Common Cents & Disruption on September 27, 2019

September 27, 2019, by John Norris

This week, I have had a number of people ask whether ‘we’ are concerned about the recent push to impeach the President, this time over a conversation he had with the Ukrainian President. In all honesty, our Investment Committee hasn’t convened over the matter, and I am not personally losing sleep. As Yogi Berra might have said: “It’s like déjà vu all over again.”

To be sure, impeaching the President of the United States of America is, and should be, a big deal. Unfortunately, I feel the current theater, if I may be so bold as to call it that, will be increasingly commonplace in the future. If one party controls House is one party and another occupies the White House, well, my advice is to get used to this sort of thing. Essentially, the perception of culpability, or the severity of same, has much to do with the ‘side of the aisle’ on which you sit.

Perhaps this is part of the reason why the markets have mostly shrugged off this week’s imbroglio in Washington. Then, there is fact it requires a two-thirds vote, a supermajority, in the Senate to remove a President from office, even if the House votes to impeach. The Democrats don’t have anywhere near the necessary votes, not even close.

So, the country will divert a lot of time and energy for the practical following outcome: status quo ante bellum, “the state existing before the war.” I think war is an apt word choice here, don’t you?

Of greater concern to me is the recent disruption in the overnight repo (repurchase agreement) markets. You ask: what in the [heck] is a repo market? Okay, a repo is an overnight loan collateralized with marketable securities. I loan you money at some level of interest, and you give me securities as collateral. You agree to repurchase your securities the next business day for the amount of the loan plus agreed upon interest rate. Voila, a repo. One more thing for this paragraph, due to the perceived credit safety and liquidity, the markets love US Treasury debt securities as collateral.

So, who does this sort of thing? Primary dealers and other firms which might carry an inventory of securities to sell to the eventually end user. Primary dealer, what is that? Fair enough, according to Investopedia.com, a primary dealer is:

“A primary dealer is a bank or other financial institution that has been approved to trade securities with a national government. For example, a primary dealer may underwrite new government debt and act as a market maker for the U.S. Federal Reserve. Primary government securities dealers must meet specific liquidity and quality requirements. They also provide a valuable flow of information to central banks about the state of worldwide markets.

By purchasing securities in the secondary market through the FRBNY, the government increases cash reserves in the banking system. The increase in reserves raises the money supply in the economy. Conversely, selling securities results in a decrease in cash reserves. Lower reserves mean that less funds are available for lending, so the money supply falls. In effect, primary dealers are the Fed’s counterparties in open market operations (OMO).

Primary dealers bid for government contracts competitively and purchase the majority of Treasury bills, bonds, and notes at auction. Primary government securities dealers sell the Treasury securities that they buy from the central bank to their clients, creating the initial market. They are required to submit meaningful bids at new Treasury securities auctions. In a way, primary dealers can be said to be market makers for Treasuries.”

Whew. That covers what repos and primary dealers are. So, what is the problem?

Due to variety of factors, these market makers often/usually/almost always ‘finance’ their US Treasury inventory with borrowed cash. This is rarely a problem, since overnight money normally isn’t very expensive and folks don’t mind taking US Treasuries as collateral. As a further FYI, these types of repos typically ‘go off’ around the Fed Funds overnight lending target plus/minus 10 basis points (0.10%). Quarter-ends are sometimes the exception, when balance sheets have to be pristine for regulatory reporting purposes, and the demand for cash is great. However, even then, overnight cash might spike to the overnight lending target plus 100 basis points, or thereabouts. It varies depending on the quarter and the time of day ‘you’ are borrowing the money…later almost always means higher.

Sound confusing? Well, it is just ‘part of it’ if you want to be a primary dealer, or some other securities firm, AND don’t want to tie up your firm’s precious capital with less profitable US debt, typically of the even less profitable shorter-term variety.

At the start of the previous week, not this one, overnight cash was almost impossible to find by midday. This wasn’t quite the quarter-end, and rates spiked to double, triple, and even quadruple the overnight lending target. So tight was the overnight repo market, the Federal Reserve had to swoop in and provide the necessary liquidity. We are talking about in the tens of billions of dollars, even upwards of low hundreds. What made this even more odd is the Fed hadn’t done an overnight repo in something like a decade or so, since the financial crisis.

