September 7, 2016

The Blue Whale

Last week US jobs were weak and the market welcomed the news.   

We tend to laugh or snort when stocks do the opposite of what they should. But if the market is powered by an economy that’s weaker than expected, why should it rise?

And if you’re an investor-relations professional or in the investment business, you need to understand these outcomes even if you’d prefer to go to the dentist for molar removal.

“It’s the Fed,” you say, rubbing your jaw. 

All right, it’s the Federal Reserve.  What does that mean?

“I’m not sure,” you say.

“What do you think it means?”

“That when The Fed raises rates the economy is better and borrowing will cost more.”

Stop. What?

Study the data pouring forth from the government and the private sector and you’ll see that when you’re doing better, borrowing costs…wait for it…LESS.  

Yes, a strong credit score – a good personal economy – means you pay less to borrow than those with weak personal economies.  Miss a payment and the rate slams UP.

“Yeah, but what the Fed was trying to do was get people to spend,” you explain. “They keep rates low to juice the economy with consumption, and when it starts to overheat and there’s too much borrowing, then they slow it down by raising rates.” 

Okay. I follow that.  But why is it a good idea to get people to spend if borrowing too much money is what created the financial crisis?  And where’s the growth by the way?

“Look,” you say.  “I’ve got a dental appointment I need to get to.” 

The Fed has got everyone thinking it’s the Millennium Falcon in Star Wars and the economic data are TIE Fighters to line up in the sights and then…boom!  We hike rates. 

That’s as absurd as fueling economic recovery with a seven-year teaser rate prompting people to borrow and spend.

Forget that. Here’s the real dilemma for the Fed. Last Thursday before the jobs data the Fed’s balance sheet shrank to the smallest level since I believe Oct 9, 2014 when it was $4.496 trillion.  It was $4.503 trillion, down about $20 billion week over week.  And Reverse Repurchases exploded to $442 billion, $100 billion more than a week earlier.

That’s tightening.  With an “RRP,” the Fed borrows from banks to take money out of the counted supply.  When bank reserves rise because the Fed buys debts, the money supply increases.  It’s like fishing line. Let some out, reel some in.

So maybe the Fed wants to raise rates and then if the dollar spikes and assets like stocks and bonds fall, it can reverse these and flood markets with money. After all, when the Fed hiked by 25 basis points last December, stocks and bonds nearly imploded. Remember January 2016?

But here’s the problem.  Prior to 2008, bank reserves ran about $10 billion (and didn’t change in a decade).  RRPs ran about $35 billion, twice the size of reserves, and changed maybe $3 billion over a whole year.  Moving rates 100 basis points was no biggie, like hauling in a minnow on your steelhead fishing line.

Now the Fed has $442 billion of RRPs and it’s paying about 25 basis point of interest on them.  Bank reserves that pre-crisis were $10 billion are today $2.3 trillion, 26,000% higher.  Now the Fed has a fly rod with test line and it’s trying to land a blue whale.

It’s potentially catastrophic. If the Fed raises to 50 basis points, unless there’s a better place for bank reserves to go, money could stampede to RRPs, causing the dollar to skyrocket and stocks and bonds (and oil) to implode – as they nearly did in January. 

The Fed doesn’t HAVE to take the money it borrows via RRPs, but it says about $2 trillion of Treasuries (collateral) are eligible. The Fed can tighten confidently only if there’s enough demand from the economy to keep the blue whale away. 

Look around. The Bear Stearns Moment of the Week is the bankruptcy of Hanjin Shipping.  It’s among the ten biggest shipping companies in the world, moving the goods of global commerce. When Bear Stearns and Lehman failed we discovered the world had a financial crisis. When Hanjin folds, you have a budding economic crisis. 

So that’s the truth. What matters isn’t if there are 150,000 jobs (which isn’t enough to offset the traditional attrition rule-of-thumb of 1% of the workforce so don’t be fooled) but what the blue whale will do.  Disturb it and things start coming apart.

The Fed doesn’t want to do that, but it can’t figure out how to get the blue whale off the hook either.  And this you see is a much bigger deal than if you make your numbers. The market wants to know the Fed will keep feeding it line. Or a line. 

 

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