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Fed dials it back

The Days Ahead: PCE inflation and home sales

One-Minute Summary The Saudi attack (see below), Brexit deadline, trade, the funding problem (also below) are all flashpoints. We know with some certainty that they lead to two things: 1) a general reluctance to hire, invest and grow and 2) a demand for safe assets.

Stocks were down 0.5% on the week. Fixed Income markets are back to where they were a month ago. The 10-Year Treasury trades at 1.72% compared to 1.5% at the end of August. We'd put most of that down to some large auctions combined with maturing Treasuries. So it does not change our view that bonds are expensive, but likely to stay that way.

We'd remind ourselves that, yes, stocks are up 19% this year but only up 2% over the last 12 months and 8% since January 2018. Even after the summer rally, 191 stocks in the S&P 500 are 10% below their 2019 highs. There is no exuberance in this market. More of a general caution and sitting on the sidelines

1.     Should we worry about the oil price spike? No. There was a large spike in oil prices on Monday after the attacks on Saudi facilities. Here’s the chart:

That's a 20% move and the largest one-day rise since the Kuwait invasion in 1990. Not surprising since the attack removed about 5.7m barrels a day of production out of a global total of around 90m. But there are a number of reasons not to worry:

  • This move only takes oil back to where it was in May and still 15% below year ago levels.

  • Saudi said it could repair the facility within 30 days, which sounds optimistic but…

  • They and the U.S. have plenty of stockpiled reserves, the U.S. at 664m and Saudi at 180m. So, that’s 150 days of supply. Other countries have their own stocks…as much as 1.5bn

  • The U.S. can quickly bring more oil on line; the number of rigs in place is 55% below what it was in 2014

  • The global economy is less dependent on oil than it has ever been. Here's the growth of the world economy against oil production.

In the last 46 years, oil production has grown 70% but global GDP has grown nearly 400%. That's a combination of service growth, efficiency and alternative sources.

The initial market reaction was for interest rates and the dollar to rally but 48 hours later, markets were back to where they started. The impact on inflation is negligible. Energy stocks rallied but quickly fizzled for a net gain of 0.8%. That’s noise.

So, no real worries on the economic front. On the geopolitical side? Well, “War in Iran” has been a Top 10 market risk for 40 years. We don't see it happening.

2.     Money markets went awry this week. Should we worry?  Sort of, yes. It all happened in the repurchase or repo market. What’s that? Say you own Treasuries. You need overnight cash. You sell the Treasuries to an investor (usually a bank) and promise to buy them back the next day. You have just entered into a “repo”. They’re a big deal in the money markets and the Fed uses them all the time to manage the money supply and bank reserves.

Normally this sort of plumbing in the money markets goes on smoothly and behind the scenes. The repo rate is more or less tied to the Fed Funds rate. But occasionally things go wrong. In this case, the story goes like this:

  1. Banks are sitting on a lot of reserves because of QE. Remember in QE a bank sells Treasuries to the Fed and receives cash in return.

  2. But these reserves are declining because the Fed is shrinking its balance sheet

  3. Their funding needs don't change but they now have less reserves.

  4. So, we have a situation where there’s less reserves but unchanged cash requirements. That puts upward pressure on overnight rates. But…

  5. Banks have plenty of Treasuries (caused by increased issuance) so can get liquid by entering into repos. Everything should work. Until…

  6. An unexpected cash need comes along.

  7. And it did in the form of i) tax payments due September 16 ii) a big settlement of maturing Treasuries and iii) Saudi Arabia selling down reserves as revenues from the facility attack fall (that last one is a guess…sovereign trades are pretty discreet). Which….

  8. Is another way of saying there was a temporary mismatch in demand and supply

And that's why repo rates hit 8% on Monday and Tuesday. Remember they normally trade around the Federal Funds rate, which was 2.25% then. So, 8% will get your attention.

The Fed stepped in with some liquidity programs for the next three days and all seemed quiet by Thursday. That’s all fine but repo rates are tied to the Secured Overnight Financing Rate or SOFR. And SOFR is the planned replacement to LIBOR, which is the rate to which loans, including mortgage ARMs and interest only mortgages, are all tied. If those loans were tied to SOFR (they're not yet but that's the plan) imagine if your ARM just shot to 10% from 3% overnight. See the problem? It’s more than just “oh, those banks being banks again.”

Here’s what it looked like (from NY Fed):

Trouble in money markets is like a “Get Out” moment for 2008 alum. We think the Fed is on top of it. Late. But on top of it. Our worry is that the weaker parts of the chain, like hedge funds and marginal lenders, may get hurt if this happens again. So, another reason to keep caution and protection to the fore.

3.     How was the Fed meeting? Anything new?  Well, they cut rates, which everyone expected. We've now retraced two of the four hikes made in 2018 and back to where we were last September. This was a “hawkish cut” as in, “we've given you a rate cut but don't expect more.”

That makes sense. On the “let’s have another cut” side, you have i) the prospect of trade really hurting the economy ii) low capital expenditure by companies and in real estate (the non-residential kind), iii) slow manufacturing iv) the yield curve and v) low inflation.

But on the “let’s hold” side we have i) robust consumer spending and ii) tight labor markets. The Fed can't really keep cutting on the fear that trade policies will disrupt the economy. We think trade is a problem but the evidence so far is limited. They've probably gone as far as they can on the worry about “uncertainty”.

It was a split decision with three dissenters. Two voted to not raise rates and one to lower by 50bp. Consensus is overrated at the Fed and split votes common. So, we’re not worried there.

The “dot plots” or summary of economic projections also came out. Here they are with the December numbers.

It’s a bit tough to read, other than all the dots are lower, but we’ll give you the highlights:  

  1. In December, they thought Fed Funds would be 3.2% for 2020. Now it's 2%.

  2. They thought the long-term rate, which is the “everything humming along nicely neutral rate” would be 3%. Now it's 2.5%

  3. No change in 2020 GDP; it remains at just below 2%

  4. Or inflation at 2.1%

We think they'll revise those down later in the year. It’s possible we may see one more cut in December but the talk over the summer that there would be three cuts this year are gone for now. The White House isn't pleased but the Fed’s holding its ground.

Overall? Markets did not react. This was all in the pricing. No changes to allocations or to our forecasts.

Bottom Line: We're going to sound like we never change our mind but, hey, the facts haven’t changed much. Markets are numb on the trade wars. We see five things that would send the markets 15% higher:

  1. Pick up in inflation

  2. Better economic data

  3. Trade confidence

  4. Brexit resolution

  5. Fiscal policy in EU

But you’d have to do one of those David Blaine feats to see any of those coming due soon.

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