In our previous article on the recent spike in repo rates, we discussed the shortfall in repo market liquidity and the Fed stepping in to add at least $75 billion per day until October 10. I closed that piece by highlighting that the October 10 cut-off date would be important to keep an eye on for any further repo operations that take place beyond it.
Well, true to form, on October 4 the Fed announced that it would be extending its repo market operations until November 4.
Just to recap, this whole situation came about when the interest rates in overnight lending markets surged to 10%. The Fed stepped in to calm the markets down but has been in a perpetual state of trying to keep them calm since September 17. This is when they first began running daily repo operations (essentially printing money and lending it out on the repo market).
Business as usual?
The extension of the Fed’s operations in the repo market is further evidence of liquidity shortages in the US banking system. While this doesn’t mean that a full-blown crisis is in the works, it’s definitely an indication of fragility in the system.
Many are now beginning to question the business-as-usual narrative and are starting to wonder whether one of the Fed’s next moves will be to return to large scale asset purchases (a.k.a quantitative easing, a.k.a money printing).
After the financial crisis of 2008, the Fed was eager to be the first out of the gate. It raised interest rates from the zero bound to over 2% and tapered its asset purchasing program, reducing the size of its balance sheet as it went from quantitative easing to quantitative tightening.
The question remains, was it too much too soon? Did the Fed over-tighten? Many are suggesting that the liquidity shortages we’re seeing in the overnight lending market is one of the first signs of this.
Too tight too soon?
Between December of 2015 and December 2018, the Fed raised interest rates nine consecutive times, taking the Fed funds rate from 0% to 2.25%. this is while the rest of the world remained with interest rates at or below zero. In July of this year we witnessed the fateful “Powell Pivot” where Fed Chairman Jerome Powell performed a policy U-turn, cutting rates by 25 basis points on July 31 and then again on September 18.
Back in January, David Rosenberg, chief economist at Gluskin Sheff + Associates Inc., went on the record, stating that he believed both the December and September rate hikes of 2018
were “the overkills.”
“I’ve been saying for a while, that when historians look back on this cycle, like they looked back at all the ten recessions we’ve had in the post-World War II-period –which had the Fed’s thumbprints all over them– the answer is, yes, the Fed over-tightened.”
What about the yield curve?
The value of a United States Treasury bond is determined by its yield. In other words, the percentage that the bond will pay you back in return for holding it rather than keeping your cash instead. There are US Treasury bonds of different maturities, each paying a different interest rate (or coupon). Under normal conditions, the bonds with longer maturities pay more than those with shorter maturities. Which makes sense, the interest you receive on an investment ought to be higher if you’re locking up your capital for longer.
This relationship can be described by a gently upward slowing line called the yield curve. In August of this year the yield curve inverted, meaning that short-term bonds pay more than longer term bonds, specifically the 2-year and 10-year. When 2-year and 10-year bond yields invert it’s a highly reliable recession indicator. An inversion of these two bond yields has taken place before each and every US recession since 1950.
Many pundits are keen on distinguishing between what’s taking place in the repo market and QE. QE, the narrative goes, was the Fed buying up assets in order to jump-start the economy out of the last financial crisis. What it’s doing now, they claim, is an attempt to increase dollar liquidity to meet the needs of banks.
The distinction is there to be observed in the very language of Fed chair, Jerome Powell. He recently spoke of the need:
“to resume the organic growth of the balance sheet earlier than we thought.”
Notice the word organic, he’s still talking about the need to increase the US balance sheet, but this time it will be “organic”. Organic as opposed to what? The fact remains that the Fed is now conjuring up at least $75 billion on a daily basis and intends to continue doing so until November 4.
While it’s clear that full-blown QE is not on the cards for the moment, what’s to happen when the equivocating slops and everyone’s under no illusion that we’re in a new recession? Should this happen, I suggest, the language will get a lot less ambiguous, at least the interpretations of it will, and another round of QE (by whatever name) will be the order of the day.