For those of you who are not familiar, the Wikipedia says this “A repurchase agreement, also known as a repo, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and buys them back shortly afterward, usually the following day, at a slightly higher price.”
If you read a lot of financial news you probably heard about how the repo rate jumped sharply last week and then abruptly came back down as the Fed Open Market Committee jumped in to provide liquidity. This occurred on the eve of the Fed’s rate decision on Wednesday and it might have been a short term event, but it had me remembering August 2007.
In August 2007, the credit markets locked up as there wasn’t any demand for credit products. I remember it clearly as it was the week before Labor Day weekend. On Friday of that week, I was scheduled to appear on CNBC. I was sitting in a television studio in West Palm Beach waiting to go on, but I was listening to the two guests that were on before me. The two guests speculated that the credit market lockup wouldn’t hurt the overall market, but rather it would be confined to the financial sector and only financial institutions would be hurt by it.
I did my appearance and went back to my office and immediately started writing an article refuting the two guests on CNBC. At that time, we had a negative savings rate in the U.S. and I was worried that a credit market lockup would have a negative effect on the overall economy. If consumers can’t borrow and they don’t have any savings, how are they going to continue spending? That was the crux of my argument. It turned out that the credit markets were a precursor for a bear market that started shortly after that.
Flash ahead to this past week and we saw the demand for repurchase agreements almost disappear. These repurchase agreements are referred to as repos and they are overnight loans from one institution to another and they are collateralized by safe investments—usually treasuries.
Of course with the Fed meeting last Tuesday and Wednesday, the uncertainty around that meeting may have been a major contributor to the circumstances. Regardless of the reasoning and timing, the fact is that the repo rate jumped from 2.29% to almost 10% in a matter of days.
One article from the Wall Street Journal pointed out that the repo rate jumped due to the amount of actual reserves versus the amount of treasuries that are out on the market.
“One of the underlying causes of this is a scarcity of reserves compared with the amount of Treasury bonds in the market. That has made banks less willing to lend to each other even in exchange for safe government bonds.”
The Fed jumped in quickly and provided the liquidity needed to calm the repo market, but what’s to keep it from happening again?
If institutions are unwilling to buy treasuries that are yielding 1.75% to 2.0%, the Fed’s target rate for Fed Funds, what is going to happen if the rates continue to fall? This should be a signal to President Trump to stop calling for cutting rates even more in order to compete with the European Central Bank and other central banks that have negative interest rates. If the demand for treasuries is falling with rates where they are, the demand isn’t going to increase with lower rates.
I used the word uncertainty to describe the environment ahead of last week’s Fed meeting and rate decision. There was an article on Yahoo Finance this morning that said “uncertainty” was the only word you needed to describe the current macro environment. The words came from David Kostin, Goldman Sachs’ top market strategist. He stated in his latest note to clients, “The macro environment continues to be defined by uncertainty.” The bold emphasis on uncertainty was added by Kostin.
The Yahoo article pointed out the various points of uncertainty—the spike in oil prices after the drone strikes in Saudi Arabia, odd rotations in the sectors, the rate cut from the Fed, and the behavior in the repo market. They didn’t even mention the uncertainty over the trade war.
I can’t help but think about the timing and how the next round of earnings reports will start in a few weeks. The timing is eerily similar to what we saw in 2007 where there was strange activity last in the summer and then when the fall earnings season started, we saw an accelerated to decline in stocks.
A certain amount of uncertainty is a good thing for the stock market, but when it becomes too much and when we see weakness in the economy or in corporate earnings, that’s when we see markets like we saw from late 2007 through early 2009.