlimited” quantities into “money for free” and started to sterilize reserves. We are witnessing the dealer of last resort (DoLR) learning the art of dealing, making unforced errors – if the Fed sterilizes with an overpriced o/n RRP facility, it has to be ready to add liquidity via the swap lines…