Oh, boy — that gut feel is back. That hollow feeling of dread hit hard when the news broke on Sept. 17 that the repo markets had gone crazy and overnight rates had spiked (to as high as 10%) as borrowers sought out scarce short-term liquidity for overnight settlement. While the Federal Reserve stepped in quickly to provide the needed liquidity — and continued to do so for several days, until calm again prevailed — the fact that such an intervention had not been needed since 2008 and that the Fed apparently got caught by surprise this time around are not realities that are likely to give comfort to market watchers like me.
I readily admit that I may have the bank analyst equivalent of PTSD — flashbacks to market crashes of years past and the tendency to flinch at the first sign of trouble — but problems in the repo market are something else altogether. For all the mystery surrounding this market, it is simply easiest to imagine it as the "plumbing" of the global financial system — the pipes through which the daily rush of liquid instruments flow — and whether you want to regard what happened as a clog or as a burst pipe, the outcome is roughly the same: a flooded cellar and a lot of damage control to be done.
There has been an avalanche of commentary on this development, ranging from the apocalyptic ("the Fed has lost control of interest rates") to the dismissive ("stuff happens, especially after 10 years"), but I think both extremes miss the point. While I don’t believe the Fed has lost control of rates — at the short end, anyway, which is really their only bailiwick — I am unnerved that they seem to have been caught by surprise by stresses in the system that have been visible for some time. This was no "glitch," as some have called it — simply an unfortunate confluence of a tax payment date and the settlement date of $78 billion in Treasurys. Estimated taxes are paid once a quarter, after all, and the settlement of $78 billion in securities is not of a magnitude that should bring the system to its knees.
Dr. Catherine Mann, chief economist at Citigroup and one of the more fact-based and calm economists out there, appeared on (where else?) Bloomberg Surveillance on Sept. 18 and gave one of the more cogent explanations for what has been going on. To paraphrase Dr. Mann, the system at this point is "tight" and has been for some time, with Fed reserves amounting to only about 23% of the Treasury market versus 100% of that market only a decade ago. In addition, the heightened requirements for bank liquidity in response to the events of the financial crisis have "trapped" more liquidity on bank balance sheets and kept it out of the system. Under these conditions, any extraordinary event (like the tax payment-Treasury settlement confluence) will produce a spike in asset prices that can be pronounced.
Sounds reasonable to me, so I'll go with that. But what I won't go with are the words of Fed Chairman Jerome Powell at his news conference on Sept. 18, where he announced the Federal Open Market Committee's decision to cut the Fed funds rate another 25 basis points and to cut the rate on excess reserves held at the Fed 30 basis points (to 1.80%). While Powell was given high marks for his mastery (at last) of the art of saying nothing that would upset the markets (like the infamous words SNL Article), he did say one thing that I thought to be absolutely disingenuous. In response to a question about the problems in the repo market, he basically brushed aside the question and said that those issues “would have no impact on the economy."
Seriously? SERIOUSLY? Powell and his colleagues on the FOMC cannot have it both ways. They cannot be seen as being ever mindful of the markets — because how the markets respond to Fed actions and pronouncements quickly bleeds into the real economy — and then dismissively say that a major development in one of the financial system’s most basic and important mechanisms is simply an isolated event and really doesn’t matter to the economic outlook all that much. I know that the chairman is not an economist, but I strongly suggest he call in Dr. Mann or Robert Shiller (who can tell him that the narrative counts) or any of the several smart real-world economists out there and have a little chat.
In any case, he has been proven wrong pretty quickly. I note this Sept. 24 headline in The Wall Street Journal: "Banks Flood the Fed With Demand for Two-Week Loans." Thus: "In its latest effort to calm short-term lending markets, the Fed offered $30 billion of two-week cash loans and received $62 billion in demand from banks offering collateral in the form of Treasury and mortgage securities. In a second offering, the Fed received $80.2 billion of demand for $75 billion of shorter-term overnight loans.... The demand for loans on Tuesday suggests that the Fed hasn’t yet met all the needs for cash as quarter-end approaches, said Gennadiy Goldberg, a fixed-income strategist at TD Securities. 'I don’t think everything is well and settled,' he said."
Yeah, no kidding — and in my view, it's not going to be well and settled any time soon. It is more likely that — to use a phrase that originated in 1810 — the chickens have finally come home to roost, and that the Fed's decade-plus-long crusade to keep rates low and to extend the business cycle has finally brought us to that point where there is so much debt that we can't service it with the systems and settlement mechanisms that we have at hand. Thus the unpredictability of the system's actual cash needs and the likelihood that these types of "events" will happen with greater frequency.
And it scarcely needs to be said that this unease in the financial system could not be happening at a worse time. The "chaos candidate" is living up to his name, and he has now been joined by the "chaos Congress." The nascent "impeachment inquiry" (whatever that may be) will likely stand in the way of getting any real business done in Washington, and it's highly likely that trade talks with China and the completion of a trade agreement with our North American trading partners will be sidelined as a result. With the 2020 election campaign already in high gear and the rhetoric (from both sides) growing more poisonous on a daily basis, I can only hope that the Fed can get a grip on the underlying issues and can act (at least in the short term) to prevent the headlines of recent days from recurring and to reclaim its historic reputation as the steady (and quiet) hand on the tiller.
What should individuals do? I think back to the afternoon of Sept. 16, 2008, when the shocking — and I do mean shocking — headline crossed the tape that the Reserve Primary Fund had "broken the buck" and that its net asset value had fallen to 97 cents per share. I remember stopping to read the headline — twice — and then saying to myself: "Oh, my God — here it comes." I then went to the phone and called my mother to tell her to go to her bank's ATM and get some cash, because things might be a little crazy for a few days and she might need some extra funds. (I resisted the urge to say that the financial system was melting down, which was an unusual degree of restraint for me.)
So yes, I might have bank analyst PTSD, but I'm still going to start carrying a bit of extra cash with me — just in case. But for 10% interest, it's yours.
