Are Markets Dreading The Fed's Exit Strategy?

Earlier this week, Jonnelle Marte and Karen Brettell of Reuters reported the Fed is focused on a repo market exit strategy after avoiding year-end crunch:

Wall Street’s worst fears of a year-end funding squeeze never materialized thanks in large part to the quarter-trillion dollars the Federal Reserve stuffed into the market to ensure nothing became gummed up.

The question now, though, is what it will take for the U.S. central bank to withdraw from its daily liquidity operations in the $2.2 trillion market for repurchase agreements, or repos - after it became a dominant player in a short three months.

“The repo operations are a band-aid, but the wound isn’t healed fully,” said Gennadiy Goldberg, an interest rate strategist at TD Securities.

The New York Fed began injecting billions of dollars of liquidity into the repo market in mid-September, when a confluence of events sent the cost of overnight loans as high as 10%, more than four times the Fed’s rate at the time. A month later, the Fed moved to expand its balance sheet - and boost the level of reserves - by snapping up $60 billion a month in U.S. Treasury bills.

The Fed will continue pumping tens of billions a day into the repo market through at least the end of January. Its ability to exit from the repo market after that time will depend on how long it takes the central bank to make the balance sheet large enough so there are adequate reserves in the banking system - and the repo operations are no longer needed.

“It seems implausible to me that the Fed will be able to stop their repo operations by the end of January,” said Mark Cabana, head of U.S. rates strategy at Bank of America Merrill Lynch.

Minutes from the Fed’s December policy meeting released on Friday showed its staffers expected repo operations to be “gradually” reduced after mid-January. However, staff members also said the central bank may need to continue offering some repo operations until at least April, when tax payments could reduce the level of reserves.

Another challenge for Fed officials: Deciding just how big the central bank’s balance sheet, which is currently about $4 trillion, should be.

“There are people at the Fed who have a preference for the smallest possible balance sheet, and we just don’t know how much their views have evolved,” said Lou Crandall, chief economist at Wrightson ICAP, a research firm.

Fed policymakers have said they will continue purchasing Treasury bills into the second quarter of 2020 with the goal of bringing reserves back above the level seen in mid-September, when they fell below $1.5 trillion.

Bringing reserves to $1.7 trillion would provide a cushion of about $200 billion to absorb shocks during periods of tight liquidity, said Joseph Abate, a short rate strategist for Barclays. Holding up to $2 trillion in reserves could offer a bigger cushion and reduce the likelihood of volatility in short-term borrowing markets, depending on what the demand is for reserves, he said.

‘LONG-TERM CONVERSATIONS’

Some financial firms are urging the Fed to stay involved permanently through a standing repo facility, which would allow firms to trade Treasury holdings for cash. But Fed officials are still working out the details and plan to keep discussing the issue at future meetings, the minutes from Friday showed.

Richmond Fed President Thomas Barkin said on Friday that in addition to a standing repo facility, long-term fixes for providing more liquidity in money markets could include adjusting liquidity regulations and setting restrictions on other programs that can affect reserves, such as the foreign repo pool.

“All those are legitimate long-term conversations to have now that we’re through the short term,” Barkin told reporters after a speech to the Maryland Bankers Association in Baltimore.

In the meantime, Fed officials could make changes to the repo offerings to help wean markets off the temporary support. Officials could reduce the frequency or the size of the repo offerings after January and bring them back during times of expected stress, Abate said.

One issue is that the Fed is allowing dealers to borrow cash at a cheaper rate than is available from other market participants, which discourages firms from borrowing in the private market they used before the Fed began to intervene, Goldberg said.

Figuring out the right structure could take some time. “What they want to do is incentivize the market to go to fellow market participants first and the Fed second, and I don’t think we’re there yet,” Goldberg said.

It's Friday and I just finished watching DoubleLine's first annual “Round Table Prime” which I embedded below at the end of this comment.

It's an excellent discussion which is a must watch for all investors, especially those of you who like me, love macro and markets.

Anyway, I've been thinking a lot lately about the Fed's exit strategy. Why? Because of the insanity we are witnessing in the markets. Stocks keep making record highs and high yield bond spreads are at record lows.

The mantra is very simple: as long as the Fed's got our back, keep taking risk, lots and lots of risk!

Problem with that strategy is it works until one day markets reverse course and only after will you find out the Fed is taking away the punch bowl.

I've been looking at the chart below, it's basically the Fed's total balance sheet, courtesy of the St-Louis Federal Reserve's FRED site:

Obviously, the big uptick came back in 2008 when the world was ending and then Fed Chair Ben Bernanke took out the big bazookas to restore faith in markets.

The Fed discovered QE can be a powerful tool to ease market tensions (more like rediscovered it as it engaged in it after the Great Depression which Bernanke was a student of).

The Fed started pumping massive liquidity into the market last September when the repo crisis threatened banks going into year-end:

Market concerns focused on a cash crunch stemming from Treasury settlements, as well as big banks concerned about meeting end-of-year capital requirements being reluctant to provide funding to institutions that need it.

To address the issues, the Fed has conducted daily operations thus far totaling more than $234 billion to dampen market volatility and keep the central bank’s overnight funds level, which is used as a benchmark for multiple other short-term interest rates, within a range of 1.5%-1.75%.

