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The Federal Reserve is in Trouble

September 19, 2019

Leading into this week’s meeting of the Federal Reserve’s Open Market Committee (FOMC), the financial markets were put into crisis. Short-term interest rates for borrowing by financials and other institutions shot up to levels that were way above the FOMC’s target range for the federal funds rate, which is the rate that Fed member banks lend to one another.

The so-called overnight repurchase (repo) rate shot up as high as 10%. Repos are transactions where holders of US Treasuries or other bonds sell them to other institutions with the agreement to repurchase them the next day at a set price. The difference between the sell and the repurchase price is the effective borrowing interest rate.

The repo market is at the core of financing for all sorts of entities from banks and their general cash and credit management to other financials. And it is crucial for the liquidity of the US markets and the economy.

US Overnight Repo Rate—Source: Bloomberg Finance, L.P.

This rate is set by the markets and will vary by institution and their counterparty, reflecting credit as well as other considerations. But the Fed and FOMC participate in the repo market as well, as the Fed’s Bank of New York is assigned to trade and position bonds and their buying and selling, including repo transactions.

It is by participating in the repo market that it works with other transactions and policy moves to target short-term interest rates and liquidity in the economy. Most just look at the FOMC for its target rate setting for fed funds, but this is just an indicator of where it wants to see the market set short-term borrowing rates.

The graph above shows that repo rates were soaring in summer 2007. This was occurring as the mortgage markets as well as other markets for pooled debt securities were imploding. Financial companies and many others were caught out as debt securities were marked down in value with rising credit concerns, which in turn meant that their portfolios were worth less.

That meant that their financing covenants were breached, bringing margin calls. To meet those calls, they had to sell debt securities, which brought lower prices and more write-downs for the rest of their portfolio. The ensuing cascading effect eventually led to their demise.

Repos were hard to come by, as counterparties questioned whether a financial would be good to repurchase the bonds back. So, rates soared for those that could have access to the market. This didn’t end well, as the stock market and the economy fell sharply into 2009.

The Fed and other central banks bought trillions of dollars of all sorts of bonds, from Treasuries to mortgages and corporates, to both pump cash into the market as well as to stabilize those financials that were still standing.

The FOMC set its target range for fed funds to zero and just above through to the end of 2015 when it began to gradually work to raise the rate closer to 1.00% through 2017.

Federal Funds Rate—Source: Bloomberg Finance, L.P.

Now, here is where the Fed began to get itself into trouble.

All along the way, the Fed stated that it would remain neutral in overseeing the fed funds and other short-term interest rates until inflation, as measured by the core Personal Consumption Expenditure Index (PCE), remained below 2.00%. In addition, the FOMC said repeatedly that it wanted to see the PCE actually move into the mid 2.00% range for a healthy economy.

But the PCE barely edged higher in 2018, seeing only a brief blip above 2.00%, and then fell into 2019. The latest release showed a reading of only 1.58%.

Core Personal Consumption Expenditure Index (PCE)—Source: Bloomberg Finance, L.P.

But contrary to its statements, the FOMC hiked its target range for fed funds four times in 2018. And it also began to allow its bond-buying program to roll-off as it stopped reinvesting maturities and interest payments.

So, counter to its goal of working to normalize interest rates gradually, with the added goal of normalizing inflation, we got tightening right as many were questioning corporate revenue and earnings growth, particularly into the fourth quarter of 2018.

The repo market ran into similar spikes in rates with the pulling of liquidity and support by the Fed.

US Overnight Repo Rate during Fourth Quarter 2018—Source: Bloomberg Finance, L.P.

The impact to the credit markets can be seen in the collateralized loan obligation (CLO) market. CLOs are individual corporate loans or pooled loans made by financials outside traditional commercial banks. This market, along with other alt-financial lending, has been taking over commercial bank lending over the past decade as post 2007-2008 regulations stomped on banks.

Collateralized Loan Obligation Index—Source Palmer Square & Bloomberg Finance, L.P.

The CLO market plunged in the last weeks of 2018 as the Fed signaled a pause in tightening and actively worked to add liquidity to the market. And it worked, as the credit markets rebounded along with the economy and other markets, including for US stocks.

But while the FOMC has admitted its mistakes in tightening and has eased its target for fed funds twice in its last two meetings, there is dissent among the voting and non-voting members. This is where the so-called “dot plot” comes in.

The Dot Plot—Source: Bloomberg Finance, L.P.

The dot plot was initiated as part of the forward guidance by the FOMC, with dots representing both voting and non-voting FOMC members’ bias (yellow dots). The green line is the median of the bias, and the white line is the fed fund futures market pricing.

The dots show a very divided FOMC, and this makes the credit markets very nervous. Into this is word that the Organization for Economic Cooperation & Development (OECD) has further downgraded its outlook for global growth to 2.90% in 2019—the lowest level since 2009.

For now, the US economy remains in growth mode despite trade concerns. Consumers are spending, which is supporting the economy, and home sales for the most recent reported month were at a 12-month high, with permits (forward-looking) up 7.70%. Additionally, consumers remain comfortable, as this week’s Bloomberg Consumer Comfort Index came in at 62.7.

But institutions, including financials, are increasingly concerned. The Fed saw massive issuance and bond sales coming last week by the US Treasury along with opportunistic issuance by major US corporations. This pulled out hundreds of billions of dollars from the market to buy those bonds, wreaking havoc on liquidity. Add in muni issuance announcements, and there is a lot of cash being sucked out of the markets.

Meanwhile, with the US as the haven for the globe, demand for US dollars is surging from foreign financials, only adding to liquidity trouble.

The Fed was caught flat-footed. It has stepped in for the past few days with billions of dollars in bond-buying for overnight repo transactions as it tries to meet market needs. Meanwhile, Fed Chairman Jay Powell in his press conference after the FOMC meeting yesterday was very poorly received, pointing out the internal strife inside the FOMC and giving mumbled guidance as to what it plans to do to ease credit conditions.

What to Own

I am increasingly concerned over liquidity and the Fed. Banks were hobbled from participating in much of the credit markets with limited trading ability and capital requirements. So, the Fed is increasingly The Bank for the markets.

Investors need to continue to focus on reliable sectors of the markets. These continue to be the defensive stocks with a US focus, such as utilities and real estate investment trusts (REITs). These have and should come through during market downturns, as they are largely insulated from global troubles.

Also, quality US bonds inside ETFs and closed-end funds should be the go-to for all portfolios, particularly in non-financials.

And lastly, I added a gold investment months ago in a model portfolio of Profitable Investing, which is also a must-own right now.

All My Best,

Neil George
Editor, Dividend Digest & Profitable Investing