Macro Wrap-Up

Notes from the Underground Trading Desk

Topics - Macroeconomics

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Notes from the Underground Trading Desk

In Repo Man, Emilio Estevez plays a young punk rocker who, after a series of the kind of bad events that so frequently befall 1980s movie characters, takes a job repossessing cars. The film’s writers more than subtly foreshadow trouble ahead for him. 1 1 Close I would spoil the ending, but I saw it so long ago I can’t remember what happened. Something about aliens, maybe? For the past two weeks, investors have been wondering if dislocations in repurchase agreements (repos) are foreshadowing economic disaster. These fears are vague but have historical precedent. In 2007 and 2008, money markets froze and rates spiked, 2 2 Close Or, if it were in Repo Man, burst into flames. giving an strong warning of the collapse of the financial system. Fortunately, there are few similarities between the current spike in repo rates and what happened over a decade ago.

Before we look at why this is, we need to define three terms. The first is a repo. Like a mortgage, a repo is a loan backed by collateral, but instead of your house, this collateral is a T-bill or a bond. 3 3 Close An early draft of this Wrap-Up referred to a repo as a “collagenized borrowing agreement.” A collagenized loan agreement is used to promote the appearance of healthy skin and bones instead of financing bond holdings. Repos are frequently used by investors to finance bond purchases without putting up much cash and were big sources of bank funding in the mid-2000s. The length of a repo can be customized and is often as short as one day.  

The second is a reserve, which is a term probably created with the sole purpose of confusing people who talk about money markets. When you make a deposit at a bank it is called a deposit. When a bank makes a deposit at the Fed, it is called a reserve. 4 4 Close A reserve is a deposit at the Federal Reserve, so it is also a federal reserve. A reserve can be traded, but only with other member institutions at the Fed, which are mostly banks. The famed effective federal funds rate is the volume-weighted median of where reserves trade among the institutions. One strange thing about reserves is that the Fed can create them out of thin air. When the Fed conducted quantitative easing (QE), it would buy bonds from banks and in exchange would create an electronic ledger entry adding reserves to the bank’s holdings at the Fed. 5 5 Close The most important thing to understand about QE is that, other than the differing durations, the reserves aren’t much different from the bonds that the Fed buys. That is why some economists think QE is so ineffective and why it doesn’t cause inflation, but that is a topic for another Wrap-Up. In the process it created trillions of dollars of reserves. 

The third is a repo man. A repo man is someone hired by a credit company to repossess items from people behind on their payments. 

Back when Emilio Estevez starred in movies, fed funds and repo markets were quite volatile. On tax days and at the end of the quarter, rates would spike up as demand for cash increased. Regulators require banks to maintain a certain amount of reserves. 6 6 Close These are known as required reserves. Any reserves the banks hold beyond that are excess reserves. Because the Fed didn’t pay interest on the reserves, banks wanted to keep as few of them as possible, but during times when money is tight (such as April 15th) they could be caught short. They would then have to borrow from other banks who would charge dearly for the privilege, resulting in the spikes in rates. The Fed tried to add reserves strategically to prevent this from happening, with mixed success.

After the Fed started quantitative easing, everything changed. When the Fed bought bonds, it gave banks reserves – in the trillions. The banks had so many excess reserves that they were rarely caught short. The fed funds market barely functioned because there was no longer a need to trade reserves to meet the Fed’s requirements. 7 7 Close Federal Home Loan Banks (FHLBs) still used the fed funds market to park extra cash and some depository institutions were able to arbitrage between the rate at which they could borrow from the FHLBs and lend to the Fed, earning the interest on excess reserves, but there wasn’t much else going on. When the Fed wanted to hike rates above zero they had to pay interest on excess reserves, otherwise it would have been difficult to manage rates higher. 8 8 Close The Federal Reserve formally began paying interest to depository institutions on required and excess reserves in 2008.  

Starting in 2017, the Fed gradually let bonds from QE roll off its balance sheet. The Fed can remove reserves just as quickly as it adds them. Even with this quantitative tightening there are still over $1 trillion of excess reserves, but it appears they are not distributed evenly across banks. 9 9 Close When people talk about unfair inequality they aren’t usually talking about some banks having more reserves than others. That means that some banks may have very few excess reserves and are forced to pay up to borrow at times. It’s just like the old days. Some commentators have pointed out that this distribution of reserves may be indicative of regulatory constraints which cause some banks to hoard and leave others unable to borrow at reasonable rates.

