I vividly remember the 2008 sub-prime crisis. The size of the leverage was daunting. I thought the sub-prime mess, with its layers of sliced and diced tranches of debt structures, would shake out badly. I had no idea it would nearly bring down the global financial system.

So when I look at this repo problem, which I don’t fully have my head around, I can’t help but think it may be a Bear Stearns hedge fund-like crack in the dam—an early warning. For now the Fed has its finger plugging the leak, but they are finding that it’s not a real fix.

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system.

At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

 

REPO

“Repo” is short for repurchase agreement. A repurchase agreement is essentially a short-term loan. Imagine you are a bank and you have clients who need to make payroll, but you don’t have enough cash on hand to cover the withdrawal. So you pledge a portion of your holdings (typically government securities) via a repurchase agreement with another bank. Bank B loans you the cash, you pledge your collateral, and you pay Bank B back tomorrow with interest. Bank B makes a little more money on the loan, picking up the yield on the government security and the interest you paid them.

Repos are typically used to raise short-term capital. It’s a short-term loan; you need cash, so you pledge collateral to me and agree to pay me back tomorrow with interest. Some repos can be for 48 hours, but most are overnight. The implicit interest rate on these agreements is known as the repo rate, a proxy for the overnight risk-free rate. Repurchase agreements are generally considered safe investments since most agreements involve U.S. Treasury bonds posted as collateral. Repos are classified as a money market instrument. They are also a common tool of central bank open market operations.

Like prime rates, repo rates are set by central banks. The repo rate system allows governments to control the money supply within economies by increasing or decreasing available funds. A decrease in repo rates encourages banks to sell securities back to the government in return for cash. This increases the money supply available to the general economy. Conversely, by increasing repo rates, central banks can effectively decrease the money supply by discouraging banks from reselling these securities.

 

The Fed

Why did rates spike from 2% to 10% in September? Why did the liquidity disappear? The simple answer is that there are not enough lenders willing to lend. The Fed has stepped in to put a Band-Aid on the problem, but the problem remains. They’ve now injected over $320 billion, and some estimate it will be over $500 billion by the month’s end.

Opinion columnist and chief economic adviser at Allianz SE Mohamed A. El-Erian said Monday on Bloomberg TV, “It hasn’t proven to be temporary. It hasn’t proved to be reversible without massive injections of liquidity. Which means that structural issues are playing a role.”

The bigger picture concerns me: The central banks may be losing control of the economy with their ability to manipulate short-term rates. Rates sit near zero percent and $12 trillion is yielding less than zero in much of the developed world. What time bomb may be triggered if rates spike higher? Can the central banks control the economy? A lot of the time, yes. All of the time, no. We sit late stage in one of the greatest central bank experiments of all time. As Martin Armstrong said in a recent blog, “The biggest danger we face is waking up to the realization that central banks can no longer control the economy. Once that is understood in the market place, the fun and games will begin.”

The graph below shows the 10x surge in repo during late 1999 and its quick removal shortly after the New Year. Note the recent surge, on the right side of the graph, dwarfs the 1999 experience and that is before an expected $500 billion spike in repo financing over the next week or two.

 

 

Unlike 1999, we have our doubts as to how quickly the graph normalizes, as the Fed continues to underestimate the scope of the growing overnight funding issues.

 

Cracks In The Bull Market Armor
  1. We are in the latter stages of the bull market.
  2. Economic data continues to remain weak
  3. Earnings are beating continually reduced estimates
  4. Volume is weak
  5. Longer-term technical underpinnings are weakening and extremely stretched.
  6. Complacency is extremely high
  7. Share buybacks are slowing

 

Definitions of Market Tops and Market Bottoms

Some good advice to keep parked in the back of your mind:

  • Market tops = high complacency, all news is good news, and negative market divergences appear.
  • Market bottoms = panic, high volatility, all news is bad and positive market divergences

 

Market Valuation

The S&P CAPE ratio has risen above 30 only three times in history.

 

 

Investment bank Goldman Sachs (GS) said last week that the S&P 500 hasn’t had a 20% correction in 10.7 years – the longest stretch in 120 years. And economist John Hussman recently noted that U.S. stocks are even more expensive than they were at the 1929 peak.

