Tag Archives: liquidity

2020 – INVESTMENT SUMMIT

RIA Advisors is proud to present the 2020 Investment Summit 

Hosted By: Lance Roberts, CIO RIA Advisors

Featuring:

  • Michael Lebowitz, CFA – RIA Portfolio Manager
  • Teddy Valle – Pervalle Global
  • Thomas Thornton – HedgeFund Telemetry
  • Jeffery Marcus – TP Analytics

Topics include:

  • Impact of Government bailouts
  • The Fed is fighting a losing battle
  • Market Outlook
  • ETF Liquidity issues
  • And more….

CLICK HERE TO START WATCHING NOW


Surging Repo Rates- Why Should I Care?

A subscriber emailed us regarding our repurchase agreement (repo) analysis from Tuesday’s Daily Commentary. Her question is, “why should I care about a surge in repo rates?” The commentary she refers to is at the end of this article.

Before answering her question, it is worth emphasizing that it is rare for overnight Fed Funds or Repo rates to spike, as happened this week, other than at quarter and year ends when bank balance sheets have little flexibility. Clearly, balance sheet constraints due to the end of a quarter or year are not causing the current situation.  Some say the current situation may be due to a lack of bank reserves which are used to make loans, but banks have almost $2 trillion in excess cash reserves. Although there may likely be an explanation related to general bank liquidity, there is also a chance the surge in funding costs is due to a credit or geopolitical event with a bank or other entity that has yet to be disclosed to the public.

Before moving ahead, let us take a moment to clarify our definitional terms.

Fed Funds are daily overnight loans between banks that are unsecured, or not collateralized. Overnight Repo funding are also daily overnight loans but unlike Fed Funds, are backed with assets, typically U.S. Treasuries or mortgage-backed securities. The Federal Reserve has the authority to conduct financing transactions to add or subtract liquidity to ensure overnight markets trade close to the Fed Funds target. These transactions are referred to as open market operations which involve the buying or selling of Treasury bonds to increase or decrease the amount of reserves (money) in the system. Reserves regulate how much money a bank can lend. When reserves are limited, short-term interest rates among and between banks rise and conversely when reserves are abundant, funding costs fall. QE, for instance, boosted reserves by nearly $3.5 trillion which enabled banks to provide liquidity to markets and make loans at low interest rates.

Our financial system and economy are highly leveraged. Currently, in the U.S., there is over $60 trillion in debt versus a monetary base of $3.3 trillion. Further, there is at least another $10-15 trillion of dollar-based debt owed outside of the U.S. 

Banks frequently have daily liquidity shortfalls or overages as they facilitate the massive amount of cash moving through the banking system. To balance their books daily, they borrow from or lend to other banks in the overnight markets to satisfy these daily imbalances. When there is more demand than supply or vice versa for overnight funds, the Fed intervenes to ensure that the overnight markets trade at, or close to, the current Fed Funds rate.

If overnight funding remains volatile and costly, banks will increase the amount of cash on hand (liquidity) to avoid higher daily costs. To facilitate more short term cash on their books, funds must be conjured by liquidating other assets they hold. The easiest assets to sell are those in the financial markets such as U.S. Treasuries, investment-grade corporate bonds, stocks, currencies, and commodities.  We may be seeing this already. To wit the following is from Bloomberg:  

“What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally. After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.”

A day or two of unruly behavior in the overnight markets is not likely to meaningfully affect banks’ behaviors. However, if the banks think this will continue, they will take more aggressive actions to bolster their liquidity.

To directly answer our reader’s question and reiterating an important point made, if banks bolster liquidity, the financial markets will probably be the first place from which banks draw funds. In turn, this means that banks and their counterparties will be forced to reduce leverage used in the financial markets. Stocks, bonds, currencies, and commodities are all highly leveraged by banks and their clientele. As such, all of these markets are susceptible to selling pressure if this occurs.

