Investment Newsletter – September 2024
At the start of October, something concerning occurred within the US financial system: the Federal Reserve’s repo rate corridor, which serves as a key anchor, broke. General Collateral repo rates surged almost 40 basis points above the reverse repo facility rate, designed to be the upper limit for the Fed’s overnight rates. This rate spike is most noticeable at month and quarter-end, as banks scramble to improve their balance sheets by soaking up liquidity, a practice known as “window-dressing. ” On September 30, liquidity dried up significantly, exposing vulnerabilities in the financial system, can be attributed to three key factors. First, higher Treasury General Account (TGA) balances. Second, a decline in Bank Term Funding Program (BTFP) balances. Third, quarter-end window dressing saw banks scaling back their repo activities due to balance sheet pressures, tightening liquidity at the end of the quarter . This combination of factors drained cash from the system, causing repo rates to spike, reminiscent of the COVID-19 financial market disruption. Mark Cabana, a rates strategist, has identified this liquidity challenge as approaching the “Lowest Comfortable Level of Reserves” (LCLoR), a theoretical threshold where reserves become so low that the market seizes up, leading to a liquidity crisis. Cabana estimates the LCLoR is around $3 to $3.25 trillion in reserves, equivalent to about 7% of GDP, based on historical trends from 2019, when the repo market previously froze. However, unlike 2019, the current system has an additional $300 billion liquidity backstop through the reverse repo facility. Despite this, with ongoing quantitative tightening and increased Treasury issuance, it’s only a matter of time before reverse repo liquidity is exhausted, and total reserves fall below $3 trillion, potentially triggering another liquidity crisis.
The Joshi rule and Sahm rule event horizons mark the point where rising unemployment usually triggers a negative feedback loop. Weak growth draws attention, leading people to cut spending, which in turn weakens sales and profits, eventually pushing the economy into recession. What makes the current US economy unusual is its ‘inverted’ nature, meaning output is driven by supply rather than the usual demand. This shift clarifies the unique behaviour of the economy. The recent increase in unemployment has been accompanied by robust supply-driven output growth. This growth has likely disrupted the typical negative feedback loops affecting sales and profits that often lead to a recession.
Long-term inflation expectations are primarily influenced by long-term historical inflation trends. Unfortunately, with the pandemic’s impact becoming a larger part of that history, long-term inflation is likely to trend higher . The only way to counteract this is to bring inflation as close to 2 percent as possible, or even below that threshold. Otherwise, there’s a risk that inflation expectations could become unanchored. That said, without a recession, and if the Fed aims to keep inflation and inflation expectations anchored at 2 percent, it cannot reduce rates as aggressively as the market anticipates.
The China equity market’s strong performance has been fuelled by two key drivers: the implementation of more robust policy measures and an initially oversold, under-positioned market. Despite the impressive rally, China equities are projected to have an additional 15-20% upside. However, the full scope of fiscal policy responses remains uncertain. Still, there are valid reasons to expect further gains in the equity market.
