Repo? What's Repo?

The last few days of news have been particularly interesting. For the first time in a decade, the Fed has had to step into the market and provide overnight liquidity to prevent overnight rates from skyrocketing.

Ok, so that's a bit of a mouthful and one of my friends asked for an explainer, so here goes.




To go back to a fundamental level, to operate the financial system needs money (that's a Nobel Prize winning comment right there), and the overnight rate is a way to ensure that those who need cash in the financial system (think hedge funds, pension funds, money managers, standard investors etc.) can access it. Now, there is only a certain amount of money in the system, so sometimes when investors need a little extra cash, they will go to the overnight markets (e.g. LIBOR - the London Interbank Overnight Rate) and they will swap some of their securities (like treasuries) for cash.

For example, imagine that a hedge fund wants to hold a position overnight, but has to pay some other obligation, and therefore needs money. Instead of exiting the position to realise the cash, they can go to another institution, lets say a big investment bank who has some spare cash, and take a loan.

Given that they only need the money for a very short period of time, the interest rate is usually quite low. In the example, lets say that the hedge fund needs $1 billion, and the bank can provide it. But, without any collateral, the interest rate is likely to be high.

So, to get around this high interest rate, the hedge fund will transfer some of its high-grade securities (like US treasury bills which have a zero (or do they??......) probability of default) and this means if the hedge fund fails to repay, the bank can keep the securities as collateral.


If it helps, repo literally means repurchase agreement - i.e. the hedge fund will buy back the securities the next day - with a small interest payment on top. So, in the example, a one-night loan would probably have only a very small interest payment to make on top. And typically, the repo rate is close to the federal funds rate - which is currently 1.75 - 2.00 % after the Fed cut yesterday.





HOWEVER!

The repo rate in the United States spiked to almost 10% earlier in the week. A massive increase and caused the cost of borrowing to increase by five times. An extraordinary amount which is bound to be painful to those holding overnight positions.


So why?


The chart above which shows the size of the balance sheet of the Federal Reserve (i.e. the quantity of high-quality treasury securities it owns) has been decreasing. Yes, it expanded massively following the financial crisis as the Fed pumped money into the economy during the phase of QE, but it has started doing QT in recent years to undo the previous QE. 
This means that the amount of cash in the economy has been shrinking, and consequently this market does not have sufficient liquidity. This problem has been exacerbated because the US Budget Deficit is now so large - at over $1 trillion a year.

This means that investors are being "forced" to buy this US government debt which in turn removes money from their hands and increases the quantity of treasury bills.

So, where is the money?

Well it's not in the overnight markets that's for sure.


As such, earlier this week the New York Federal Reserve has been pumping money into the system and buying back these treasuries to keep the market afloat and bring these rates back down to normal levels. $75 billion was offered on both Tuesday and Wednesday to calm the markets. (Source: https://www.marketwatch.com/story/here-are-five-things-to-know-about-the-recent-repo-market-operations-2019-09-18)


Ok, so why is the market excited by this? 

This question at least is easy to answer. Quantitative Easing.


Could the Fed turn the taps back on to solve this problem? It doesn't look like it yet, but if this lack of liquidity continues, they may be forced to intervene. It does appear that the Fed has been too aggressive with its QT, as the financial plumbing is already starting to clog up.

Saudi Strikes, a Fed Meeting and More

Ok guys I’m back from my holiday and I should be posting regularly once again.

Rather than getting back into a quiet week it seems that everything has kicked off and the market is back into its seeming panic mode.


So let’s start with what’s already happened lately; the strikes by the Houthi rebels (or perhaps Iran).

Approximately 5% of world production has currently been taken offline. A crazily high number. It will be interesting to have a look at the drawdown figure in the API numbers this week!

The strikes have naturally caused a significant amount of market churn in Saudi Arabia with a sizeable fall in the market index. Similarly, it looks pretty likely that the commodities markets will be soaring at the open shortly; especially after the comments of this man:

That’s right Mike Pompeo.


Despite the instant comments and admittance by Houthi rebels that they were responsible for the destruction, Pompeo and the presidency insist that it was, in fact, Iran responsible for the strikes.

In response, Iran retaliated stating that it was prepared for a full-fledged war with the U.S.A.
(Source: https://news.sky.com/story/iran-says-its-ready-for-war-with-us-after-saudi-oil-attack-accusations-11810252)


Once again, the prospect of war in the Middle-East is likely to cause a vault in oil prices at the market open. The result of these strikes and increase in tension could cause the price of oil to jump $10 within the next few days (maybe even hours) according to some sources.

Interestingly, if you compare to a chart in a previous post showing the narrowing range in oil, this could be the technical push required to rocket oil back up towards $70 or higher per barrel. (Linked Below).

https://lythoughtsonfinance.blogspot.com/2019/07/where-now-for-oil.html


So, what else is happening this week?


Well, FOMC meetings, US rates, UK inflation numbers, RBA meetings and more. But, the bug mover this week will be oil no doubt.

Could the Fed Become Political?

I want to start this article by apologising for the lack of content over the last couple of weeks, I have been on holiday and therefore haven't had any time to post. 

Today, I have decided to post something slightly different than my usual technical analysis and instead am looking at a more controversial issue which could shape monetary policy in the United States. 

Anyhow, earlier today I read two interesting articles from a former Federal Reserve Official regarding the politicisation of the Fed. Article 1 Article 2

To summarise the articles, Dudley essentially says that the Federal Reserve should not bow down to Trump and should fight back. The crux of the argument is that if the Fed bows down and cuts rates now, it could incentivise the President to be (even) more aggressive in imposing tariffs and hence make the interest rate cut worthless to the consumer. 

In turn, this would (to coin a phrase) reduce the amunition of the Federal Reserve in the event of a wider economic downturn. Dudley argues that the Fed could actually openly defy the President and refuse to play ball; to say that they would not support self-inflicted injury to the United States economy. 

Dudley was keen to stress that the Fed should not back a Presidential candidate in the election as this would be a step too far, but he did suggest that the Fed could present its arguments to the President, which could force him to rein in his rhetoric. 

What I personally find most interesting about this suggestion, is that it implies that the Federal Reserve has a duty not just to the United States, but also to the world. Chairman Powell is in a dangerous place because a deterioration of the world economy will undoubtedly cause a deterioration of the US economy, and thus, he must act to support the world economy and the US economy. By bowing down before the President, he will be exacerbating the trade war, and causing the recession which he is already trying to avoid. 

The controversy surrounding these articles was so great that Dudley felt the need to clarify many of his comments in the second article. Ironically, he blames the politicisation of the Fed upon President Trump's criticisms of the Federal Reserve and specifically on the criticism of Chairman Powell. 

Let me know any thoughts you have in the comments about whether the Fed should be more political. 

Thanks