Repo markets in the limelight

Summary

• Funding markets — White knuckling it through a dollar shortage.

• Macroeconomic update — Trade talks still in the driver seat. 

• International Organizations — The push for fiscal stimulus.

• The week ahead — Fed to set the stage for QE lite.

The biggest development on the week came from the Federal Reserve which spent the better part of the week trying to regain control of the US money market. The New York Fed was forced to intervene in funding markets for the first time in a decade after a shortage of cash from a perfect storm of idiosyncratic factors pushed interest rates above the Fed’s target. The graph below shows the Fed losing control of interest rates, with the white line showing the actual rate and the other 2 lines showing the target range — Remember that the Fed cut rates by 25 bps this week and the Fed Funds rate spiked higher.

The latest seizure in funding markets comes from a story that’s been lurking in the background for almost a year now — the shortage of US dollars. I’ve been trying to flush out this topic over the past few months and it appears that things boiled over last week. There wasn’t one main “trigger” that caused the havoc in funding markets but rather a combination of things. The most intuitive factor was that corporate taxes were due last week, which increased the need for US dollars from corporations. That aside, the Treasury also spent the last week building its checking account, also known as the Treasury General Account, again draining the system of dollars. Since the debt ceiling was lifted, the government has been relentlessly borrowing cash and, to add fodder to it all, last weeks sell-off in interest rate products likely increased activity in the repo market (with retail clients selling interest rate products, making banks long collateral). If that last bit didn’t make sense, don’t worry about it, I’m going to simplify things a lot more in the next few lines. One of the key markets in the economy is the repo market (the repurchase agreement market), which is where market participants exchange collateral (typically government bonds) for cash. This market is like the oil that lubricates the economic engine. The amount of cash available in the repo market is largely a function of the number of reserves deposited at the Fed. The number of reserves held at the Fed has been declining dramatically since September of 2017 when the Fed announced that it was going to begin “normalizing” policy by allowing bonds that were bought during the crisis to mature without replacing them. At the risk of oversimplifying things, I want everyone to picture this market like this — If you’re in high school, the amount of money you needed in your chequing account is significantly less than the amount of money you would need if you were married, have kids, etc. Well, the same applies to the economy. As the economy grows, the demand for cash increases as liabilities grow. Again this is grossly oversimplified but I think it gets to the heart of the issue. What the Fed is trying to figure out is what the optimal level of reserves is in the system -- too many reserves and cash just sits there... too little and we get weeks like last week. The chart below, although crude, shows a pretty simple interpretation of the bank reserves and the interest rate. The red line shows the number of reserves in the system. Right now it appears that we are around the kink in the blue line.

The reserve scarcity debate has been going on for a long time and the reality is that no one knows what the sweet spot is for these reserves. What became clear this week is that the $US 1.35 trillion currently in the system isn’t enough, especially on weeks where there are excess stresses on cash. The Fed’s current “fix” is more of a bandaid approach — injecting liquidity as needed to keep the market functioning. The committee fell short of announcing any definite plans to regain control of this market but, options are not limited. Apart from the most obvious approach of simply increasing reserves, the Fed could open up a standing repo facility to help alleviate these crunches in cash when needed. This alternative has been in the cards for quite some time. The bottom line is that there will need to be an increase in reserves to match what appears to be an increase in demand -- This gets at the longer-term solution. There will likely be an announcement on balance sheet expansion at the next FOMC meeting in October. Now, it’s important to understand the context of what I just wrote. Yes, the Fed will likely announce some form of quantitative easing (the purchase of assets) at their next meeting in October but, this will be a technical adjustment that’s being used to adjust the funding market, not spur economic growth. As Charlie McElligot from Nomura put it on Thursday, this isn't a "break the glass in case of emergency" program. With that said, there’s a risk that markets misinterpret the news as a QE package that targets economic growth. In this case, equities will likely drift higher — There’s plenty of “sticky” positive gamma at higher strikes to help keep equities at higher levels (remember that positive gamma acts as a shock absorber in markets). The chart below shows the gamma at each strike.