This is not an indication that we are headed for another financial crisis. In 2007 and 2008, the funding markets dried up across the board, but in this case, it has been mostly isolated to repos. Other short-term rates such as fed funds and LIBOR have only been intermittently elevated, and commercial paper markets seem to be functioning normally. The main difference between repos and those other markets is that repos are collateralized. What the spike may indicate is that there is an excess of the Treasuries that are used as collateral. Treasuries have become so plentiful that they are no longer wanted anymore. To use the mortgage analogy, the borrower probably has the income to make the payments on time, but the bank doesn’t want another house as collateral, so they’ll decline the loan or charge a higher interest rate. In contrast, in 2007 and 2008 rates went up because cash was so scarce that no one believed that even the biggest banks could make good on their payments. 

As they did in the past, the Fed has been trying to bring rates down. It has been temporarily adding reserves through secured short-term loans to banks – in other words it is lending in the repo markets. This seems to be effective, which is another indication that it is not a deeper credit problem. Repo rates will probably continue to have occasional spikes, unless either regulation changes or the Fed expands its balance sheet again to flood the market with reserves.  

Investors typically don’t need to follow the ins and outs of repo rates closely. It really doesn’t matter if repo rates spike at every quarter end. For most of our lifetimes, money market volatility occurred regularly, but few people cared except for a few finance desk bank employees who probably worked in a small room in the basement below the trading floor. 10 10 Close One of the contributors to this piece may have previously worked in one such basement.  What investors should look for are signs of stress across money markets, which can indicate that banks are unable to fund themselves. Money market stress can also give hints that there is a run on cash elsewhere in the economy. We just aren’t seeing signs of that yet. Investors should also be aware that if someone tells them that the car they repossessed is an alien spaceship that can travel in time, it is probably a sign that something is wrong.  

What We Are Watching
China Manufacturing PMIs (Monday)

After falling sharply in the second half of 2018, Chinese manufacturing PMIs have been stable at low levels for most of this year. The official CFLP manufacturing index has been in contractionary territory for four consecutive months, while the Caixin index has been hovering around the 50 level for seven months (more on PMI level interpretation below). With growth weakening all over the world, the stability of Chinese PMIs may reflect policy stimulus from Chinese authorities. Next week’s data will provide an update on the extent to which Chinese stimulus has been successful in mitigating downward pressure from the U.S.-China trade dispute. Market participants have been sensitive to trade war developments as a key risk to the fragile global economy and may view Chinese PMIs as a gauge of how significantly the dispute is impacting activity.

U.S. ISM Manufacturing PMI (Tuesday)
The ISM Manufacturing PMI was unexpectedly weak last month, falling below 50 for the first time since 2016. Readings below 50 indicate that, on net, survey participants reported negative trends in dimensions of their businesses such as production, orders, and headcount. While the weakness of the PMI highlights the headwinds faced by the U.S. manufacturing sector, it would take a meaningful further decline before the index is at levels typically seen during broader economic recessions. Regional manufacturing surveys have not given much reason to expect improvement in the ISM this month, and a strike at a large U.S. automaker could impact firms up and down the auto industry supply chain. If the ISM falls further below 50, it could raise the odds of additional rate cuts from the Fed, perhaps leading to weakness in the U.S. dollar and gains in fixed income. 

U.S. Employment Report (Friday)
The U.S. unemployment rate remains near multi-decade lows at 3.7%, but nonfarm job growth has been decelerating, with average gains slowing from 223,000 in 2018 to 173,000 over the last year. 11 11 Close Bureau of Labor Statistics. While this is still a relatively healthy pace of job growth, the trend has become noteworthy, with industries such as retail, manufacturing, and transportation showing signs of weakness. Over the next few quarters, labor market data will be impacted by hiring around the 2020 Census. In August 2019, 25,000 jobs were added due to temporary Census hiring and much larger totals are likely around the April 1, 2020 date. Weakness in other sectors could be partially masked by government hiring around the decennial event. Wage growth will remain a focus in this week’s report, as softness could allow the Fed to take a more dovish stance at its upcoming meetings. An upside surprise in wage or payrolls data could cause fixed income assets to sell off as more hawkish Fed expectations may be priced into markets.

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