September 16th marked the beginning of the recent repo crisis. If you are unfamiliar with the repo market, I highly suggest watching this video before you read this post. Since then, the Fed has been in emergency mode, effectively “bailing out” the overnight cash repo markets continuously.
These efforts were supposed to allow banks some breathing room to build up their cash reserves and resume overnight lending as normal once again. According to new research on the topic, this has not happened. Zoltan Poszar (who helped design the repo system) explains in his recent Global Money Notes #26 the likely cash crunch we face coming into the end of the year, what the Fed will have to do in response, and what the likely outcomes will be.
In this post, I will break down his technical report into common language. Full disclosure: anytime you are distilling complex topics, there will be details that are skipped or misrepresented. The purpose of this is to provide a broad overview of the problems in a way most people can digest, while maintaining the accuracy and integrity of the whole as much as possible.
Let’s dive in.
Nothing Has Changed Since September
The Fed has intervened almost every night in the repo market since the rates first spiked out of control on September 16th. The interventions and cash injections have usually been to the tune of about $75 billion. Despite all the liquidity the Fed has been providing, it has only served as a bandaid. The problem which caused the spike in the first place has not been resolved. If the Fed were to withdraw the overnight injections, the rates would spike immediately.
There are a few underlying issues causing the liquidity crunch. The main is a lack of cash reserves at banks. The major players who usually provide the overnight lending do not have the cash to lend. And the ones that do have the cash to lend are not lending it. Instead of cash to lend, banks’ balance sheets are filled with collateral – mostly treasuries.
Despite the Fed increasing its own balance sheet, essentially performing Quantitative Easing (QE), the banks have not been able to turn their excess treasuries into usable cash. This is because the Fed is only buying TBills in an attempt to avoid admitting they are doing QE. They are not buying treasuries. This has put the biggest banks in a bind because these big banks are required to buy treasuries at auction, and now they have no one to sell them to.
Year-End Cash Needs Will Increase Dramatically
While it seems that the Fed has been able to keep a lid on the repo issue, what is really happening is pressure building under the surface. Coming into the end of the year, cash and liquidity needs increase drastically. This is for a few reasons that are too technical to get into here (has to do with relative value hedge funds), but just know that every year, the last few weeks demand excess cash.
This happened last December, just like it happens every year. Most people are not aware, but last December there was a spike in repo rates as well as the year came to a close. The difference was that last year banks had much more in excess reserves than they do this year, and they didn’t have the bottleneck of G-SIB restraints they do now.
Bottleneck: G-SIB Scores Force Repo Only
G-SIB means “Globally Systemically Important Banks” which is a fancy term for too-big-to-fail. After the financial crisis, this designation was given to large banks. With the designation comes certain liquidity/reserve requirements, and what banks can do with that money.
One restriction is the order in which banks can deploy any excess reserves they have. First, banks can lend in repo markets. Then they can use reserves to buy treasuries. Finally, they can lend through FX swaps (foreign currency markets). Without getting into the details, it is important to know that G-SIB scores are very high right now due to the stock market performance and a flat yield curve. Last year there was a stock-market sell-off at the end of the year which helped banks because it gave them flexibility with their excess cash.
Due to current G-SIB scores, banks are currently limited to operating in the repo markets only with their excess cash. That’s great, right? If we are going to have higher cash needs, isn’t it a good thing that banks are forced to prioritize repo lending?
The problem is the FX swap market. This will force the FX swap market to be virtually dry of lending. With the repo market tapped out, the vacuum in the FX swap market will be magnified. Additionally, just because banks are required to prioritize excess liquidity in the repo market doesn’t mean that banks have any liquidity, to begin with. In other words, the Fed has shoved a lid down on rates in the repo market, and the pressure building is going to burst in the FX swap market.
Both Equities and Treasuries Could Sell Off For Cash
With a massive surge in demand for cash, there will only be one thing that institutions can do. Sell their assets. These assets are treasuries and equities.
When equities sell-off, there is a stock market drop. The extent of the drop may be insignificant, but it all depends on when the Fed steps in to “rescue” the system again. It’s possible this triggers a large correction in the stock market in a very short period of time. As with all fast-moving drops, these things tend to trigger more and more selling as a self-propelling machine.
When treasuries sell-off, there is a spike in the yield. A spike in yields is disastrous for an economy standing on a foundation of debt. This is because debt service becomes more expensive. And if an economy or country can barely afford the debt as-is, it will collapse if the debt gets more expensive. So disastrous that it is unthinkable the Fed will not step in to try and stop it.
The Only Available Fix
How will they stop this? They will start buying treasuries again. If the Fed starts buying treasuries again, they will turn bank reserves into cash which will allow banks to operate as lenders again. This will also put a floor underneath the sell-off that could get triggered in the year-end liquidity crunch.
Easy fix then, right? Well, if it is so easy, why doesn’t the Fed just start buying treasuries right now and avoid the problem before it hits? First, they have made it very clear they don’t intend to change their current course of action until the “incoming data” demands a different course of action. They reiterated this approach yesterday in the December 11th FOMC Press Conference.
What data counts as demanding a different course of action? Well, clearly not a looming cash crunch evidenced by current reserve levels and year-end cash needs. They have chosen to be reactionary, not proactive. This means that it will likely take a big stock market correction or treasury sell-off to prompt a change in course.
The Bigger Issue
The bigger issue here is that the whole system is horribly fragile, and it is deathly reliant on continuous, increasing debt monetization by the Fed. And debt monetization is ultra-inflationary. Every attempt by the Fed to stop, reverse, or slow down this balance sheet expansion has exposed the enormous cracks in the foundation. And every cover-up leads to more and larger future inflation.
This means it can’t go on forever. Even with ever-increasing intervention/stimulus/accommodation, the hens will come home to roost. Printing money solves no fundamental problems, it only delays the consequences. And the longer you delay the consequences, the worse the problems grow under the surface. It is simply a matter of time before this facade breaks.
What Can I Do?
The stock market isn’t safe. US Treasuries are not safe, let alone corporate bonds. Cash isn’t safe (the fallout will be inflationary or hyperinflationary). Where does one go to find shelter?
The ultra-wealthy are stockpiling gold. Physical gold. While everyone has access to buy gold, most people have their wealth tied up in retirement accounts and cannot use those funds to buy gold.
The $VIX has also recently spiked dramatically in the last few days, despite the stock market staying relatively flat. This indicates higher amounts of “fear” in the market by gauging options pricing. This could mean that big money is buying options on the market to hedge or profit from a market correction/crash. Options are available to anyone who knows how to use them.
Another choice is to re-align your portfolio to have minimal exposure to fixed-income. While this will over-expose most to equities, it will protect you from inflation destroying the value of fixed income. Being over-exposed to equities also allows the advantage of using options to hedge your portfolio.
Please remember that none of this should be considered individual investment advice, but is meant to be purely educational.
Regardless of whether you choose to try and brace for impact or ride the waves of the storm, know that the next few weeks are likely to be…exciting – to say the least. And if the problems end up being as big as it looks like they could be, the next few weeks might go down in history as the match that lights the fuse.
Disclosure: I am currently short the S&P500 through the use of put options. This is not investment advice.
If you are interested in learning how to use options to protect your portfolio, sign up for my Options Foundations course today.