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Repo Market giving signals for FRED:RRPONTSYD by sztywnywariat

On of the few main investing topics in the span of couple of weeks is inflation . We get informations coming in that in the next months it will get even higher and we need to be prepared for it. But, if everyone expects inflation rise in the 3rd quater of the year, then knowing the market laws (everyone’s usually wrong), it is worth considering if, there is possible a reverse scenario.

In our opinion, it is real that the coming months will bring lower inflation . This is confirmed by the recent events in the US money market. We admit that this is not an easy topic, but sometimes it’s worth checking what is happening behind the scenes when markets are steadily growing and everything seems to be going according to the best-case scenario. Ultimately, the smart investor prefers to know about the risks ahead of time, rather than only seeing them when the wallet is red.

Repo and Reverse Repo – What is it?

The money market (repo market) is where two groups meet. On the one hand, we have entities (banks, funds) that need to borrow funds and offer collateral in return (most often treasury bonds). On the other side, we have financial institutions that have a surplus of capital and want to invest it in the short term.

In general, the rate of return on such an investment is similar to that set by the US central bank , ie . the FED. Sometimes, however, there are exceptions. This was the case, for example, in September 2019, when banks did not want to borrow their funds at 2% per annum (this is what the FED had set). The interest rate soared to 10%. This was before the outbreak of the pandemic.

In short, the problem in the repo market was that there was a shortage of people willing to borrow money. The situation was saved by the Fed.

Today, we see the exact opposite situation and it concerns the reverse repo market. What exactly do we mean? Banks and various types of funds try to cram huge amounts of cash and obtain collateral for it. The scale of the phenomenon is really considerable. One trillion dollars entered the overnight reverse repo market (funds left for one day in exchange for collateral) on the last day of June. Not a billion, but a trillion.

Now you could scratch your head and ask: what happened that in less than 2 years we have gone from a liquidity crisis to a situation in which banks and funds are so eager to convert cash into collateral in the form of, for example, short-term US bonds.

Here, however, the explanation is quite simple. Just in the course of these 20 months or so, the US central bank flooded the system with a newly created currency. The FED bought up gigantic amounts of bonds and MBS , or simply put – it took a large amount of securities from the system and threw printed dollars into it.

At the same time, the US government increased its debt significantly and then began handing out funds in the form of checks as well as other programs. This can be seen in the state of Treasury General Account, which we can very simplify call an account from which politicians take money and spread it as they see fit.

(Tradingview doesn’t have this chart :(,aaand i can’t post a link here cuz i’m not a paid PRO member so type in FRED WDTGAL)

You can see that the level of funds in the account increased significantly as a result of last year’s actions, and then began to decline rapidly with the implementation of the distribution programs. Today we are slowly approaching a situation in which the “wellspring” begins to dry up and the United States will be forced to issue more bonds.

Summing up, we already know why there is no liquidity crisis of any kind at the moment. It was handled by reprinting on an unprecedented scale. However, we still do not know why large banks and funds began to “park” cash so intensively on the reverse repo market.

In order to find an explanation, we came across two hypotheses that may give some idea of what is happening.

Explanation 1

According to the first hypothesis, banks and funds seek shelter in safe papers mainly because the economic environment will be less favorable in the coming months. What exactly is it about? Just look at the changes that were made last year.

First, there were checks, sometimes referred to by us as “helicopter money”. I am talking about dollars that were literally distributed among US citizens (sometimes all, sometimes selected groups). Since March 2020, such actions have taken place several times.

Second, the possibility of postponing mortgage payments has been introduced.

Third, the possibility of postponing rent payments has been introduced.

So these were the changes that drove American spending, but now, except in a few states, this Eldorado is about to end.

In order for everyone to understand what it means, it is best to show it as the home budget. Suppose you have extra income (checks) and very limited expenses (deferred installments or rents). In such a situation, you can increase your expenses – invest or consume. The Americans did just that. Some packed up on the stock exchange and raised asset prices, and some consumed. Hence the rebound in GDP and higher inflation .

Now it’s about to end. And since the US economy is dependent on consumption, problems can arise. Hence the conservative approach of many banks and funds, hence hundreds of billions on the reverse repo market.

Explanation 2

Well, in March 2020, the Fed reacted very strongly to everything that happened in the financial system and markets. One of the introduced changes assumed the suspension of the supplementary leverage ratio. It sounds confusing, so let’s explain right away – this change allowed banks to pursue a looser policy, they did not have to hold large amounts of very liquid assets.

A year has passed and the requirements have returned. And if we look at the chart again, we will notice that the first increase in interest in reverse repo occurred at the end of March.

It is true that the funds that banks and funds placed on the reverse repo market did not bring any interest, but here it was difficult to find an alternative. In mid-April, 30-day treasury bills had a negative interest.

In mid-June, however, the FED introduced a certain change, namely it increased the interest rate for overnight reverse repo loans from 0% to 0.05%.

It sounds ridiculous, but with trillions of dollars, such a difference matters. Commercial banks and funds jumped at the bargain, and the reverse repo market (let’s call them short-term deposits with the Fed) began to swell. Ultimately, demand on the record day amounted to the aforementioned trillion dollars.

With this one incentive, the Fed began to clearly limit the liquidity in the system. This seems strange given that their long-term goal is to create inflation . So why is the Fed taking such action? In this case, the explanation is as follows: The Fed is consciously contributing to further liquidity problems in the market. When they come, the central bank will again have to act as a “last resort”, just like in September 2019. In that case, it lent as much as needed to the primary dealers. Now the whole action would take place on a slightly larger scale. In the notes from the FED meeting in April, you can even find a passage that refers precisely to the establishment of such a permanent tool, thanks to which every bank and some funds could quickly borrow from the central bank . Interestingly, it was discussed in a situation where the situation on the market is exactly the opposite and banks have excess liquidity.

So you get the impression that the FED is trying to create a problem and then quickly come up with a solution that will further increase the central bank’s influence on the system. Perhaps he wants to do it in advance, knowing that at some point problems will arise anyway, and then it will be necessary to save many financial institutions.

Now think about one thing. Recently, the FED announced that it will want to raise interest rates (increase in the cost of the loan) within a dozen or so months. At the same time, at central bank meetings, there is talk of a tool that would allow banks to borrow at the central bank’s request in the repo market. It would be similar with selected funds. This is a fairly straightforward way for the financial sector to operate on “reduced” interest rates, while ordinary citizens will have to deal with ever higher loan installments.

Summary

Regardless of whether we consider explanation no. 1, no. 2 or mix both these hypotheses, we can come to similar conclusions. The repo market is sending warning signals once again. It is difficult to say at this point whether they relate only to the more difficult environment for the economy or to major problems in which the FED will contribute.

Whether it is one or the other scenario, it suggests that in the second half of the year we may face less inflation pressure. At some point, however, it will cause a problem to which politicians and central bankers will react by the only way they know – with reprinting and a greater budget deficit. And then inflationary pressure will come back again.

When it comes to the stock exchange itself, we cannot clearly state that this reduction in liquidity by the Fed will cause some large drops. Ultimately, in the fall of 2019, we had a liquidity crisis on the repo market and the stock exchange held up. On the other hand – there is no guarantee. The previous year showed that a relatively short period is enough for assets to become significantly cheaper. And we must be prepared for that too.

source: independenttrader

translated by: @sztywnywariat

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