December 23, 2024 | Premium Service | In this issue of The Institutional Risk Analyst, we ponder how changes in the Fed’s balance sheet set the stage for financials and other industry sectors in 2025. We also share our portfolio with subscribers to the Premium Service as year-end approaches.
The best performers among financials during the rally in 2H 2024 were first the GSEs, then the consumer lenders followed by the asset gatherers and then the mainstream consumer banks. Now that the narrative about successive interest rate cuts by the Fed has been disproven, what's next for financials?
The strategists at Goldman Sacs (GS) see “gains ahead for stocks and bonds,” but concede that President Donald Trump remains the random factor. This is another way of saying that they have no idea what will happen over the next four years. Below we handicap some of the major asset classes in the world of financials and credit, in part because we already known what is happening. Debt levels are rising and equity market valuations are testing new highs. Dealers, credit managers and central bankers, however, are preparing for the next market crisis.
“Markets are falling out of love with government bonds,” notes David Kotok, CIO of Cumberland Advisors. “We see negative 10-year swap spreads in Yen, Euros and Dollars. (h/t @Usama_Polani). As global government bond supply increases and central banks have stopped buying, government bonds are ‘cheap’ relative to equivalent instruments. Market participants prefer a synthetic Treasury position relative to a cash position.”
Kotok told The IRA last week that on $28 trillion of tradable US Treasury debt (exclude what the government owes itself) each basis point means $28 billion of added financing pressure on the US. Since the Fed ignores this and manages the interest rate, the pressure is revealed in the necessity to have a larger and larger balance sheet at the central bank. And as the balance sheet grows via purchases of securities, so too do bank reserves and deposits, stoking further inflation.
The veteran bond market analyst and co-founder of Cumberland Advisors thinks that the Fed should cease QT now or very soon. “They are getting close,” Kotok warns. “And the repo cushion that helped in the last shock is gone. Congressional miscreants are playing with very large matches.”
Of course, the December Fed rate cut and particularly the downward adjustment of the rate paid by the central bank in reverse repurchase agreements (RRPs) is part of the normalization process coming out of COVID and the disastrous pandemic lockdown. The Fed panicked in 2020 and added so much liquidity to the US economy in 2020-2022 that residential home prices rose more than 40% over those three years.
Q: What happens to default rates on residential mortgages as and when home prices fall? Is the term "partial claim" meaningful to FOMC members?
Issuing RRPs was required to address the Fed’s mishandling of the COVID emergency under then-Chair Janet Yellen and after Chairman Jerome Powell. Both Fed chairs decided to engage in massive fiscal action (aka "QE") funded with deposits from banks. The Fed eventually was forced to issue trillions of dollars in ersatz T-bills in the form of RRPs to sop up the excess cash from QE and post-COVID fiscal action. Think of Yellen or Powell as the "Sorcerer's Apprentice" from Walt Disney's Fantasia and you get the idea.
While the Fed bought securities from banks to increase reserves, it illegally took deposits from the GSEs, foreign banks and private money market funds. Why? To prevent interest rates from going negative under the weight of the huge reserve position created during COVID. The trillions in excess liquidity created by the Fed via QE is shown in the chart below from FRED, showing RRPs and the Treasury General Account (TGA). The chart not only shows the extraordinary actions of the Federal Reserve Board, but also the idiocy of the Congress in borrowing and spending trillions more.
The “excess” liquidity created by the Powell Fed is the amount above the level of liquidity needed by the US economy and is measured in the trillions in RRPs issued by the Fed during the past four years. Think of the RRPs at the Fed as a benchmark for how much excess liquidity remains in the US economy. That is, not much.
The Fed’s model may suggest ample liquidity in the system, but what is the situation in particular? What does the upsurge in repo rates at the end of September and in November suggest for system liquidity? None of the media who supposedly cover the Fed seem able to ask any questions about the balance sheet of the central bank.
Secured Overnight Financing Rate
Now the incoming Trump Administration is calculating how much more debt can be piled upon the existing public tab to fuel the Republican agenda, but without the surfeit of excess liquidity to cushion the market reaction. The Fed is withdrawing liquidity from the markets while also withdrawing duration in the form of reduced volumes of RRPs. Given the table set by the Powell Fed and the fiscal aspirations of the incoming Trump Administration, what is the outlook for financials and other inflated sectors?
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