It seems that the central bankers and monetary academics of the past century had a better grasp of our monetary system than the empty suits that run our central banks today. This is a fact and the Repo market is just one clear example of on what the current Fed's policy of the past decade is routine based. They have a set of tools and things done in the past, and when all hell breaks loose, they don't know what else to do but follow the playbook of the past, running old plays one by one, hoping to solve the problem.
In 2008, when the world grasped the extent of the financial damage of the Global Financial Crisis, the measures that officials took in the course of three months were some of the most drastic in our history. Today, Fed Chair Jerome Powell and Treasury Secretary Steve Mnuchin, rather than understand the problem and why it is happening, are just using the same old measures from 2008 and throwing it at the market every two hours, hoping that by trial and error one of them will cause some magical reaction and support asset markets everywhere.
In less than a week, we have gone through the entire 2008 playbook, and the system is still broken. Now what?
There is an old saying, "the markets are always right", and it could not be truer than it is today. But by markets, I do not mean equities, which are perhaps the least sophisticated of all asset classes being pushed and pulled by a multitude of players with tons of liquidity and different mandates. I mean the Bond, Rates, and Swaps markets.
These have been and always will be the most sophisticated and intelligent of all markets, and what we see there will filter down eventually into all other asset classes -- as their market is just real. It cannot be manipulated or meddled with in terms of the story it is telling you, or the warning it is giving. The Fed would do well to hear what those markets are telling us, rather than watch the equity market tick for tick, trading the P&L. Those markets have, one by one, been signalling extreme duress over the past two weeks.
In the most simplest of layman terms, the Coronavirus was a black swan event that left no choice but to expose a system that was already teetering on the edge. Due to the infectious nature of the pathogen, the entire global economy and businesses have had to shut down and go into lockdown to avoid it spreading further. This has meant that everyone in the supply chain -- from retailers, businesses and companies down to the little fruit vendor on the street -- are all struggling to raise cash fast enough as sales came to a grounding halt. They have fixed costs and expenses, so there is a rush for cash across the board, not only from banks but also corporates drawing all their credit lines down to the individual.
Over the past few years, companies like Boeing (BA) and many other leveraged ones used all the cash and free money available in the system to buy back their stock and elevate their earnings to appear to be "earnings accretive". They did not save for a rainy day nor keep cash on hand. Now, when they are starved for cash as business shuts down, they are running to the Fed to bail them out, again.
This is highway robbery. Why should the tax payer have to pay these companies when they have been irresponsible to start with (debate for another day)? The only way the Fed knows how to get money into the system is via the Repo market, which allows it to inject liquidity into the system quickly so that the banks can then lend it out to the economy and plug the hole. Therein lies the next problem. These banks do not have enough reserves or have used risky or junk collateral against their balance sheets and so are unable to raise enough collateral to then take this Fed money and give it back out. The rates are soaring, despite various Fed injections, but the problem is not only the banks, it is the small and medium-sized companies as well as corporates.
It all started with a little market tumble. The Fed did an emergency interest rate cut by 50bps and the market fell as before it was worried, but now it knew something else was happening. Repo markets demanded higher and higher dollars as bids were unfilled. Then two days later, the Fed announced $1.5 trillion worth of repo auctions each week for the next three weeks ~ $4.5 trillion in total.
Markets rejoiced, as that was a bazooka repo auction (the size of the entire current Fed balance sheet). Then without waiting on Sunday, they announced the mother of all liquidity injections by cutting U.S. interest rates by a 1 full percentage point (100 bps!) down to near 0%, as well as saying it would start buying $700 billion worth of Treasury paper (QE 5, and this time it's official). To the Fed's dismay, markets fell 13%, utter collapse. Then they come in this week, announce a $1 trillion fiscal package to be approved to save the economy.
The repo market, despite all this injection, was still seeing rates soar higher. The Fed is very confused as they throw the entire house and the kitchen sink at the problem. on Tuesday, dollar cross currency swap spreads started blowing out. This is the amount of dollar that is short in the system as everyone from banks to companies to small businesses including international companies and borrowers scramble to buy dollars as they are all short cash, and all short dollars.
Something snapped further. The Fed, clearly petrified, announced on the same day $1 trillion in daily repo auctions. To their dismay only $10 billion of it was actually requested by the banks out of $500 billion on offer. If that does not tell you the problem is elsewhere, I am not sure what will.
The Fed is clueless and literally dumbfounded. They may as well add 10 more zeros to that number and it would not matter. The problem is that the money from the central bank is not reaching the economy, as banks are unable to actually lend it out. The Fed is lowering lending standards, but they are still unable to do so, because they have too much crap on their books and cannot extend further.
The high yield and junk bond collateral used as Treasuries is blowing up and raising margin calls. To take it a step further, now Hedge Funds have been involved in this trade as well for the past few years: "Free money", they say, and ultimate greed to make the 20%+ returns they promise their investors.
But it is not the job of the Hedge Funds to play this market, nor to lend it out to the real corporates -- so even they are scrambling. Hence, it is almost certain a big Fund blew up on Tuesday, as they rushed for the door. They are too big to fail, but they will not be bailed out. There was a sneak preview of this back in September 2019, but the Fed -- rather than investigate -- just said let's throw more money at the problem, hopefully it will go away. And it did, for a short while, to come back and haunt them three-fold.
Since the banks were not lending to the commercial market, the Fed on Tuesday also announced plans to enact the commercial funding paper market facility to actually give money to the companies to fund their day to day operations. That is a good start, as they need it the most. But also announced a $1 trillion repo auction for one day (to put it in perspective, that is the entire QE1 that was done in 2009 -- but we did it in one hour yesterday!).
The banks are dysfunctional and unable to carry out the central bank's job. But how much is enough? The stock market dropped 27% from all-time highs in 16 trading days. We have not seen anything like that in history. Even in 1929, it took 42 days to get a 20% correction from highs.
This is not just a U.S. problem. This is a global problem. The central banks have to be the lender of last resort and save not only the entirety of corporate America, but now they will need to bail out the rest of the world that has also borrowed in dollars and is seeing a funding freeze. The central bank has to increase its lending swap lines not only to G-7, but to a host of other countries that need it as well, as they scramble to buy dollars and exacerbate the problem.
What started as an economic crisis (demand shock post Coronavirus slowdown) is slowly turning into a Financial crisis worse than 2008. That is the recipe for utter meltdown, and the Fed is not prepared -- nor has it ever dealt with this. This is what happens when you use debt to pay back old debt, to then print to pay back the new debt. Companies have not been growing and debt has been rising. When one domino falls, it takes the entire system down. Now it is too late as more than few dominoes have fallen.
Commodities, Bonds, Gold, Precious Metals, Equities -- everything is being liquidated, no mercy. There will be casualties, we have yet to hear of them -- just like 2008 -- but this crisis is much worse than that, even. These are not investable markets, yet. Wait it out, the damage is beyond a small fix now. Containing the peak infection from the virus is the first step, then the next is getting the world engine to start, a harder task as the car has been stalling over the past two years.
The market in the past decade was labelled as the "Everything Bubble," and what will it take to stem the demise? Everything.