For a while now, the Fed funds effective rate has pushed up against the upper bound of the Fed funds target rate. If not for the Fed, short term rates would have risen above the target range. We see this pressure in repo rates, not just this week but for some months now, where repo is pushing above IOER. This week, just before the FOMC met to cut rates (by 25 bps), overnight repo traded up to 10% prompting remedial action by the Fed to provide liquidity. An initial injection of 53 billion USD was followed by 75 billion USD and is going to be increased to 80 billion USD tonight. Repo is settling down, the markets have been calmed, pundits assure us that this is not a prelude to a 2008 type credit crisis. And they are probably right. 2008 was a credit squeeze in the mortgage market, transmitted by the banking system into full blown panic endemic to fractional reserve systems. This time is different. Slightly. 

Corporate credit has increased significantly in the last decade. The corporate bond market has increased 3 fold, the leveraged loan market doubled. But generally, corporate balance sheet leverage is manageable because earnings have grown. Household balance sheets are the least stretched as banks rationed credit to meet new regulatory standards. The increase in leverage has occurred on sovereign balance sheets. Aggressive tax cuts have increased the national debt and resulted in increased treasury issuance. 

At the same time, the Fed has, since early 2018, begun to shrink its balance sheet gradually. But just as the implications of QE were not well understood as it was being phased in, the consequences as it was being phased back, are also not well understood. We are seeing some of its effects now. 

The market experts are probably right that the repo surge is probably nothing to worry about, but they are illuminating. A number of factors contributed to the repo surge. The FOMC was to meet on Wednesday and announce a rate cut on Thursday. This was widely expected but the concern was that the Fed would send a signal that was insufficiently dovish and could cause a back up in rates. We saw this earlier in the month with the ECB when its 0.1% rate cut and resumption of bond purchases at 20 billion EUR a month was deemed insufficient, or ineffective, and rates backed up aggressively. The reduction in the Fed’s balance sheet over the past year, coupled with increased capital requirements for the banks, led to a shortage of reserves to deploy in the repo market. September 15 is the quarterly deadline for payment of taxes. The treasury issuance calendar has also been full, financing the increasing national debt. 

We now have a hypothesis for why the yield curve had inverted earlier this year. The shortage of reserves led to a liquidity squeeze in the money market resulting in rising short term rates. The Fed owns just under a third of the mid section of the yield curve and under two thirds of the long end. The roll back of balance sheet led to a demand and supply imbalance that lifted the short end and the long end, leaving the belly fairly balanced. The result was a curve inversion up to 10 years, and a normal curve out to 30. 

So we have a theory for how the curve got this way and it has nothing to do with growth expectations. But an inverted curve induces recession as banks borrow at the short end to lend at longer maturities. Maintaining positive margins means that the bank credit market fails to clear. The result is a shortage of credit for SMEs. Large caps have access to the bond market and continue to fund more or less as usual. Quality bank credit assets that can be securitized are also taken out of the equation. That means that the causality between curve inversion and recession is diluted but not completely mitigated. Curve inversion causes credit rationing. 

The Fed needs to cut rates or restore some QE. From an economic perspective, data do not support further rate cuts or bond purchases. Further accommodation may exacerbate valuations and prolong a credit expansion cycle that is in need of decompression. However, the financial system may not be robust against balance sheet reduction. 

I don’t know if this is the justification for President Trump’s encouragement of deeper rate cuts, but the Fed needs to resume QE if it wants to cut rates. This raises a couple of questions. Is QE trap? Is it a policy which once embarked upon cannot be exited without inducing recessionary conditions? 

Since the ECB announced a rate cut of 0.1% taking the desposit facility rate to -0.50% and a resumption of bond purchases at a rate of 20 billion EUR per month, the 10 year bund yield has predictably moved from -0.71% to -0.45%, a 0.26% rise, substantial when yields are that low.

The ECB’s move was not as big as the market had hoped for, and yet, it is not clear what the market could have hoped for. Negative rates had not worked for Europe since the ECB cut rates below zero in 2014 and then reduced it further in 2016.

If QE had significant impact on Eurozone growth, it took 2 years to take work, and its effectiveness quickly faded. It seemed from the data that ever increasing amounts of bond purchases would be required to maintain growth, not even accelerate it. Eurozone QE began in early 2015 and Eurozone economic activity sagged in 2016 before picking up in 2017. As QE slowed in 2018, manufacturing has slowed significantly from early 2018 to date (September 2019).

Some of Europe’s problems are specific. While China and the US girded for trade war, Europe has remained trade focused. Its economy is highly reliant on trade with imports and exports representing over 80% of GDP. China’s metric is just over 35% while the America’s is just over 26%.

The EUR has tracked economic growth closely ceteris paribus. The weakness in 2014 was probably due to dollar strength as the US tapered its QE. The impact of European QE supported the economy and the EUR for a while, before growth carried the EUR higher throughout 2017 and Q1 2018. Since then it has been weak.

The Fed meets 18 September and is widely expected to cut rates by 25 basis points. The futures market implies that the probability of a rate cut is 98%. The Fed is in a difficult position. It has already once caved to market and Presidential demands for a rate cut and it may cave once again. The jobs market is tight and earnings are stable. If there are signs of weakness, they lie in PMIs which represent the sentiment amongst purchasing managers, surely dented by the President’s trade war. President Trump wants two things, among others; a trade war with China and rate cuts from his Fed. He is likely to get the second as a consequence of the first.

But other things are evolving. Despite such strong odds for a rate cut, the 10 year treasury yield has risen 44 basis points to 1.9% in the space of two weeks. Inflation has perked up, core CPI rising from 2% in May to 2.4% in August. Disruptions to Saudi oil supply has caused a 10% overnight surge in oil prices. If supply cannot be restored quickly or Yemen makes further successful attacks on Saudi petroleum assets, inflation could be headed higher. But these are mere exogenous shocks to inflation.

