RAOUL PAL: Hi, I'm Raoul Pal with Real Vision here in the Cayman Islands. I've been thinking through and watching and talking about what's been going on the repo markets for some time. If you remember back in about July and August, we started to realize there was some really big structural problems happening when the treasury's general account needs to be topped up. And that was going to require them to issue an enormous amount of bills, which the market wasn't in a position to absorb. We'd already noticed, back the previous year, that there'd been problems with funding and liquidity in these money markets.

So I'd been following that story and watching it develop. We started to see some spikes in collateral rates, and we saw spikes in the repo rates. And it started to look like it was going to get under tremendous pressure by year-end, as the treasury were feeding the market more bills and taking cash out.

There was a load of complications to do with inverted yield curves and bank regulations and a bunch of things that meant that this could be a huge problem. Luckily, by the time we'd gotten to October, the Fed figured out what the problem was, and they started to massively inject liquidity into the money markets via repos and some thing they called not QE. But most of us don't really know what that is.

They were buying treasury bills, but it wasn't those long-dated bonds we need from QE. Was this money going into the markets? Some people thought it wasn't. Some people thought it was. All we do know is the equity markets went on a tear at that point, and it was an extraordinary period where suddenly equity returns were outsized. They disconnected from the business cycle and disconnected from almost any economic fundamental. Things like Tesla went up in a straight line. Apple added $350 billion of market cap in literally two months.

It felt much like the Fed injections of liquidity back in 1999, 2000. And although they were different in nature, the outcome seemed to have been the same. It may have created, and it's not clear yet, an enormous spike bubble high. It's not clear that that's playing out fully yet because the Fed have now said they're not going to just temporarily be involved in the money markets. They're more likely to be involved in April and then beyond. They may change where they're going to operate on the curve. They're going to be part of our lives going forward and so is this use of the treasury general account, which I think is something that most people don't really understand the importance of.

So I want to find out what the hell this is all about, what it means for us. Does it affect us in markets? What do we need to know? There are questions out there that people are asking. They're good questions, which is well, if the Fed almost indirectly having to monetize what the treasury is issuing, can the market absorb larger debts from the US government?

Well, of course they can. We've seen it in Japan. We've seen it in Europe. But it depends on timing. Is the market structurally able to deal with it? What's the role of hedge funds in all of this? The Fed told us that hedge funds were a key part of this whole story, but they never told us what and why.

So I want to go on that journey of discovery with you and go deep into this topic. It's something we're going to do more of on Real Vision, where we choose a topic, a timely topic, and dig deep, get a bunch of experts to really understand so you've got more than just the nuance, more than just a one-person interview, but a real journey of discovery that we can all go on together. So I hope you enjoy it and find it useful.

So I'm going to reach out to four different experts and ask them what their views are on the repo market to give us a broad understanding because there are many views on what's happening and what it means. The first person I'm speaking to is George Selgin from the Cato Institute. What we're going to get from George is the top-down picture, just a basic understanding of what this is all about and what's actually going on. And then as we move through, we'll dig in deeper.

George, great to speak to you today, really excited to understand what your perspectives are on the repo markets. Everybody's head scratching. People are trying to figure out everything from is this QE, what's going to happen to the Fed balance sheet, is it affecting asset prices? So many questions. So I'd love just to kick off with your top-down perspective on what has been going on, I know there's a historical reference that people need to understand, and then what's your view on what the situation is right now?

GEORGE SELGIN: Sure, well, the current operating system of the Fed, which has been in place since 2008, requires that banks have so many reserves that they actually have more than they need. And so in principle, when that's true, the Fed can control interest rates just by changing the interest rate it pays on reserves and also a second rate is that's a little bit lower than that they pay for non-banks.

What's happened is that over the course of beginning of 2017 and beginning in 2018, the Fed was shrinking its balance sheet because they assumed that they had way more reserves after three rounds of quantitative easing than they needed to maintain this system and to have it work the way it was supposed to. Evidently, that didn't happen because it turned out that repo rates started to climb above the Fed's target.

And notoriously so, in mid-september of 2019 when there were some spikes in the rates that clearly caused problems. And what that seemed to suggest is that the Fed had gone too far and the reserves had become scarce, despite the fact they were still over $1 trillion in excess reserves left in the system. So that's the basic background of what took place.

RAOUL PAL: So the Fed then started, essentially, adding liquidity to the repo markets to try and offset the treasury general account as it was issuing new treasury bills. Asset prices took off on the back of that as well. Do you think those things are linked to or is it separate? Because there's a big debate going on, is it QE or not QE? The Fed has said it's not QE. And the smell test of the market tends to suggest that it is QE.

