Back in September the market received a warning from the REPO market where interest rates unexpectedly spiked higher. Before describing what may be interfering with REPO market operations, I want to point out that signals from the bond market, while important, generally represent a time horizon of a year or more. Unlike other technical, fundamental, or sentimental signals, bond market signals are usually a warning about the potential for trouble in the economy or stock market down the road. The more lag in the signal the higher likelihood policy action can avert potential problems so these signals may never develop into an actual recession or bear market for stocks. That does not mean we should not take the issues in the REPO market seriously or that it could not erupt into a more challenging problem.
We do know the Federal Reserve started raising interest rates and selling bonds to reduce the size of their balance sheet. The chart below provides a picture of the downward trend in the Federal Funds Rate (the rate at which institutions lend to each other) over the last several decades. More importantly, we can see the level where the market became spooked causing the Federal Reserve to reverse course and return to lowering interest rates.
Some of the biggest participants in the REPO market are banks and other financial institutions that need cash to settle trades. Borrowers pledge U.S. Treasuries and other high-quality securities as collateral to raise cash. They replay the loans, often the next day, plus a nominal rate of interest and get their bonds back. Borrowers repurchases, or repo, their bonds. Initially the problem in the REPO market was thought to be a shortage of readily available cash, but $1.4 trillion in reserves remained in the system at the time interest rates shot up. It’s still unclear exactly what caused rates to rise so dramatically in the REPO market back in September, but some commentators have suggested a problem with a major bank, possibly an international bank (Deutsche Bank would make the suspect list), may have contributed.
Another problem may be collateral, specifically, packaged subprime consumer loans. According to the Federal Reserve in Q3 the delinquency rate at the nearly 5,000 smaller commercial banks in the U.S. jumped to 6.25%, higher than during the financial crisis. The rate for Subprime auto loans, a $1.3 trillion dollar market, rose to 4.71%, a new high since the last financial crisis.
Household goods and electronics retailer Conns Inc. (CONN), saw its share price slammed 32% after reporting credit deterioration issues earlier this month. Specifically, they warned of problems in their subprime credit portfolio. As a result, they are tightening credit standards and increasing their provision and allowance for charge offs.
In addition to the low-quality high-risk debt markets, another issue facing the market and economy may be the sheer amount of corporate debt. The Fed’s low interest rate environment has provided incentive for corporations to borrow. While corporate balance sheets appear to be in decent shape relative to asset levels, the debt market for non-financial businesses has grown to $18 trillion. In terms of percent to GDP, corporate debt is at an all-time high.
The biggest take away from the REPO episode may be the embarrassment the Fed experienced. For a short time they lost control of a part of the market they are intimately involved with. The massive reversal in policy, where they are now injecting $60 billion a month into the banking system, has postponed their goal of normalizing rates. This development could call into question the Fed’s effectiveness. Historically the Fed has been great at goosing asset prices but lousy at preventing deep recessions and severe stock market declines.
Right now the Fed is committed to maintaining stability in the REPO market. If there is a problem with a bank or a portfolio of collateral, policy makers may be able to isolate and inoculate it. The Fed has signaled interest rates will not be raised in 2020 and they are back in the bond buying business adding liquidity to the marketplace. On balance, this is positive for stocks and the economy.
As we approach the end of 2019, REPO market interest rates have settled down and the stock market is making new highs. There is little talk of a recession in 2020.
In closing, even though Hanukkah and Advent have been underway for much of December, many of you may be entering an extended period for rest, reflection, and family time. I hope you, your family, and friends experienced much success this past year and are able to enjoy a relaxed time together over the balance of the season and into the New Year.