We leave you with a couple of thoughts-

  • If the repo rate is 3-4% above the Fed Funds rate, the borrower must either not be a bank or one that is seriously distressed. As such, is this repo event related to a hedge fund, bank or other entity that blew up when oil surged over 10% on Monday? Could it be a geopolitical related issue given events in the Middle East? 
  • The common explanation seems to blame the massive funding outlays due to the combination of Treasury debt funding and corporate tax remittances. While plausible, these cash flow were easy to predict and plan for weeks in advance. This does not seem like a valid excuse.

In case you missed it, here is Tuesday’s RIA repo commentary:  Yesterday afternoon, overnight borrowing costs for banks surged to 7%, well above the 2.25% Fed Funds rate. Typically the rate stays within 5-10 basis points of the Fed Funds rate. Larger variations are usually reserved for quarter and year ends when banks face balance sheet constraints. It is believed the settlement of new issue Treasury securities and the corporate tax date caused a funding shortage for banks. If that is the case, the situation should clear up in a day or two. Regardless of the cause, the condition points to a lack of liquidity in the banking sector. We will follow the situation closely as it may impact markets if it continues.

The Weaponization of the Dollar

The Uncivil Civil War discussed the sanguine approach many investors take towards equity risk despite clear signs of domestic political turbulence. The article put the upcoming elections and the growing political divisions amongst the populace into context with market risks.

While we read plenty of politically related articles and many more investment related articles, we have found precious few that bridge the gap and gauge the effect politics has on markets. The intersection of markets and politics is important and should be followed closely, especially with a mid-term election months away. As so eloquently described by the late Charles Krauthammer, “You can have the most advanced and efflorescent cultures. Get your politics wrong, however, and everything stands to be swept away. This is not ancient history. This is Germany 1933.

In this article, we readdress politics and markets from an international perspective. In particular, we focus on suspicions we have regarding Donald Trump’s negotiation tactics and goals for the U.S. relationship with Turkey.

Emerging Markets and the Dollar

China, Turkey, and Iran are all classified as emerging markets. While the classification is broad and includes a diverse group of countries, these countries have many things in common. One is that their currencies, for the most part, are not liquid or highly valued. Thus, they heavily rely on the world’s reserve currency, the U.S. dollar, to conduct international trade.

As an example, when Pakistan buys oil from Qatar, they transact in U.S. dollars, not rupees or riyals. To facilitate trade efficiently, these countries must hold excess dollars in reserve. In almost all cases, emerging market nations rely on U.S. dollar-denominated debt for their transactional needs.

Dollar-denominated debt is currently the cause of much economic pain for Turkey. To understand why, we present a simplified example. Suppose on January 1, 2018, a Turkish corporation borrowed $100 million U.S. dollars with an agreement to pay it back with interest of 5% on August 15th, 2018. The company, as is typical, converts the loaned dollars to Turkish Lira.  On August 15, 2018, the company will convert the Lira back to dollars in order to pay the principal and interest due on the loan.

The following graph charts the Turkish Lira versus the Dollar over the life of the loan.

On January 1, 2018, one U.S. Dollar was worth 3.79 Lira. Over the next eight months, the U.S dollar appreciated significantly versus the Lira such that one U.S. dollar was worth approximately 5.81 Lira. As such, the company will now need 5.81 Lira to purchase each dollar it needs to repay the loan. Due to the strengthening of the U.S. dollar versus the Lira over the time period of the outstanding loan, the company would need 584,282,000 Lira to pay back what was originally a 378,750,000 Lira loan. In other words, the true all-in cost of borrowing was not 5% but 54%.

Turkey’s public and private sector dollar denominated loans outstanding are currently estimated to be around $500 billion. Turkish borrowers must grapple with repaying outstanding dollar-denominated loans by using more Lira to acquire the necessary dollars, and with the fact that interest rates, as set by Turkey’s central bank, have risen from 8% to 17.75%. To make matters even worse, the annualized rate of inflation is estimated to be over 100% in Turkey. Needless to say, dollar appreciation versus the Lira is bringing the Turkish economy to its knees.

