Larry Berman: What’s up with the repo market?
The repurchase “repo” market is the function that deals with cash management in the bank-to-bank funding markets. You may have heard there have been some issues in recent weeks. It’s nothing investors need to worry about today, but it will be when the economy gets stressed like it did a decade ago. If banks can’t fund each other, the economy simply grinds to a halt. Many businesses fund their day-to-day cash flow needs in the money markets. A Bloomberg News article last week highlighted some of the issues.
The first has to do with the unwinding of the U.S. Federal Reserve’s quantitative easing program, or QE. The Fed started to reduce the balance sheet in October 2017 as the economy strengthened. A strong economy simply requires more cash in circulation. When the Fed reduces the asset side of its ledger (selling bonds), the Fed has also had to shrink its liabilities to balance its balance sheet. Those liabilities consist of currency in circulation, which has naturally increased with the economy, and bank reserves, which have fallen.
Because of post-crisis rules such as Dodd-Frank and Basel III, banks have been forced to set aside reserves to meet the more stringent requirements, putting a strain on the available cash they can use. Capital constraints have made taking large positions in short-term money markets far less lucrative. JPMorgan CEO Jamie Dimon summed up the conundrum last week, saying that “banks have a tremendous amount of liquidity, but also have a tremendous amount of restraints on how they use that liquidity.” At his post-policy news conference on Sept. 18, Fed Chairman Jerome Powell sidestepped questions about whether he felt bank regulations were a catalyst for the market turmoil. They are clearly a contributing factor.
A big consideration is the massive increase in the U.S. deficit in recent years. More supply of bonds sucks liquidity in the cash markets. Dealers at Treasury auctions have increasingly turned from lenders to borrowers in the repo market to absorb the additional supply. This year, net issuance will reach roughly $1.2 trillion, after $1.3 trillion last year. It was half that amount in 2016. The projections from the Congressional Budget Office (CBO) suggest trillion-plus deficits for at least the next decade. This issue is not going away.
Liquidity constraints came into full view over the past week when corporate tax payments, big Treasury auctions and maneuvers by financial firms to manage their capital requirements prior to quarter-end drained cash available for repo transactions. The overnight lending rate quickly shot up to 10 per cent and the Fed temporarily lost control of its benchmark rate. In the past, the Fed has disputed the idea that its balance-sheet unwind left bank reserves in short supply. And Instead, the Fed has opted for a temporary fix. On Friday, the New York Fed announced a series of overnight and term operations over the next three weeks to boost short-term liquidity. That follows four straight days of repo transactions, something it hasn’t done in a decade. A number of investors, strategists and at least one former Fed official have come out to warn that more may need to be done.
Boston Fed President Eric Rosengren acknowledged last week that permanently expanding the Fed’s balance sheet (permanent QE) is one option on the table and the one he personally prefers. (The other two being continued ad-hoc interventions or a so-called standing repo facility, which would make cash loans available on a daily basis). Growing the balance sheet might also be the easier one, some strategists say. Pumping cheap cash into the financial system has historically come with the risk of spurring too much inflationary pressure.
Fixed-income is going to be a challenge in investment portfolios. This issue may lead to a permanent QE and expansion of liquidity. We are entering a new era of ultra-low bond yields and liquidity as the U.S. government has lost control of the fiscal purse. This will have material impacts on your portfolios in the future and bears watching.
If you’re NOT a millennial, you might remember the good old days where you could earn six-to-eight per cent with very little risk, simply buying bonds. If you have greyer than I do, you’ll remember the bad old days of double-digit inflation and 15 per cent bond yields in the 1970s. The great financial crisis ushered in a new era of massive debt and ultra-low rates. Now as far as the eye can see, fixed-income is “broken” because, in real terms, rates are somewhere between zero and negative. Should you just forget about this asset class entirely? Is higher risk investing the new normal? Will inflation come back? Will Modern Monetary Theory and popularist politics turn the financial world on its head? Will we all be forced to pay banks to keep our cash safe in the near future? Join Larry for an overview of how to understand fixed income, how it has historically played a role in portfolios, and how/why we’ve arrived at the current paradigm.
It's not all bears and bond bubbles, however. As usual, we’ll be showcasing portfolio techniques for thriving in the times we’re in, and what may be around the next corner. We’ll look at liquid alternatives, convertible bonds, options strategies and currency strategies as a source of yield, high yield without the high risk, and long/short tactics for navigating the forgotten world of fixed income. Larry will bring it all together for you in a portfolio context with ideas on how to use ETFs along with less correlated investment instruments (like gold) to put these ideas into action.
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