On Monday alone (December 30), the Fed injected another $18.65 billion for a two-day repo operation — exchanging high-quality capital for cash — and $30.8 billion in a one-day offering. However, both issues were undersubscribed, having offered $75 billion and $35 billion, respectively. That means there was less demand and thus lower funding pressures.

While there’s still one trading day left in the year, it appears that the Fed will close 2019 in control of the banking industry’s vital plumbing system.

So, the Fed averted a crisis by stuffing the banks full of cash and what did the banks do with all that liquidity? What else? They started taking risks in markets and having a jolly old time in their treasury operations.

Remember what banks love the most: money for nothing and risk for free (backstopped by the Fed, of course).

I know, my friends will tell me that banks are heavily regulated now and they can't take risks like they used to but I say "bullocks!".

There is another reason why the Fed started stuffing big banks with a massive infusion of capital starting in mid-September. We had just come off Quant Quake 2.0 and a lot of high octane quantitative hedge funds were reeling, and they're the big clients of the big banks providing them with big fees.

So, in one fell swoop, the Fed averted a repo crisis and a potential run on many big quant hedge funds which were suffering massive losses at the end of September.

That's all fine and dandy but now we are January 2020, markets keep roaring higher, investors are getting very nervous and everyone is wondering what I'm wondering: What is the Fed's exit strategy?

Never mind what the claptraps on CNBC are telling you about earnings surprising us to the upside, I'm telling you, you'd better keep a very close eye on the Fed's balance sheet because when it reverts, these markets are in for a whole lot of pain.

My friend Martin Roberge of Cannacord Genuity sent me his weekly Portfolio Incubator and I note the following:

Our focus this week is on the eerie resemblance between the current environment and the rapid advance in US equities in the second half of 2017, up until early in 2018 (see our Chart of the Week below). Back then, equity markets were cheering the US fiscal boost and strengthening global growth prospects. This time around, we believe trade optimism and Fed liquidity injections are supporting the advance. The end result is the same: a fear of missing out on further gains in the stock market. But the market buying frenzy eventually hit a climax by the end of January 2018. Growing fears of a trade war with China and expectations that the Fed would hike rates at a rapid pace eventually spooked markets. Interestingly, the market is trading at similar valuation multiples compared to levels prevailing near the 2018 market peak. However, the earnings backdrop is much less supportive, as equity analysts are cutting estimates (third panel). That said, currently, the tape is bullish. Investors should simply acknowledge that fact but stand ready to de-risk rapidly on any change in sentiment.

Martin appropriately called his weekly market wrap-up "All-In!" and there's no question equity investors are all-in as investors succumb to FOMO (fear of missing out) and TINA (there is no alternative..to stocks!).

But US stocks ended down on Friday, reversing back from all-time highs, as investors digested weaker-than-expected jobs data to end a volatile week full of geopolitical concerns.

As I stated last week, what's really spooking markets is a US slowdown and the prospect that the Fed will stop its liquidity injections or reverse course.

And it's not just the Fed. Jim Bianco of Bianco Research just posted a great comment on Bloomberg on why he thinks central banks are the biggest risk to the economy in 2020. The chart below he posted speaks for itself:

It's quite evident central banks are trying to fight the specter of global deflation by creating asset inflation but it's a dangerous strategy that could backfire in a spectacular way and wreak more havoc down the road.

One thing I've been grappling with is the Fed, the dollar and inflation. In my Outlook 2020, I stated the Fed can't influence inflation expectations, only create more asset inflation through its QE operations (and that's what this is QE even if they're not calling it that).

But more QE has weakened the US dollar somewhat (not a lot) and the dollar channel is extremely important because as the greenback weakens, import prices rise and inflation goes up.

However, the relative strength of the dollar over the last year means US import prices will fall in the months ahead and inflation pressures will ease.

All this to say, I'm not sure when or how the Fed will exit these markets because if it does it too soon and too abruptly, the greenback will resume its uptrend and markets will tank, both of which are deflationary.

In theory, there's no limit to how high the Fed's balance sheet can go (as a percentage of GDP). In practice, more QE having incremental effects on markets and inflation expectations is dangerous because it could create a crisis of confidence in the Fed and other central banks, and that will have major negative repercussions.

We're obviously nowhere near this point but keep all this in mind as you ponder the Fed's exit strategy and your asset allocation.

Below, DoubleLine’s Jeffrey Gundlach hosts the first annual “Round Table Prime” featuring today’s Financial Market Thought Leaders who will weigh in on the economy, central bank policy, global yields, stock markets, opportunities and best investment ideas for 2020. Featured guests include: Jeffrey Gundlach - DoubleLine, Steven Romick - First Pacific Advisors, Danielle DiMartino Booth - Quill Intelligence, James Bianco - Bianco Research, Edward Hyman - Evercore & David Rosenberg, Rosenberg Research.

Take out a notebook and take an hour of your time to listen carefully to this discussion, it's excellent, especially the last 30 minutes. I'm more bond bullish than Gundlach and think Rosenberg is spot on in his inflation forecast but there's a lot more to cover so take the time to watch this.

And Tom Lee, Fundstrat head of research, joins 'Fast Money Halftime Report' to discuss the Dow hitting 29K and what's driving the rally. Like I said above, beware of claptraps on CNBC, this isn't a valuations story, it's a Fed liquidity driven story.