Enter Donald Trump

Donald Trump, who authored a book entitled “The Art of the Deal,” takes great pride in his negotiating skills. Readers of this book know he highly values leverage in negotiations. As the President of the United States, Trump clearly has enormous leverage to change the global landscape. In the case of trade negotiations, we have seen repeated threats of tariffs against Mexico, Canada, Europe, and China. We believe the goal is to force these countries to renegotiate prior trade treaties or remove tariffs. For Trump, the leverage is the threat, which does the heavy lifting by forcing countries to negotiate or face still retaliatory tariffs or other penalties.

We suspect that Trump may also be using dollar appreciation to force nations, especially emerging markets, to comply with his demands. If you are looking for clues, consider the following Tweet from Donald Trump (8/16/2018): “Money is pouring into our cherished DOLLAR like rarely before.” Based on his bragging it seems Trump has few qualms about the recent strength of the U.S. dollar.

Regardless of the causes of the recent ascent of the U.S. dollar versus most other currencies, there is little doubt that Trump is using the dollar as a negotiating tactic to get what he wants.

There are a few reasons that Trump would manipulate the dollar, verbally or in actuality, to bring Turkey to the negotiating table. While we have no unique insight, the following reasons should be considered:

  • Turkey opposes U.S. sanctions on Iran and vows to ignore them
  • Turkey sits at a strategically important geographic intersection surrounded by Europe and Asia through which much east-to-west international trade passes
  • If in a position to provide Turkey with a bailout, the administration can slow the growing de-dollarization trend

The bottom line is that it is likely that Trump is angling to sway Turkey towards stronger relationships with the U.S. in order to influence its relationship with China, Russia, and Iran. Keep in mind China’s One Belt One Road (OBOR) project, thought of as a new silk road, would provide increased economic competition and harm to America’s economic interests. China relies on Turkey’s participation to complete this project.  As we put the finishing touches on this article, we also learned that Turkey, Iran, and Russia are in talks to schedule a trilateral summit.

Domestic Concerns

There is a healthy debate to be had about whether or not the dollar is being used as a negotiating lever. Since we may never know the answer, we focus on the potential outcomes if it is. If the dollar does strengthen further, how might it affect economic activity and assets?

The following graph, courtesy David Rosenberg at Gluskin Sheff, shows the recent decline of many assets that are sensitive to the value of the U.S. dollar.

Of the assets above, only oil and U.S. homebuilders are having much effect on the U.S. economy or the performance of domestic investments. We think these losses will be broader-based globally and involve the US stock and bond markets if the dollar continues to appreciate. The following are potential domestic issues that could be brought about by further strengthening of the U.S. dollar:

  • Deflation
  • Worsening trade deficit, possibly prompting tougher sanctions and tariffs
  • Reduced corporate earnings
  • Contagion from a banking crisis in emerging markets spreading to domestic banks

When those and other economic headwinds become more evident, it is likely all markets will react. That reaction may move from asset class to asset class sequentially, as we are currently observing, or it may hit all assets at once in a sudden cascade of revaluation.

Summary

As we wrote this article, the U.S. stock market is showing some signs of weakness. Earnings-per-share forecasts for the S&P 500 have risen by 18% this year but the index is up only 6%. This might be an acknowledgment by investors of the international and domestic problems associated with dollar strength, or it may be something else entirely like liquidity constraints. If the market continues to stagnate as the dollar moves higher, we should turn our attention to the Administration for signs of rising concern over the value of the U.S. dollar.

If in fact they do change their stance on the “cherished DOLLAR”, we would take this as a signal that either the domestic pain of a rising dollar has reached its threshold, or Turkey is acquiescing to U.S. demands. If the dollar fails to respond to verbal or direct manipulation, then it would be clear the market has another agenda and our concerns would be much graver.

For additional context on the role of the U.S. dollar in the global economy, we recommend our prior article Triffin Warned Us.

Wicksell’s Elegant Model

“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.” Mickey Mantle

The word discipline has two closely related applications. Discipline may refer to the instruction and nurturing of an individual. It can also carry the connotation of censure or punishment. The purpose of discipline, in either case, is to sustain integrity or aim toward improvement. Although difficult and often painful in the moment, discipline frequently holds long-lasting benefits. Conversely, a person or entity living without discipline is likely following a path of self-destruction.

The same holds true for an economic system. After all, economics is simply the study of the collective decision-making of individuals with regard to their resources. Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses.

