US Fed Is Caught in a Trap, If It Tries to Escape All Hell Breaks Loose

via smh.com.au

There’s something quite odd about a sharemarket that rises more than 26 per cent over a year in which world economic growth was the weakest since the financial crisis.

That is, however, what the US market has done (the Australian market has risen just over 20 per cent) even though US GDP growth last year was only just above 2 per cent.

The cessation, temporary or otherwise, of trade hostilities between the US and China has helped the outlook for this year, with the International Monetary Fund predicting global growth will rise from last year’s 2.9 per cent to 3.3 per cent. A recent Wall Street Journal survey of US economists produced an average forecast for US growth this year of only 1.9 per cent.

Expectations of modest growth, however, oughtn’t to be enough to explain why markets are at levels that appear euphoric.

The better explanation for why the stock markets have been surging – they are up about 3 per cent already this month – lies with the usual suspect.

It would appear that it has been the US Federal Reserve Board’s response to the seizure in the US “repo” market last September that has driven sharemarkets to new heights. Since that market froze in mid-September, with rates soaring as liquidity disappeared, the US sharemarket has risen almost 11 per cent.

Repo markets provide short-term liquidity to companies and institutions in exchange for high-quality collateral such as US Treasury bills. The borrower sells the securities for cash while simultaneously contracting to buy them back in the near term – as little as 24 hours – for a slightly higher price.

The Fed did two things in response to the malfunctioning of the repo market.

It injected and has continued to inject massive doses of short-term liquidity, providing at least $US120 billion ($175 billion) of overnight and 14-day cash each month in exchange for high-quality collateral through its own repo facilities.

It also, moreover, started buying Treasury bills at a rate of $US60 billion ($87 billion) a month.

It has done so because it believes that, as it reduced the size of its balance sheet by allowing securities it purchased during its three big post-crisis quantitative easing (bond and mortgage-buying) programs, bank reserves – the cash they hold with the Fed – have also fallen to levels too low to enable them to lend enough cash into the repo market.

The story is slightly more complicated than that because a strand of the explanation for the banks’ inability to deploy their reserves is the post-crisis prudential reforms that force them to hold more high-quality liquidity of their own, leaving fewer of the reserves available for lending.