GEORGE SELGIN: Yeah, I tend to side with the Fed on this issue because there are two ways the Fed could stimulate the market, at least according to the perceived theories. One is by actually reducing its target rates, and it has done a little bit of that. But the other one is quantitative easing. But quantitative easing only works when the Fed is buying long-term bonds. And therefore, it's reducing rates, but at the longer end of the maturity spectrum.

The Fed purchases that have been going on these last few months have not been long-term bonds. So they really just amount to swapping reserves for short-term bonds. And independent of any change in the Fed's target rates, that's not supposed to make any difference. That's not really supposed to stimulate markets. It is supposed to prevent a shortage of reserves or make up for a shortage so rates don't spike above the Fed's target, which of course, would be problematic.

But other than that, it's not supposed to be a source of stimulus. It's hard to imagine the theory that would make it much of a stimulus if short term rates aren't changing. If the market is responding to what Powell calls the organic balance sheet adjustment, then we don't have a theory to explain why it would. That is a challenge.

RAOUL PAL: And so the Fed has signaled that this balance sheet tightness that's going on by the primary dealers is likely to continue. They've also talked about some hedge fund balance sheets as well over this tightness of liquidity in the repo markets. Do you think this is going to be a standing repo facility where it's just going to be ongoing now? Is there a structural change to how the Fed wants to operate to keep the repo markets and the money markets running effectively?

GEORGE SELGIN: Well, there are three different pieces of Fed policy that are really involved here, three different options. The Fed can expand its balance sheet permanently, which it's been doing, it can have these ad hoc repo operations that it's also been undertaking, or it can establish a true standing repo facility.

Now, I know the Fed intends to stop the ad hoc repo purchases, the ones that it has been undertaking where it decides on a daily basis whether to do any more. It's hoping that just expanding the stock of the permanent size of the balance sheet, through the outright security purchases, will eventually allow it to taper down those repo operations.

But that still leaves the question whether it might install a standing repo facility at some date in the future. But it should be understood, the way that facility is supposed to work is not that there is supposed to be activity there all the time. There are supposed to be regular repo operations. It is meant to be just a standby facility, the very presence of which provides some assurance to banks that they can always go there if they need to, but that they don't use on a regular basis. So if the Fed goes that route, it still won't have every day repo interventions, as it has had in the recent months, but it will have a facility that could kick in on exceptional occasions when demand for reserves spikes for any reason.

RAOUL PAL: Is this process just because of the treasury general accounts and the excess bills that came into the market and taking out the liquidity from the market? Is that what the Fed is trying to see through and get to the end of before the treasury general account gets drawn down over time again? What stops them continuing?

GEORGE SELGIN: So there are three factors that came together to cause this reserve shortage that the Fed is now trying to address. One is its own unwind that I mentioned earlier, where from October 2017 to about a year later they were contracting the balance sheet and reducing reserves that way. The other was growth in the credit treasury general account, which also reduced reserves. That account has gone up to over $250, it's heading towards $300 billion. So that's a drain on reserves. Finally, there's the foreign repo pool. That's another drain on reserves.

So all three of these things were causing the supply of reserves to shrink. And the Fed's present purchases are meant to offset all of them, have to offset all of them if the Fed is going to solve the problem for any length of time. So you can't really say that the Fed's expansion is to address any one of these factors.

The other thing that's been going on and was a source of problem is the government has been issuing bonds. And the liquidity requirements of the dealers have gone up because of those bond issues. So you've had reserves being dropped down by those three factors and increased liquidity needs as a result of the dealers having to maintain inventories of bonds that they're asked to purchase and then sell.

And finally, you have all the liquidity requirements from Basel and otherwise that also are generating high demand for liquidity compared to in the past. So this is actually a confluence of quite a few factors that the Fed has to try to somehow make up for in the next few months.

RAOUL PAL: And after that, do you think that some of these bills, because they're quite short-term, they're just going to roll off them or there's been talk about extending it out to two-year notes as well. How do you think the balance sheet is going to play out?

GEORGE SELGIN: Well, the balance sheet is going up now. It's not going to go down again. It's never going to go down again. So when these bills roll off, the Fed's going to replace them. Because unless it does something to curtail the total demand for reserves or to otherwise increase the supply, it has to permanently increase its balance sheet or we'll have shortages again.

If they could get the treasury general account back down or if it can permanently reduce the foreign repo pool, they won't have to keep the balance sheet as large as if they failed to do those things. But so far, the Fed has only taken a somewhat modest approach to reining in the foreign repo pool. It did change the rules in a way that has helped a little bit, but it's not clear it will help for good.