With all that in mind, US funding markets, particularly the repurchase agreement markets (repo), will likely remain fairly choppy until we see the Fed start to expand its balance sheet. These volatile periods will likely be concentrated around quarter-end when companies need to balance out their books, and year-end, when everyone is on vacation and the B-street is running the desk (aka the junior traders). What’s important to note is that this wasn’t a complete disaster and as long as the Fed doesn’t fall asleep at the wheel, everything should be fine, or as good as it can get given the macroeconomic backdrop. Despite US jobs growth slowing in August, the rest of the subsequent economic data all came in stronger than expected, reassuring investors that the US remains on (somewhat) solid footing. The Fed delivered on market expectations, cutting rates by 25 bps while their economic forecasts weren’t anything to write home about. Similarly to the ECB, the FOMC committee members appear to be fragmented on where the economy is going. The FOMC dot plot showed that no member expects interest rates to fall below the 1.50 percent mark (that's just one more cut). Markets continue to price in 70 percent of at least one cut by January of next year with around a 40 percent chance of 2 cuts this year. What’s more pressing against all of this is how markets deflected the largest oil supply disruption in history and the worst funding squeeze since the crisis. The only event that sparked a reaction in US equities was one slight change to the China trade itinerary on Friday, where Chinese officials flew home early. To be fair, this was the first negative development (if you want to call it that) relating to the China trade talks in about a month. The positive news flow has been one of the key factors that have pushed markets higher since mid-August. While on the surface it may seem like progress is being made, in reality, there isn’t any. What the Trump administration has unraveled is something far bigger than his administration can handle and will likely be dragged on for years to come. That’s not to say that interim deal can’t be struck, although recent rhetoric from the President suggests that a deal is not necessary before the election next year. The Fed has certainly reduced the urgency of a deal by providing ample accommodation, knocking trade talks well behind where we were at the start of the year. Remember that the President is not satisfied with the depth of the Fed rate cuts, often referring to the FOMC as “boneheads” — it’s not out of this world to assume that he would engineer rate cuts by escalating tariffs again. Considering we are going into an election year, the risks of doing so are high. The US consumer has managed to carry the US economy for now but eventually, their backs are going to give out. Ironically, Fed rate cuts appear to have served to undermine consumer confidence, with August consumer confidence coming in at a 7-month low. The bottom line is that we continue to be caught in this trade war feedback loop and, for the time being, there's little evidence to suggest things will change. Meanwhile, in China, the PBOC cut it’s 1-year prime loan funding rate to inject more stimulus following some dismal industrial production numbers. Data has continued to disappoint in China, with exports contracting unexpectedly and retail sales and fixed investments missing expectations as well. This shouldn't come as much of a surprise but China’s monetary system is more complicated than brain surgery. Although I don’t fully understand it, I can’t see this week’s cut in the 1-year prime loan rate being enough to stop the economy from sliding. The fact that overnight rates were left unchanged emphasizes Beijing’s hesitation to “flood” the market with liquidity, choosing to go for a more “targeted” approach. This ties back to the idea of China’s deleveraging campaign, that started before the trade war started to materialize. These more “targeted” policies appear to be a way for China to avoid undoing all of the work they had put in a few years ago. The problem is that these experimental policies are coming at a time where a miscalculation can have dire circumstances for global growth — especially if deflationary risks start to materialize. One bellwether that raised a few eyebrows last week was FedEx, the shipping giant who took a beating this week after cutting revenue estimates for the next 12 months. The chart below shows how FedEx’s stock price does a fairly decent job of tracking GDP growth in the US.

FedEx has been caught up in a lot of the Huawei news and recently lost a “big client” (they used that in their press conference) almost as if the world didn’t know they were referring to Amazon. If history is any indication, the US GDP print is ripe for disappointment. The OECD, a Paris based organization, cut its global growth outlook to the lowest level since the financial crisis. I don’t think anyone cares what the OECD thinks but their latest report touched on a few things my previous email lamented on — the need for Fiscal policy to take the wheel. The report highlighted the risk of global growth stagnating and developed economies sliding into deflation, emphasizing that the need for fiscal policy to step up and sustain the global expansion is greater than ever. The BIS, the Bank for International Settlements (the central bank of central banks so to speak), also echoed a similar message stating that “the highly unbalanced post-GFC recovery has overburdened central banks”. Well, it looks like the message was received loud and clear in India where the Finance Minister announced a corporate tax cut from 30 percent to 22 percent. India’s tax rate has now been brought into line with other Asian countries and the hope is that this will begin to bring more companies to India. Indian equities were higher on the news. One country who has been impressively stubborn on opening up their checkbook has been Germany. There was speculation this week that the worldwide climate protests ahead of the UN climate meeting in New York would spur Germany to issue green bonds. It was a long shot at best and on Friday we got confirmation that Germany was sticking to its fiscal guns and its latest climate initiative would not impact the governments budget deficit. With the media blackout from the Fed gone, speakers will likely start to set the stage for the introduction of QE lite later this fall. 14 Fed speakers are scheduled this week and surely one of them is going to start to paint some details on how the Fed plans to address the latest funding stresses. Apart from Fed speakers, the US will get it’s final estimate of Q2 GDP data, with the Atlanta Fed nowcast tracking close to 2 percent and the New York Fed tracking closer to 2.2 percent. The market expects the US economy to grow by 2 percent in Q2. In Europe, we get flash manufacturing data along with other sentiment surveys. The Reserve Bank of New Zealand (RBNZ) will meet this week with the market expecting them to keep their rates on hold. Remember that the RBNZ is similar to Australia in that it is a good proxy for China’s economy given their exposure to Chinese demand. Meanwhile, in emerging markets (EM), the Bank of Mexico and the Philippines are expected to cut rates while the outlook for EM continues to be bleak due to a stronger dollar, ongoing global trade tensions as well as a renewed geopolitical risk premium.

Tiago Figueiredo