In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal. If I can borrow at 2% and there appear to be many investments that will return more than that, I am less likely to put forth the same energy to find the best opportunity. Indeed, at that low cost, I may not even use borrowed money for a productive purpose but rather for a vacation or bigger house, the monetary equivalent of using water to hose off the patio. Less rigor is applied when rates are low, thus raising the likelihood of misallocating capital.

Happy Talk

In November 2010, The Washington Post published an article by then Federal Reserve (Fed) Chairman Ben Bernanke entitled What the Fed did and why: supporting the recovery and sustaining price stability. In the article, Bernanke made a case for expanding on extraordinary policies due to still high unemployment and “too low” inflation. In summary, he stated that “Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

To minimize concerns about the side effects or consequences of these policies he went on, “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated.” In his concluding comments he added, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” During her tenure as Fed Chair, Janet Yellen reiterated those sentiments.

Taken in whole or in part, Bernanke’s comments then and now are both inconsistent and contradictory. Leaving the absurd counterfactuals often invoked aside, if asset purchases were in 2010 “unfamiliar as a tool of monetary policy,” then what was the basis for knowing concerns to be “overstated”? Furthermore, what might be the longer-term effects of the radical conditions under which the economy has been operating since 2009? What was the basis of policy-makers’ arguments that extraordinary policies will not breed unseen instabilities and risks? Finally, there is no argument that the Fed has “the tools to unwind these policies,” there is only the question of what the implications might be when they do.

In the same way that no society, domestic or global, has ever engaged in the kinds of extraordinary monetary policies enacted since the Great Financial Crisis (GFC), neither has any society ever tried to extract itself from them. These truths mandate that the uncertainty about the future path of the U.S. economy is far more acute than advertised.

Even though policy-makers themselves offered no evidence of having humbly and thoroughly thought through the implications of post-GFC policies, there is significant research and analysis from which we can draw to consider their implications apart from the happy talk being offered by those who bear no accountability. Looking back on the past 60+ years and observing the early stages of efforts to “unwind” extraordinary policies offers a clearer lens for assessing these questions and deriving better answers.

The Ghost of Irving Fisher

Irving Fisher is probably best known by passive observers as the economist whose ill-timed declaration that “stock prices have reached a permanently high plateau” came just weeks before the 1929 stock market crash. He remained bullish and was broke within four weeks as the Dow Jones Industrial Average fell by 50%. Likewise, his reputation suffered a similar fate.

Somewhat counter-intuitively, that experience led to one of his most important works, The Debt-Deflation Theory of Great Depressions. In that paper, Fisher argues that overly liberal credit policies encourage Americans to take on too much debt, just as he had done to invest more heavily in stocks. More importantly, however, is the point he makes regarding the relationship between debt, assets and cash flow. He suggests that if a large amount of debt is backed by assets as opposed to cash flow, then a decline in the value of those assets would initiate a deflationary spiral.

Both of those circumstances – too much debt and debt backed by assets as opposed to cash flow – certainly hold true in 2018 much as they did in 2007 and 1929. The re-emergence of this unstable environment has been nurtured by a Federal Reserve that seems to have had it mind all along.

Even though Irving Fisher was proven right in the modern-day GFC, the Fed has ever since been trying to feed the U.S. economy at no cost even though extended periods of cheap money typically carry an expensive price tag. Just because the stock market does not yet reflect negative implications does not mean that there will be no consequences. The basic economic laws of cause and effect have always supported the well-known rule that there is no such thing as a free lunch.

Cheap Money or Expensive Habit?

Interest rates are the price of money, what a lender will receive and what a borrower will pay. To measure whether the price of money is cheap or expensive on a macro level we analyze interest rates on 3-month Treasury Bills deflated by the annualized consumer price index (CPI).  Using data back to 1954, the average real rate on 3-month T-Bills is +0.855% as illustrated by the dotted line on the chart below.

When the real rate falls below 0.20%, 0.65% below the long-term average, we consider that to be far enough away from the average to be improperly low. The shaded areas on the chart denote those periods where the real 3-month T-Bill rate is 0.20% or below.

