A month ago, I wrote about the Strange Market Behavior Surrounding the Fed’s Second Rate Cut. In a nutshell, that article described how the Fed had to intervene in the "Repo" lending market where banks lend overnight to other banks. It's a tough topic to understand — and hard for most people to work up much interest in.
But unfortunately, we've got to revisit it again, as a month has gone by and there are still problems. Which is, in and of itself, a problem.
Because this can get pretty deep pretty quickly, I'm going to do my best to bottom-line this.
My primary concerns are these:
- The Fed's statements haven't matched reality all year. Are they simply trying to keep things calm by fooling us, or are they actually fooled themselves?
- The scope and speed of Fed (and other central bank) actions has been increasing all year. This seems troubling given that they keep telling us there's "nothing to see here."
Fed-speak vs reality
This started last December/January with the "Powell pivot." In mid-December, Jerome Powell (chariman of the Federal Reserve) basically waved off market concerns and announced a ninth interest rate hike. Parts of the credit markets froze up, the stock market plummeted, and just two weeks later came the mea culpa reversal and the end of the rate-hike cycle.
In July, we got the first Fed interest rate cut in nearly 11 years, accompanied by a message that the economy was fine and this was just a "mid-cycle adjustment" — not the beginning of a new rate-cutting cycle. Within weeks, that facade had been shattered, we got a second rate cut in September, and the market is projecting something like a 95% chance the third cut will follow this month.
Then a month ago, as the Repo market was clearly freaking out about something with the overnight rate on highly-collateralized loans between banks climbing to absurdly high rates of 6%, 8%, and even 10% (when those loans should have been happening routinely at closer to 2%), the Fed intervened while spouting assurances that these anomalies were mainly due to corporate quarterly taxes and other calendar-related "bottleneck" type reasons. Again, "nothing to see here."
Yet here we are a month later, and the problems persist.
Scope is getting bigger, speed is getting faster
As market analyst Sven Henrich puts it:
First came the hints in January. “Flexible on the balance sheet” Jay Powell suddenly was uttering following the Q4 2018 stock massacre producing a 3.5% market rally in one day on that pronouncement. Then we got treated to a multi month jawboning show of Fed speakers increasingly sending dovish messages and markets gladly jumped from Fed speech to Fed speech. Powell again rescued markets in early June after the May market rout. “Ready to act” was the rallying cry then and markets rallied dutifully into the July rate cut.
But then the dynamics changed. Rate cut 1 in July was sold. Rate cut 2 in September was sold. Then came repo operations also in September, now in October the $60 billion per month treasury bill buying program was announced and launched.
You note the accelerated pace of Fed actions here? We went from pausing rate hikes to ending balance sheet roll-off to multiple rate cuts and aggressive daily repos and balance sheet expansion. And all of this now since just July. And guess what? Another rate cut coming next week.
September's "temporary operations" to address "seasonal bottlenecks" in Repo have been quickly followed by China blasting huge liquidity into their system earlier this month, the European ECB formally restarting their QE program, and the Fed massively expanding its Repo operations (from not being involved to $75 billion to $120 billion) while also restarting their own QE via the Treasury Bill buying program mentioned above.
To be clear, what they wanted us to believe was a one-off "calendar issue" has since morphed into a need for massive daily liquidity support of the banking system. And while they are maintaining that the T-Bill buying isn't QE, it sure seems exactly like what they used to call QE when they were targeting longer-term Treasuries. Now they prefer to call it "balance sheet expansion" — to the tune of $60b/month. But as we've noted, the Fed hasn't exactly been forthcoming and transparent in its communications this year.
You know why not? If the financial markets are concerned enough to warrant all this action already, imagine what would happen if the Fed admitted there actually was a problem.
What is going on?
This brings us around to the title of this post — "Risk, Return, and Liquidity." Most of us are pretty fluent in the first two of those: Risk and Return. We get the tradeoffs, at least conceptually.
It's easy to forget that there's a third crucial component to the financial system, liquidity, which greatly influences those other two. The temptation is to assume it's always there, because it almost always is in our modern investing system. So we largely ignore it, especially as equity-focused investors where liquidity tends to not be a problem.
The best that I can piece the details together, what has been going on over the past several weeks (and really, to a lesser extent all the way back to last December's big sell-off) is primarily about liquidity. Specifically, the concern among banks that the systems in place to provide liquidity — like the Repo market — might not be functioning properly and that liquidity might not be there when it's needed. And so, in the words of analyst Jim Bianco, we're seeing "liquidity hoarding" among the banks.
This is at least partially a function of the higher regulatory standards imposed following the Global Financial Crisis a decade ago. But the net effect is that the big banks are hoarding Treasury paper, aren't lending to each other as would be expected, and as the Fed's interventions have clumsily failed to quickly contain the problem, have actually increased worries about the Fed's ability to deal with an actual crisis — given that all the drama of the past month has taken place in the absence of any actual crisis (at least that anyone seems to know about).
That's a lot to digest, without even getting into the global shortage of dollars caused by the Fed's shrinking of the balance sheet, and so on. It's all connected, but it's a lot of work to follow all the threads. The thing that makes me concerned is seeing the speed and scope of these actions increasing, while the Fed maintains that there's nothing out of the ordinary and that everything is fine.
None of that means we're on the verge of any dramatic problem. Things could carry on this way indefinitely. But it doesn't inspire confidence either. Because if banks aren't willing to stick their necks out an inch to lend to each other in the overnight Repo market, they sure aren't going to stick them out a mile to provide liquidity in much more risky credit instruments should the need arise.
The unintended consequences of getting "tougher on the banks" may just be a market that's quicker to seize up under duress because the banks no longer have the exposure to a broad inventory of bonds and other credit instruments. And those tougher regulatory requirements appear to have the banks in an extremely risk-averse posture.
No easy answers, just plenty of concerns.