NotQE And The Repo Monster
The “repo” market has been in bad shape since September. In the space of an hour, interest rates jumped from about 2% to lend money overnight to about 10%. The Fed blamed tax bills and other factors.
Now, four months later, the Fed is still dealing with the repo problem. Today, they announced they were considering more extreme action.
What Is A Repo And What Is It For?
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer, generally a large bank, sells government securities to investors, usually another bank or a hedge fund, usually on an overnight basis, and buys them back the following day.
Repos are typically used to raise short-term capital. It is generally a way for banks to meet short-term cash needs or capital requirements. The interest rate charged is usually about the same as the Fed Funds rate.
What Is Happening With Repos?
The most common theory proffered by would be Austrian economists is that debt is coming home to roost. They claim banks are short on cash because they have been buying U.S. Treasuries.
There is a modicum of truth to that, however, it does not explain why repo interest rates spiked so hard and so fast in September. Two other things do.
First, there is a general shortage of cash on bank balance sheets as they try to maximize profitability. Four banks make up about half of all cash reserves at U.S. banks. For some reason, they are suddenly tighter on lending to other financial institutions. The four banks are:
Why would all four suddenly start lending less overnight?
That leads us to the second issue. There is clearly a problem financial institution or more than one in the system. This could include other banks or hedge funds which borrow from banks.
If there is a fear of a systematic breakdown, then the big four repo lenders could be saving their powder.
What Is The Fed Doing?
The Fed has been buying U.S. Treasuries from banks and paying them cash. So far, they have expanded their balance sheet, a form of quantitative easing, by nearly a half trillion dollars since September.
There is a popular hashtag going around: #NotQE. What does that mean? People are making fun of the Federal Reserve for saying this is not quantitative easing.
Both groups should be made fun of because there is an element of falsity and truth to both. Certainly the Fed buying U.S. Treasuries is a form of quantitative easing. However, in this case, it is not going into the economy and markets as it did back from 2009 to 2014.
This money is mostly going to bank balance sheets and to fund very short-term banking needs. Some is certainly getting into markets, but the evidence is that most is not as shown by fund flows.
So, while the stock market has risen in Q4, it is likely due more to seasonality than the Fed. We will see soon how fund flows in Q4. I suspect a small uptick, but nothing like a half trillion dollars.
Why A New Fed Approach?
Currently, repos go through the big banks. The Fed is considering making smaller banks, securities dealers and hedge funds eligible to borrow at the Fixed Income Clearing Corp, or FICC.
This would take the big banks out of middle man position in lending to those other institutions. Here it is important to ask, why aren’t the big banks lending.
I believe there is a stealth bailout of large hedge fund going on. One that is large enough to cause a systematic problem. A Long-term Capital type of event or even a Lehman Brothers type of event.
Who is the dangerous party right now? Hard to say. Here are the candidates.
I would find it hard to believe Bridgewater or Renaissance are in trouble.
Bridgewater did take on some interesting short positions in the past year and had only a .5% return in 2019. Could their leverage be posing a problem?
Renaissance Technologies just keeps making money using a quant approach.
Man Group is heavy into alternative investing. I believe they could be at risk.
AQR is firing people after losing money in 2019 and saw assets fall by 20% in 2019. There has been questioning of AQR on Seeking Alpha. I recommend reading that piece for some understanding of how risks are managed and sometimes managed badly. This could be a problem firm.
Or, what we could be witnessing is that many of the hedge funds are in need of cash to pay investors who are walking out the door. The Fed could be facilitating an orderly wind down to avoid what happened at the end of 2018.
Someday we’ll know. Until then, I want to be cautious.
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