Of note, there are two significant timeframes when real rates were abnormally low. The first was from 1973 to 1980 and the second is the better part of the last 18 years. The shaded areas indicating abnormally low real interest rates will appear on the charts that follow.

The chart below highlights real GDP growth. The post-war average real growth rate of the U.S. economy has been 3.20%. Based on a seven-year moving average of real economic growth as a proxy for the structural growth rate in the economy, there are two distinct periods of precipitous decline. First from 1968 to 1983 when the 7-year average growth rate fell from 5.4% to 2.4% and then again from 2000 to 2013 when it dropped from 4.1% to 0.9%. Interestingly, and probably not coincidentally, both of these periods align with time frames when U.S. real interest rates were abnormally low.

Revisiting the words of Ben Bernanke, “Easier financial conditions will promote economic growth.” That does not appear to be what has happened in the U.S. economy since his actions to reduce real rates well below zero. Although the 7-year average growth rate has in recent years risen from the 2013 lows, it remains below any point in time since at least 1954.

Similar to GDP growth in periods of low rates, the trend in productivity, shown in the chart below, also deteriorates. This evidence suggests something contrary to the Fed’s claims.

Despite what the central bankers tell us, there is a more convincing argument that cheap money is destructive to the economy and thus the wealth of the nation. This concept no doubt will run counter to what most investors think, so it is time to enlist the work of yet another influential economist.

Wicksell’s Elegant Model

Knut Wicksell was a 19th-century Swedish economist who took an elegantly simple approach to explain the interaction of interest rates and economic cycles. His model states that there are two interest rates in an economy.

First, there is the “natural rate” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working age population and the growth in productivity. The chart of the 7-year moving average of GDP growth above serves as a reasonable proxy for the structural economic growth rate.

Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand. Although it is difficult to measure these terms with precision, they are generally accurate. As John Maynard Keynes once said, “It is better to be roughly right than precisely wrong.”

According to Wicksell, when the market rate is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

If the market rate rises above the natural rate of interest, then no smart businessman would be willing to borrow at 5% to invest in a project with an expected return of only 2%. Furthermore, no wise lender would approve it. In this environment, only those with projects promising higher marginal returns would receive capital. On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

To further refine what Wicksell meant, consider the poor growth rate of the U.S. economy. Despite its longevity, the post-GFC expansion is the weakest recovery on record. As the charts above reflect, the market rate has been below the natural rate of the economy for most of the time since 2001. Wicksell’s theory explains that healthy, organic growth in an economy transpires when only those who are deserving of capital obtain it. In other words, those who can invest and achieve a return on capital higher than that of the natural rate have access to it. If undeserving investors gain access to capital, then those who most deserve it are crowded out. This is the misallocation of capital between those who deserve it and put it to productive uses and those who do not. The result is that the structural growth rate of the economy will decline because capital is not efficiently distributed and employed for highest and best use.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Summary

As central bankers continue to espouse policies leading to market rates well-below the natural rate, then, contrary to their claims, structural economic growth will fail to accelerate and will actually continue to contract. The irony is that the experimental policies, such as those prescribed by Bernanke and Yellen, are complicit in constraining the growth the economy desperately needs. As growth languishes, central bankers are likely to keep interest rates too low which will itself lead to still lower structural growth rates. Eventually, and almost mercifully, structural growth will fall below zero. The misallocated capital in the system will lead to defaults by those who should never have been allocated capital in the first place. The magnitude and trauma of the ensuing financial crisis will be determined by the length of time it takes for the economy to finally reach that flashpoint.

As discussed in the introduction, intentionally low-interest rates as directed by the Fed is reflective of negligent monetary policy which encourages the sub-optimal use of debt. Given the longevity of this neglect, the activities of the market have developed a muscle memory response to low rates. Adjusting to a new environment, one that imposes discipline through higher rates will logically be an agonizing process. Although painful, the U.S. economy is resilient enough to recover. The bigger question is do we have Volcker-esque leadership that is willing to impose the proper discipline as opposed to continuing down a path of self-destruction? In the words of Warren Buffett, chains of habit are too light to be felt until they are too heavy to be broken.