The sudden rocketing repo rate and the Fed’s injection of money four times this week to keep the Fed funds rate in the 1.75% to 2% range was spooky. It invokes memories of the 2008 crisis where the repo rate rocketed as liquidity dried up in the global banking system.

The repo rate skyrocketed as creditors tightened up their lending to borrowers because the Fed is doing rate cuts. Think about it. The Fed cuts because the economy is weakening. If the Fed is cutting rates, creditors have to be more careful with loaning out money in a weakening economy.

Worse, President Trump was correct in saying that the Fed should have lowered rates by more. We know this because of the US dollar chart.

Daily chart of UUP.

A meaningful rate cut would have shown the US dollar selling off. Instead, the US dollar kept rising right through the rate cut. This means that other countries are cutting rates faster than the US and so it’s largely offsetting the advantages of rate cuts.

Creditors viewed the rate cut as too small as to stop the slowdown in the US economy and so they pulled back on their lending which created liquidity problems in markets this week.

The other issue with creditors is that since 2018, the Fed has been shrinking its holdings of bonds and reversing its crisis-era policy of pushing money into the financial system. The change has reduced the supply of money available in the short-term lending markets. The surge in short-term rates suggests that the Fed might have removed a bit too much, making reserves too scarce. With a weakening US economy caused by a weakening global economy, the Fed needs to be more accommodating in terms of interest rates as well as not shrinking its holdings of bonds and removing any more reserves from the system.

The other major issue that is reducing liquidity in bond markets is Russia and China reducing their bond holdings:

This loss of confidence and rise in uncertainty is probably not a one-off event.

So far there’s no sign of spillover overseas but investors are on the watch for any warning signals, given the dollar’s dominance in cross-border trade and investment.

If the repo market continues to have issues over the next couple of weeks, offshore markets are likely going to start getting hit in a bad way.

After the U.S. Fed’s second “insurance” rate cut of 2019, officials’ median rate forecasts hint at no more cuts this year. The shift has come as a shock given expectations prior to the Fed meeting were for several more cuts by the end of the year.

The Fed thinks the U.S. economy can get on fine without further short-term stimulus but the repo market says otherwise. Upcoming data may show us whether that view is accurate or if, in chairman Jerome Powell’s words, “a more extensive sequence of rate cuts could be appropriate”.

New dot-plot projections show Fed policymakers at the median expect rates to stay within the new 1.75% to 2.00% Fed funds range through 2020. Futures traders, meanwhile, see a better than 50/50 chance that the target rate will be another 25-50 bp lower by the year end. As we get closer to the 2020 Presidential election, the Fed will be more inclined to sit on their hands and do nothing in order to not interfere in the election process.

The problem here is that the US does not operating in a vacuum. The US economy is being pulled down by the rest of the world as they cut rates to gain competitive advantages over the US in trade in terms of currency devaluation.

The ECB has already pledged indefinite stimulus and that’s a big problem for the US if we don’t cut rates faster to slow down the rising US dollar.


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