A lot has been written in the news recently about the repo problem. A couple of days ago overnight funding rates spiked to 10%, which has been unheard of since the financial crisis. How can it be that with all the money being printed by global central banks, dealers are not able to finance their holdings of Treasuries overnight at reasonable rates, and a corporate tax payment date can move the Fed funds rate way beyond the Fed’s target range? Could this “latent illiquidity” be a bigger problem than it first appears? Has the Fed lost control of the one thing it can control? My view is that the repo problem is one symptom of large interest rate differentials between the US and the rest of the world, and is causing traditional buyers of US Treasuries, i.e. foreigners, to hesitate because it costs them money to do so on a currency hedged basis. (Source for all data in this paragraph: Bloomberg and the Wall Street Journal).
The Fed’s solution to the whiff of illiquidity in the markets has been to flood the system with more money each morning. The way the Fed has done this is to buy $50 billion to $75 billion worth of Treasuries from dealers every day in exchange for cold hard cash. In the short term, this has driven the lending rates back into their target range. For now. Listening to Federal Reserve Chairman Jerome Powell’s press conference yesterday, it appeared that the Fed has declared victory and they have the situation under control. But I don’t need to remind readers that small anomalies in the basic foundation of markets, like the world’s most powerful central bank not able to control the one rate they need to control, is potentially the symptom of something more structural and consequential. Putting in short-term cash to ease the repo squeeze is like trying to unclog the plumbing of a large city using a plunger.
I believe that the real problem is that the current global financial system and its plumbing has evolved since the financial crisis in a more or less ad hoc and random basis. The Fed, ECB, BOJ and other central banks created a whole slew of acronyms to solve short term problems. This is like building the infrastructure in a house without a coordinated plan, where each room has different size pipes feeding it water, or multiple gauges of electrical wiring distributing electricity.
Let us take the plumbing analogy one step further to see why the problems we are seeing are inevitable, and why throwing more money at it is not a permanent solution. We have the Bank of Japan flooding the system with a huge pipe, taking rates more and more negative and buying up more and more of the local debt. Some of the money leaks out into the rest of world looking for yield. We have the European Central Bank also printing money and making larger and larger pipes that drive money from the core countries to the periphery. Some of this money also leaks out looking for return, since it costs money to keep money at the ECB due to the negative yields. All symptoms are that the banking system is now saturated with free money in Europe, and is beginning to refuse this liquidity spraying out of a firehose. Then we have the Fed, which went from a big pipe to a tiny little pipe as QE became quantitative tightening.
In an effort to maintain their credibility and their independence from politics, the bankers have used the afore-mentioned plunger this week to clear the relatively tiny pipe, rather than to ease aggressively, which would be similar to replacing the clogged up tiny pipe with a brand new bigger pipe. So the core problem is this – the last decade has seen a flood of money that has been created that has to find its way to its ultimate destination, but it has to do so via a network of rusty, aging pipes that are clogged up. Throwing more water in to clear the pipes, using a clog remover or a plunger, will just not do the job. The pipes are clearly backing up!
This has potential serious consequences for the clearing of the bond market and hence for other asset markets.
The main effect of short term rates being much higher in the US than the rest of the developed world is that the short term interest rate differentials between the US and the rest of the developed world are very wide. For example, US short term rates are over 2% higher than both Europe and Japan (where they are negative). In the past, US Treasury issuance was swept up by foreign investors due to the nominal yield, safety and liquidity of the US government bond market. Today, for the marginal European or Japanese investor, the negative carry on buying a US Treasury and hedging the currency risk is quite large. As I have written in previous articles, this turns expected bond returns upside down. A US Treasury has negative currency hedged yield for Japanese and European investors. So despite the high nominal yields being provided by US bonds, they are not being bought like before. If fiscal deficits continue to increase, there will be more of these bonds that will need to be cleared. As a matter of fact, risk takers in the US obtain a higher yield by buying Japanese and European bonds and hedging the currency risk, turning low yields into higher yields. So the water is indeed flowing back uphill! (Source for all data in this paragraph: Bloomberg).
Compounding the plumbing problem is that dealers are required to bid on Treasury auctions. So they are stuck with these Treasuries no one wants to buy. Since they have to keep lots of cash on reserve at the Fed, they are liquidity poor even though we are looking at massive reserves. Since the US yield curve is inverted in every maturity except the very long end, holding these Treasuries is a loss-making, negative carry trade for the dealers. This is not unlike the broken plumbing in Europe, where banks are asked to deposit reserves at negative rates, but lend at zero, hence losing money every day they are open for business. Let’s hope this repo problem is not a precursor of larger problems for the US financial sector.
In my view, there are a few possible resolutions to the problem. First, the simple solution would be for the Fed to cut rates and re-steepen the yield curve, so banks can make money on the carry trade, and foreign buyers can step back into the US bond market with reduced hedging costs. The Fed is unlikely to do this for political reasons unless the equity market forces them to do so. The second solution is for the Treasury to follow through with issuance of longer dated bonds, or move issuance to longer maturities generally. This is largely untested, and might receive push-back from dealers since they will have to bid on these long duration securities that they will have to finance. The third solution is for the Fed to re-start QE aggressively and buy Treasuries in all the auctions. This is likely, but might run into limits, not to speak of credibility issues since they only recently stopped QE.
Ultimately, what we are experiencing is the collateral damage from the piecemeal solutions that were put in to solve problems around the globe in an uncoordinated manner. The plumbing is a symptom of much deeper structural problems due to uncoordinated and experimental monetary policy globally. The real solution would be to rip out all the pipes in the house and replace them with brand new plumbing. But that is very unlikely since the rooms, so to speak, are occupied with entrenched views local to each region. As long as rates are negative in much of the world and much higher in the US, we are likely looking at a continuation of these problems for US bonds. Without global short rate convergence, it is unlikely that the problem will be solved easily.
The risk to broader markets is investors realize that the plunger is not enough to clear out the clogging, and that the pipes start to burst, i.e. the problem overflows into corporate credit and high yield markets, and a vicious cycle of de-leveraging starts. While unlikely, if that were to happen, an aggressive cut by the Fed, or QE infinity as in Europe might be the only solution – but too little, too late. At least for now, it seems that the Fed is reluctantly beginning to move closer to the ultimate solution of cutting short term rates below intermediate rates. What was a pivot at the beginning of this year could become a snowball; to this end, it was interesting to see the “mid-cycle adjustment” comment of the last meeting replaced by “insurance cut” at this meeting (Source: press conference post the FOMC meeting). As we enter the dangerous fourth quarter for markets, we have to keep our eyes and ears open for stranger noises coming from the pipes submerged below the financial house.