Republican Presidencies usually coincide with rising budget deficits and the national debt. The Trump Presidency has seen the deficit rise from 3.1% of GDP to 4.4% of GDP. There seems to be a greater acceptance that fiscal policy will be engaged to address the next downturn. Even in Europe where the Maastricht conditions provide formal guidelines on government debt to be broken, the sentiment towards fiscal rectitude seems to have relaxed. If there is a significant secular change to attitudes it is surely towards engaging fiscal policy. And if the world turns on the fiscal taps, the probability of steeper term structures, and rising inflation, is higher.

Bond markets may not be prepared for this. So far, the narrative is that duration is the safe harbour from credit and equity risk. this will be tested if inflation rises and if a trend towards steepening term structures begins.

If inflation and higher long term rates is the price we have to pay for growth, it will be important what our deficits go to finance. There are two main paths, trickle down economics or wealth transfers through more progressive taxation. If the behaviour of humans over centuries is a guide, we must expect self interest to dominate and trickle down economics to be the chosen route. The fiscal accommodation will work but its effectiveness will be blunted. That means that the price we pay for growth will be very high. If a more progressive tax and spend policy is pursued to effect wealth transfer from rich to poor, the redistribution alone will boost growth, and the deficits will add to it. The price we pay for growth will be lower. But because it will be borne more by the rich and influential, the likelihood of this is lower.

What might change the calculus above is if societal change occurs alongside.

I’ve been of the view, like so many other investors, that the would be dovish and a) launch LTRO early, b) cut rates, and c) do some form of QE (the market thinks outright QE, I thought unconstrained LTRO.)

This view has led me to be long EUR duration from Bunds to Italian and Portuguese treasuries. I have also been long Euro IG credit duration due to the steepness of the credit term structure. This was a over a year ago. It has been a good trade.

The past month has seen in acceleration in these trades. My view, however, has now changed. The European economy has been weak, victim in no small part, of the trade war raging between America and the rest of the world. Economic data suggests the ECB has to be dovish and increase its reflationary efforts. The TLTRO and LTRO calls are based on the details of what the ECB can or cannot do. QE is needed once again but the dearth of German ISINs and the need to buy more peripheral debt is constrained by teh ECB’s need to buy pro rata to its capital key. Repo operations allow the ECB to facilitate private commercial banks to do the buying on its behalf, without these inconvenient limitations.

The risk to the trade has always been political. The end of the Draghi term at the end of this October and the beginning of Lagarde’s leadership of the ECB is a risk.

Christine Lagarde is a consensus builder and communicator. She leans towards dovishness but is likely to be a moderator rather than a leader of the ECB’s policy committee.

On September 4, Lagarde called for European governments to do more in fiscal policy to boost Eurozone growth. While Lagarde is a supporter of monetary accommodation, it was a signal that she at least is listening to the views of the hawks, or that she thinks that further monetary accommodation will have limited impact with rates already through the zero floor. I expect that Draghi may announce another round of QE but a moderate one, (not more than 25 billion EUR of net purchases a month,), disappointing the market’s expectations of further blank check accommodation, or he may simply do nothing but talk, and hand the baton to Lagarde. Lagarde’s September 4 statement is a signal that she will be more circumspect and may demand that member states’ treasuries pick up the slack instead of leaving it to monetary policy.

If so, the impact on rates markets will be negative. Expect curves to steepen and rates to back up.

Inequality has reached acutely high levels. There are certain drawbacks.

1. An important impact of inequality is that the capital and resource allocation decisions are concentrated in the hands of the few. The efficiency of this capitalist, free market, economy, tends to the efficiency of the centrally planned (for example, Soviet) economy.
2. A related theme is that the consumption patterns of the population are distorted by the heavily skewed wealth and income distribution. The needs of the few outweigh the needs of the many.
3. Economic models based on aggregates or averages lose their explanatory and predictive power. Simple adjustments for skew fail to capture the dynamics of income and wealth disparity. Policy designed based on such models obtain unintended outcomes.
4. Inequality results in over saving, which results in a insufficient demand for goods and excess demand for assets.
5. Inequality suppresses interest rates which makes land and capital cheaper and therefore overemployed in production. Labour is forced to compete by restraining wage growth. This is a self-reinforcing feedback loop.
6. A redistribution of wealth from rich to poor would increase the velocity of money and spur economic growth. This is unpopular as it disadvantages the rich and influential and is unlikely to be implemented in a continuous fashion.

I don’t know how yield curves get inverted but when they do, recessions tend to follow after. Why? Banks borrow short term and lend longer term and an inverted curve means that the bank credit market fails to clear. It results in a credit shortage which chokes off growth.

We will still get our recession, but not for reasons of an inverted curve. Not this time.

The corporate bond market is 3 times larger than it was ten years ago. Big companies don’t fund via the banks. The squeeze will be felt by small and mid caps who cannot access the bond market, and households. However, quality consumer loans that get securitized will also escape the credit crunch to some extent as banks lend, warehouse and syndicate.

The curve inversion recession couple will be weaker this time. And yet we will get our recession and this data point will be a spurious one for the history books. All dynamic systems exhibit cyclicality and while policy and central banks have distorted the frequency and phase of the cycle they cannot prevent it altogether. The trade war will raise underlying inflation levels and weaken growth. But mostly, while QE supported growth it also exacerbated income and wealth inequality by rewarding asset owners over labour. Concentration of capital leads to inefficient allocation contributing to eventual decline. We will get our recession but its not the curve.