QE is effectively an asset swap, where the Fed buys Treasuries from banks, and pays them with bank reserves.

In doing so, the Fed removes the preferred form of money (USTs) that the financial system uses to transact in global repo markets.

The result of which is more frequent “liquidity events”, where participants in the financial system, out of fear and a desire to be prepared for the next event, hoard already scarce USTs for themselves rather than lend them out.

This further lowers the availability of USTs for use as collateral, while reducing the amount of USD loans made in the repo market. 

Also, scarcity means that more market participants are willing to pay higher prices to secure Treasuries for their own collateral needs, which drives yields lower.

This in turn sparks a scramble for collateral of the highest quality, Treasury Bills (T Bills), causing a further drop in short term rates that then remain at really low levels. If this sounds familiar, it’s because it describes the reality the world is living in, and has been living in ever since the Great Financial Crisis of 2008.

As such, ultra low/negative short term rates are not indicative of ultra loose central bank monetary policy.

Recall Milton Friedman’s interest rate fallacy: low rates signify an environment where money supply is tight. Low and negative rates at the short end of the US yield curve exemplify this perfectly – there are not enough USTs relative to global demand for them, because the global financial system uses it as a form of money. 

Even so, the Fed, and central banks all around the world, continue to remove sovereign debt (also used as collateral, but not as good as USTs) from their banking systems, which stems from their misunderstanding of the role played by bank reserves.

As a result, central banks have added trillions upon trillions of bank reserves into their banking systems, where they sit inert; while simultaneously taking out the form of money that the financial system actually uses to transact.

Is it any surprise then, that short term rates across the developed world are at levels that economists term “ultra low”, or even outright negative?

Hence, the global financial system faces a global collateral shortage, as the central banks in the world’s largest sovereign debt markets, the Fed, ECB, and the Bank of Japan, are all busy gobbling it up.

All of which does make one wonder – did none of them consider second order effects before implementing QE?

If they did not, why didn’t they do so in the intervening decade(s), as short term interest rate markets were yelling that something was not working properly?

More frighteningly, if they did, and yet still went on to repeat the same course of action over and over again, one must ask: do these people understand what they are doing?

To be continued…