U.S. Repo, the Fed, Coronavirus, and Global Demand/Supply Shocks

On March 2nd, I discussed the growing impact of the coronavirus infection's on the stock market and the Federal Reserve monetary policy counseling waiting for more data or a modest 25 basis points cut at the March 17-18 FOMC meeting, only to be immediately frustrated with the quickness of changing information when, on March 3rd, the Fed, after an emergency FOMC telephone conference, cut the Federal Funds Rate 50 basis points.

As I pointed out on March 3, the market noise of March 2nd when the Dow went down 5.09% on significantly lower volume was not the cause (the stock market is noise and not of data interest to the Fed) and I pointed to the repo spike on the morning of March 3rd of the one day U.S. Repo to $108.608 billion which was $8.608 billion more than the $100 billion Fed cap on one day repo.  On 2/28 U.S. Repo was only $26.240 billion and on 3/2 it doubled to $53.140.  On 3/4 the submitted amount was $111.478 leaving $11.478 billion not accepted over the $100 billion Fed cap.  3/5 went down to $87.357 billion; 3/6 was $89.607 billion; and 3/9 was $112.932 billion, all of which was accepted because the Fed raised their cap to $150 billion through 3/12.  In comparison the significant 2019 repo market stress, which was very disruptive, began on September 17, 2019 at $53.150 billion and never went over $90 billion on any one day through November, 2019.

The 14 day repo has been capped at $20 billion and on 3/3 $50.950 billion was not accepted and on 3/5 $52.550 billion was not accepted, but on 3/9 the Fed raised the cap to only $45 billion through 3/12.

You can find recent repo operations here and you can do an historical search here.

The Fed announcement and news conference was fairly uninformative stressing only evolving risks and the Fed's intention to act as necessary.  Tim Duy, who had correctly called the 50 basis points cut, correctly notes the market will not be satisfied, but believes early action by the Fed will help short circuit recessionary dynamics and allow the Fed to squeeze through without returning to the zero bound.  However, Stephen Williamson expressed concern, as I did on March 4, that the potential gains of the Fed cut were too small and the potential costs too large and the Fed should have waited for more data or cut less aggressively. Both economists indicate that fiscal stimulus from the Federal government is needed as the Fed cannot do it alone though monetary policy.

Williamson is also not supportive of the Fed continuing to buy $60 billion in treasuries each month if the market is seeking safe assets and the Fed could sell treasuries exchanging treasuries for cash in its assets and reserves. However, the Federal Reserve has a model of a supply of ample reserves in the implementation of monetary policy.

The Peterson Institute has published two papers recently on Central Banks ability to fight recession and a program for the Fed to fight the next recession which indicates " Traditionally, the Fed has responded to economic downturns by cutting the federal funds rate. But if it continues in the traditional manner, without making any decisive changes to the way it conducts monetary policy, it will have less scope than it should have to counter the effects of the next recession"  The Peterson program is concerned about Effective Lower Bound problems and emphasizes monetary policy at lower Federal Funds Rate necessitating QE.

The Federal Reserve is analyzing the 2019 repo market stress has focused on the confluence of several technical factors and transactions leasing to a decrease in the reserves of the Federal Reserve.
On the other hand, the BIS not only acknowledges the confluence of factors and transactions but notes the four largest U.S. banks, which are heavily involved in overnight repo operations, had bulked up on U. S. Treasuries leaving smaller reserves for lending while money markets have increased risky lending to hedge funds which use repurchase (repo) agreement to fund arbitrage trades.  When the stock market is volatile, hedge funds have more need for repo.

When you consider the continuing global economic demand shock impact from the Trade War and the continuing volatility in equity, bond, and treasury markets there is a lot of pressure for an economic downturn.  The Saudi-Russia oil dispute and plummeting oil prices, the decline in the U.S. ten year treasury to .318% in 3/8-9 overnight trading but ending at .54% on 3/9, and the stock market volatility continuing with the Dow down 7.82% on 3/9 and 3/10 Dow futures up over 1000 points, as I write, all contribute to a growing possibility of not only a demand shock but also a supply shock.  Supply shocks demand governmental fiscal stimulus, but will the government respond strongly and quickly enough?

Without the fiscal stimulus, recession becomes more probable.  According to a recent MIT study which devised an historically back tested new model for predicting the likelihood of recessions, the was a 70% chance for a recession in the six months following November 2019 and 86% for the 12 moths after November 2019.  The six month period would be May/June 2020.

The MIT paper has yet to be proven in reliable in evolving current data, but the equity, bond, and treasury markets continuing volatility and evolving demand and possible supply shocks, means we should be on recession watch  (a recession requires two quarters of negative growth and 1st Quarter 2020 looks like +.7% but March could change that).

Keep your eye on the daily U.S. repo operations.  If it keeps moving up, much less continuing at the high submissions seen this March, you will probably see another Federal Funds Rate cut at the March 17-18 meeting --- maybe sooner.  The Fed needs to maintain liquidity and has demonstrated with the 50 basis points cut it is ready to act strongly.  The market wants a 75 basis points cut, but the market is noise (not data driven but reactive to data) and, like a two year old child, is never satisfied (want want want).  Some economists want a 1% cut or cut to zero, but such a preemptive strike is, in my opinion, very risky;  I want to the Fed waiting for the data and saving ammunition to deploy if a recession appears more likely as the risks evolve in the current demand and possible supply shocks.


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