As for the treasury general account, nothing is happening to reduce that. Indeed, the treasury is now talking about maintaining an even larger balance in the TGA than it has been doing so far. One wonders whether the Fed and the treasury are actually talking to one another because it's as if the right hand didn't know what the left hand was doing on this.

RAOUL PAL: Interesting enough, one of the theories that circulates around is that Mnuchin wants to force the Fed's hand to inject liquidity in the repo markets because whether it's a real flow-through effect or just a Pavlovian effect, the equity market went up, which seems to be primarily a politically-driven thing. That was the theory that goes around I thought was interesting.

GEORGE SELGIN: Yeah, I can't speak to whether there's anything to that. But I really think that if there's any connection between what markets are doing now and Fed policy, it's more likely to be based on the fact that the Fed is not in any mood to raise interest rates. And the spiking of the rates and the efforts it's taken to combat that underscored for people that the Fed is not about to tighten.

That's a different avenue for encouraging stocks than quantitative easing or whatever you want to call the Fed's balance sheet expansion itself. I think it's this first avenue that's really mattering. People are just rightly perceiving that the Fed is not going to be rate raising rates anytime soon. That, of course, will boost the stock market.

RAOUL PAL: So you think it's more of a technical issue than it is a system-wide issue, I presume. If you agree with that, obviously, there's a regulatory problem that's here somewhere that's at the foot of some of this. What are your thoughts on that?

GEORGE SELGIN: Well, I think it's a technical issue, but it's more than a technical issue and it's more than a regulatory issue as well. I think the big question here is after all the trouble the Fed has had keeping this new operating system functioning smoothly, whether they should reconsider the possibility of changing from a abundant reserve, or floor system as it's called, to a corridor like System.

In fact, they've had a corridor going. It's just a really dirty, unintentional corridor system where they've got all these different rates, et cetera, and they keep having to tweak them. So I think the big question is whether they really want to keep going this way.

It has to be kept in mind that back in 2018 I think it was, when the FOMC first decided among themselves, well, we're going to stick with this post-crisis system after all, they said in the minutes, but of course, if it turns out to call for a lot more reserves than we presently think is necessary, we're going to reconsider. Well, it turns out it's calling for a lot more reserves, and we hope that there will be some end to this expansion that will accomplish what the Fed wants it to accomplish.

But since the system seems to need so many more reserves than was anticipated, they should stick to their promise back then, even if it was a promise only made among themselves, but it's now public because we know what they've said. They should stick to that and reconsider the whole arrangement because it's turning out to be a mess. And it's not a healthy situation to have an interest-rate-setting arrangement that causes so much problem. There's so much trouble. It has to be jury rigged. It has to be toyed with. It has to be tweaked. It's time for them to reconsider that.

RAOUL PAL: Now, if the market is struggling with liquidity at the primary dealer level and we go to a recession where the government or the treasury needs to issue significantly more bonds, because that's usually what happens, is the market able to deal with it?

GEORGE SELGIN: Well, I think in that case, we will see genuine quantitative easing, that is the kind that nobody will be able to doubt or deny is quantitative easing. Particularly that will be the case if interest rates can't be lowered much more. That's a very possible contingency. There's now only 1.75 or fewer basis points by which they can lower their policy rates.

So they will have to resort to quantitative easing, and they will probably be buying long-term bonds. And presumably, therefore the treasury will have no problem unloading the bonds in that situation. But of course, quantitative easing is controversial, even as a device to fight recessions with. There are still some doubts as to how effective it was before. Indeed, I'm worried that they're going to resort to quantitative easing even if there isn't a recession.

But because there's a lot of pressure to use the Fed's balance sheet to support various fiscal programs, and that pressure may be mounting in the future. And the one problem with the present system is not only that it doesn't work well, but that it lends itself to quantitative easing even when you don't need it. That's something you couldn't do with a corridor system.

In a corridor, you get quantitative easing when interest rates can't go any lower, but you can't do it otherwise. In the present system and the floor system, they can resort to it anytime for any reason.

RAOUL PAL: Very interesting. George, listen, thank you very much for your perspectives. I think it's very good to set down the top-down understanding. As I said, I'm going to speak to a few more experts in the field to get some different nuances and see where we get to. And hopefully you'll get to watch the piece, and we'll get some broader understandings of what other people are thinking. Because it's a fascinating time and something's broken. And we need to figure out how serious it is, I guess.

GEORGE SELGIN: Well, I look forward to seeing what the other commentators have to say. I hope we don't disagree with each other too much and that among us, we're able to put some pieces of the puzzle together.

RAOUL PAL: Perfect.