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Fed Cuts Rates Again

Jeff Remsburg

For the second time this year, the Fed cut interest rates … but gave mixed signals on where we go from here

Earlier this afternoon, FOMC policymakers cut interest rates by one-quarter point. That lowers the target range from “2.00% – 2.25%” to “1.75% – 2.00%.”

Though certainty of a cut — the second this year — had been waning in the run-up to today, the move was still largely anticipated. After all, in the six weeks since the Fed’s July 31 meeting, we’ve seen new tariff-hike announcements from both the U.S. and China, a yield-curve inversion, and most recently, a spike in crude oil prices following the attack on Saudi oil facilities.

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But while markets got the cut they were expecting, they didn’t get overwhelming assurance that further cuts in 2019 will be coming. Given this, markets were volatile in the wake of the announcement. The Dow dropped around 200 points before turning around and erasing all losses. As I write toward market-close, the Dow is actually up 30 points.

***In what was likely a contributor to today’s rate-cut decision, the U.S. repo market has been under major pressure this week

The FOMC’s decision today was likely made easier by events in the repo market beginning Monday. This is a lesser-known part of the U.S. financial system, so let’s make sure we’re all on the same page about what’s been happening.

In what’s called a “repo” trade, Wall Street firms and banks put up U.S. Treasuries and other high-quality securities as collateral in order to raise cash. Usually this is done overnight, with the cash being used to finance the banks’ trading and lending activities. The following day, borrowers repay their loans with interest, after which their bonds and other collateral are then returned to them. This gives rise to the name “repo,” since the banks “repurchase” their bonds.

What happened beginning Monday is that the cash available to banks for these repo trades unexpectedly dried up. This caused the associated interest rate to shoot up to as high as 10% for some overnight loans. That’s more than four times the Fed’s targeted rate.

This forced the Fed to inject more than $50 billion of emergency liquidity into the market to prevent borrowing costs from spiraling even higher. This is the first such injection since the financial crisis.

So, what caused this?

Here’s Neil George, from yesterday’s Profitable Investing update:

With the big issuance of Treasuries last week, corporate issuance and news of a potential resumption in muni issuance, there is a cash squeeze for dollars.

Adding to the mess is the huge demand for US dollars from around the globe. This also extends to many US corporations raising cash to make corporate income tax payments.

All of this has resulted in a surge in overnight borrowing rates …

This shows that the FOMC needs to ease in its target for the federal funds rate and also needs to resume buying bonds to control tightening credit.

The liquidity injections have continued today. The New York Fed made available $75 billion in cash to market participants in exchange for collateral. This is in addition to yesterday’s $53.2 billion injection.

***This cash-flow shortage points toward a bigger challenge facing the Fed and the U.S. financial system

Coming out of the financial crisis, after the Fed cut interest rates to practically zero. It also bought more than $3.5 trillion of bonds. This enabled banks to build up massive reserves which they held at the Fed. These reserves provide banks with intraday liquidity for their operations.

But reserves, which topped out at $2.8 trillion, have been declining ever since the Fed began raising rates. They began depleting even faster after the Fed started to cut the size of its bond portfolio.

As you’re aware, the Fed has now not only stopped raising rates, it has cut them. And last month, it stopped allowing its bonds to roll off the balance sheet.

But is it enough to stop this growing liquidity crunch?

A challenge for the Fed is that it has become more difficult to determine exactly how much reserves banks want to hold. This is due to changes in regulations designed to ensure banks can meet deposit-withdrawal demands in times of heightened stress.

DoubleLine Capital’s Jeffrey Gundlach is referred to as the “Bond King.” His take is that dwindling reserves and this week’s repo market issue will force the Fed to resume its bond-buying program. Some action will be needed to address the 50% decline in excess reserves that’s occurred over the past five years. Bank reserves at the Fed last stood at $1.47 trillion, which is the lowest level since 2011.

Given this, some analysts had expected the Fed would hint at a renewal of bond purchases coming out of today’s FOMC meeting. And in fact, in Powell’s press conference, he said it’s possible such balance-sheet growth will resume.

Here’s Powell, commenting on both reserve levels and bond purchases:

Going forward, we’re going to be very closely monitoring market developments and assessing their implications for the appropriate level of reserves. And we’re going to be assessing the question of when it will appropriate to resume the organic growth of our balance sheet.

***Mixed voting and the updated dot plot suggest a divided committee

Returning to today’s rate-cut, it was marked by a record number of dissents. This raises questions about the degree to which Fed members are on the same page. Specifically, seven out of 10 officials voted for the cut, but Esther George and Eric Rosengren voted for no change, while James Bullard voted for a 50-basis point cut.

And what about the overall dot plot?

If you’re less familiar with what this is, the dot plot is a chart that anonymously reflects each Fed official’s rate forecast. Fed policymakers provide their projections for where they expect rates to go. These projections are then charted on a so-called dot plot. You could think of it as a loose roadmap of where future rates might be going.

Below is the latest dot plot, released after this afternoon’s meeting.

Seven of 17 officials penciled in one final cut this year. The remaining 10 were evenly split between those who believe the new rate levels, after Wednesday’s cut, would be appropriate and those who thought rates shouldn’t have gone any lower.

This calls into question another cut in 2019. And as you likely know, the markets hate uncertainty, which is behind much of this afternoon’s volatility.

If you look at the plot for 2020, you can see an even wider dispersion in where members want rates to go. One thing is for certain — Powell will not have an easy job in light of these differing opinions and what’s sure to be more pressure from Trump, who has already said Powell and the Fed “Fail Again,” have “no guts, no sense, no vision.”

So, a bit of a mixed bag today. Looking forward, the trade war lingers, geopolitical tensions are rising, and we’re still dealing with the unexpected liquidity event in the repo market. Despite all this, the committee’s projections on parts of the U.S. economy are actually optimistic. Policymakers increased their U.S. GDP growth projections, with the median member now projecting growth of 2.2% in 2019. That’s up from the median projection of 2.1% back in June.

Lots to digest. We’ll continue to keep you updated.

Have a good evening,

Jeff Remsburg

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