Speaking at the New Orleans Investment conference, Danielle DiMartino Booth, expert US Federal Reserve critic, as well as CEO and chief strategist of Quill Intelligence, told attendees that significant indicators are pointing to a looming financial crisis in the US and abroad.
Despite the Federal Reserve cutting interest rates three times in four months, DiMartino Booth thinks Fed Chair Jerome Powell won’t get the result he is looking for — economic stability.
“I think Jerome Powell wanted to engineer a soft landing for the economy and right now he is probably taking a victory lap saying you know, ‘I’ve managed to pull off an Alan Greenspan sequel,’ something in the spirit of 1995 or 1998,” DiMartino Booth told the Investing News Network (INN), referring to the times former Fed Chair Alan Greenspan was able to cut rates, then raise them, which prompted economic expansion.
“I distinguish the difference between now and then as, in 1995 we were at the beginning of an economic expansion, there was a lot of runway. Now we’re at the tail end — we’re late cycle — of the longest economic expansion in US history.”
The author of “Fed Up,” which uses her insights learned from time working at the Federal Reserve bank in Dallas to analyze the 2008 economic meltdown, also spoke to INN about how the Fed has warped the term price discovery, distorting the investment landscape.
Looking back at the repo liquidity panic of a few weeks ago and the accompanying fears that bond markets may face future liquidity shortages, one has to wonder. How can financial markets lack liquidity when the Fed between 2008 and 2014 created literally trillions of dollars in reserves, the basic stuff of all market liquidity, and in the years since has removed few of them? Banks still hold abundant unused reserves. Yet for a brief period a few weeks ago the shortage of liquidity was so profound that repo rates jumped from 2-2 ½% to 10%.
The “plumbing,” as the ins and outs of trading are called these days, surrounding repos is complex, convoluted even. At base, they work like this: A bank in need of cash, say because of a temporary draw down of its deposit base, will sell from its store of treasury securities, promising at the time of the sale to buy the securities back at a set price in a relatively short period of time, say a day or a week. Effectively, the treasury securities act as collateral for a short-term loan, except that it is worded in terms of a sale and repurchase, hence the word repo, for repurchase agreement.
There were indeed extraordinary cash demands during the recent scare. Quarter end raises liquidity needs among banks, if only for reporting to regulators. Corporations and individuals also draw down billions to pay their estimated taxes. At this particular time, Treasury bond auctions approaching $100 billion also drew cash out of the system. Some observers also point to a holiday in Japan that interrupted normal liquidity flows. Liquidity needs may even have accompanied the attacks on Saudi oil facilities that predated the cash squeeze by only a few days. But little of this was unexpected, and besides, the system still should have had ample cash to meet the needs. With the federal government running huge budget deficits and selling billions in new notes and bonds, markets hardly faced a shortage of collateral. At the same time, banks had ample reserves laying idle in deposits at the Fed. Some 90% of the reserves, almost $1.5 trillion according to Fed statistics, were uncommitted. It would seem that some of these funds could have easily served the system’s cash needs, especially as repo rates rose during those few days of the scare. But as it is, the Fed had to inject yet more money into the system.
It would seem then that the problem has other roots than an absolute shortage of liquidity. Two reasons spring to mind: First is the fear banks have of today’s zealous regulators. Rather than raise questions among the many different sorts of bank examiners, much less look as if they might fail a stress test, the banks strive to retain excesses of capital and, crucially in this respect, reserves as well. Forever, it seems, banks and other financial institutions have strived at quarter end to look better in the eyes of regulators. These days, that drive impels them to avoid risks or complex loans, perhaps including repos, and hold back reserves even if they can get 10% on a fully secured short-term arrangement.
Second, the Fed pays the banks interest on their reserves. This practice is relatively new. Until 2008, the Fed paid no such interest. But that year, in an effort, the Fed claimed, to give itself a new policy tool, it began to pay interest on reserves held by banks above the amounts required by regulations, the so-called “free” or “idle” reserves. So now banks not only are inclined to ingratiate themselves with regulators by holding more reserves then are required by law, they also get paid for doing so. True, the rate comes no where near the 10% briefly offered on repos, but earning even a small amount on reserves makes bank managements that much less eager to commit their them to a repo or any loan for that matter.