Whoa. Did I just write the Fed hasn’t done an overnight repo like this since the financial crisis of 2008? I did, and that is/was kind of concerning. You dig?

So, if that was the problem, what was the cause?

Here is the part of this narrative where I don’t reinvent the wheel, and paste a response I gave a current commercial banking who had the same question. Here goes, plagiarizing myself…yet again:

“The quick answer to why overnight rates in the repo markets have been so squirrely is the demand for overnight cash has been greater than the supply of it. That is obvious, but why and why all of a sudden?

Unfortunately, no one has an answer which completely satisfies, at least me. Okay, corporate tax payments were due, but that shouldn’t have been a huge shock to the system. Further, there was some additional US Treasury issuance, but that too shouldn’t have come as a shock, or presumably so. The two combined causing a short-term cash crunch? Maybe there is a measure of truth to it, but something still doesn’t seem quite kosher. The repo market is kind of like indoor plumbing…it is just supposed to work, and you typically don’t give it much thought. When it doesn’t, you want to know why, what is required to fix it, and how much will it cost?

As I type this, I don’t really have a great answer as to why the sudden, short-term cash crunch…outside of the oft-given reasons…with one possible add-on. As you probably know, the Fed had been drawing down on its balance sheet for a while (unwinding quantitative easing). At this point last year, it had $4.01 trillion in ‘securities held outright’ on its balance sheet. As of the last reading, it had $3.593 trillion. That is obviously a little more than $400 billion less. However, this means the Fed sold securities back to primary dealers through the NY Fed, and got ‘cash money’ back. In essence, it took cash out of the banking system in return for its debt securities. With interest rates as low as they are, it is entirely possible the primary dealers haven’t wanted to tie up their core capital to finance their holdings/inventories, and have simply borrowed the cash in the repo market. The thing is, there is now less cash in the repo market to finance a larger inventory of US debt securities. Significantly increasing the supply of US Treasuries while decreasing the Fed’s balance sheet has put a double whammy on the system…larger inventories to finance and less cash with which to do it.

Couple this with the fact the ‘excess cash’ in the banking system seems to be held at money center banks, and you have a situation where there is too much demand for overnight financing and too few players with the necessary funds to provide it…even if there is ‘plenty to go around’ the system as a whole.”

 

While it isn’t perfect, this is a pretty good summation of the situation. Too many Treasuries to finance, too few lenders in the market, and the Fed has been shrinking its balance sheet. Add this all up and you have a problem. One of the variables will simply have to change. Which one will it be?

First off, I think we can scratch off the first variable, as no one thinks there will be fewer US Treasury debt securities moving forward. Anyone that does has already started happy hour, and it isn’t even time for lunch where I am as I type. Second, the largest financial firms doing business in the US are already participating here, so who do we add with the necessary overnight liquidity? Um, good question. Then there is the third variable, the Fed has been shrinking its balance sheet. That is another way of saying the Fed has been shrinking its holdings of US Treasuries, dumping them on the primary dealer network in the process. Hmm.

Since we can’t really do anything about the first two variables, seriously, I suppose the Fed will have to expand its balance sheet…or at least not shrink it. If it doesn’t, hey, the repo market will seize up again, and it isn’t a question of if. Let’s think about this: if the overnight market routinely ‘seizes up’ and rates shoot well above the Fed’s target, is the Fed really in charge of monetary policy? THAT, my friends, is the issue at hand. IF the Federal Reserve doesn’t provide a backstop for the US Treasury market, buying at least some portion of them, it runs the risk of losing the effective control of its own policies.

Okay, I admit that last sentence might be a bit alarmist, but might is an apt word. Treasuries and Exchequers around the world are swamping the world with debt someone has to buy. This will eventually crowd out or soak up increasing amounts of liquidity…which would be better spent/invested in a number of different ways. No, we aren’t a breaking point, yet. However, the recent disruption in the repo market suggests we might be closer to it than we thought even a few weeks ago, perhaps.

To me, that is a little more, um, interesting than déjà vu all over again in Washington.

 

Have a great weekend.

 

John Norris