Other valuation measures also appear to be elevated.

 

 

US China Trade Deal, Phase 1

The “Phase 1” US-China trade deal eases the tariff burden, for now, but doesn’t fix the core issues. It also won’t stop further escalation in the two countries’ technology war. Uncertainty will probably return, possibly soon.

Key Points:

  • The deal defers some tariffs but doesn’t touch others, and also leaves open the possibility of further hikes.
  • Adding to confusion, China claims there is a formula for additional tariff reductions. US officials deny this.
  • High tariffs are here to stay. This deal reduces but doesn’t eliminate policy uncertainty.
  • Combined with the successful US campaign to paralyze WTO dispute resolution, there is now no effective check on US ability to engage in unilateral trade action.
  • The agricultural export commitments probably can’t be met, but no one will know because the detailed product lists will be kept secret.
  • Other structural reforms were mostly banked earlier this year. There is no evidence so far this new deal advances the ball.
  • Beijing still has plenty of room to subsidize domestic companies and hamstring foreign competitors.
  • Even with a trade deal, the US will almost certainly escalate its technology offensive.
  • Attempts to cut off China from Western technology will further encourage Beijing to develop domestic substitutes.
  • If trade frictions rise again, as seems likely, a weaker Renminbi will be an early result.

 

Bottom Line:

The purchase commitments in this deal resemble the “managed trade” that the US practiced with Japan in the late 1980s. It might not be disastrous, but it also won’t solve our real trade problems. Resolution on those now seems pushed out to 2021, at best. Also, Economists question the US’ ability to ramp up exports to China to the levels that are in the “interim” deal. China (supposedly) agreed to buy $200 billion of US goods over the next two years above what it imported in 2017.  This seems implausible.

The rollback of tariffs do not immediately undo the damage which has already occurred.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • The “repo” market is suggesting that something is “broken.”
  • All of which is leading to rising recession risk.

According to corporate filings, Chinese companies don’t lose money. This data quality issue is one of the reasons many foreign investors remain cautious on Chinese shares.

 

 

 

Good News for the Markets
  • Markit’s composite employment index (manufacturing + services) rebounded sharply.

 

 

  • The NAHB homebuilder optimism index hit a multi-year high.
  • Copper continues to rip higher.
  • US industrial production rebounded last month as the GM strike ended.

 

Bad News for the Markets
  • US credit card delinquencies are grinding higher.
  • Goldman Sachs predicts that the continued decline in stock buybacks could cause stock-market turmoil in the new year. Stock buybacks declined 15% to $710 billion this year, according to a Goldman estimate. The firm expects another 5% drop in 2020, but a bigger decline could cause trouble.
  • Another survey of Wall Street strategists shows that even more of them are lukewarm on the prospects for stocks in 2020. Their average guess is for the S&P to gain a lowly 4%, their smallest estimate in 13 years.
  • Boeing’s troubles will be a drag on economic growth.
  • US retail sales surprised to the downside. Consumer spending momentum seems to be slowing.
  • Wholesalers’ inventories-to-sales ratio remains elevated.
  • Contractors in commercial real estate construction have become less upbeat on next year’s business opportunities.
  • GDP expectations are coming down.

 

 

  • Bank lending is weakening

 

 

Market Data
  • In the Rydex family of mutual funds, traders have positioned themselves in perhaps the most aggressive way ever. Ratios of assets in bullish versus bearish funds, including those using leverage, are at or near all-time highs, while the percentage of cash held in the money market fund just hit an all-time low.
  • A survey of sentiment among home builders recently neared an all-time high as they think it’s a great time to build. At the same time, the consumers who actually buy the houses think it’s a poor time to buy.
  • Commodities have finally been holding up well, and the CRB Index just enjoyed a Golden Cross as its 50-day average crossed above its 200-day average.
  • A year ago, the “dumb money” was the most bearish in 20 years. Now, a year later, they’re the 2nd-most optimistic, barely eclipsed by a few days in April 2010.
  • Positioning in the options market suggests that even a little further upside could trigger heavy sell orders. Relative to average volume levels, this Gamma Exposure is at a record level.

 

Interesting

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