CASH, MARKETS, AND DEMAND FOR THE FED REVERSE REPO PROGRAM
SUMMARY
Initial indications of credit stress have us on high alert. Excess cash in the system appears to have led to soaring demand for the Fed’s reverse repo program, which may be causing a corresponding decline in the money supply and volatility in the equity markets. This has yet to cause any major dislocation in the credits markets, which typically precedes any major economic event, but we are monitoring this situation closely.
SPIKE
The Fed’s reverse repo program allows eligible firms, like banks and money-market funds, to park cash overnight at the Fed in exchange for bonds, like U.S. Treasuries, on the Fed’s balance sheet. As shown in the chart below (Figure 1), demand has skyrocketed for the Reverse Repo program since April.
Figure 1: Since April 2021, demand for Fed overnight reverse repo operations has surged.
This could be a result of the Fed buying record numbers of U.S. Treasury bonds, which leaves little available for other banks and funds that need them for a multitude of their own reasons. A lack of optimism by the banks in the overall economy could also be an explanation. In either case, there is an excess amount of cash in the system, which many argue is a major cause of the inflation we are seeing as indicated by the CPI numbers, the NFIB Small Business Actual Prices paid, and ISM Manufacturing Prices Paid indexes. Essentially, the money the Fed is injecting into the market is now coming right back to its own balance sheet through the reverse repos.
In our experience, most major economic dislocations are led by stress in the credit markets, so we are watching this data closely. One of our favorite indicators to monitor is credit spreads (Mortgage and other Bond Yields minus their corresponding government treasury yield). We would expect any financial dislocation in the credit markets to show early on here and we will act accordingly. As of now, everything looks to be in order. One interesting note is that we are seeing the yields, and spreads, in Mortgage-Backed Securities begin to increase, which could indicate this is the first area in which the Fed may begin tapering their bond purchases or investor concerns around the housing market as whole.
Figure 2: The option-adjusted spread on U.S. investment-grade corporate credit, high-yield, mortgage-backed securities, and U.S. agencies.
As noted above, the credit markets appear to be functioning properly, but we are watching the newfound interest in the Fed’s reverse repo program, which has begun decreasing liquidity in the markets and the economy as a whole, as indicated by the dramatic decrease we have recently seen in the year over year growth of the U.S. money supply.
Figure 3: The money supply, and its drastic 2021 decline, in the context of recessions as defined by the National Bureau of Economic Research
The decrease in liquidity growth could also explain the dislocation we are seeing in the stock market. Although the S&P 500 is trading within 1% of an all-time high, the broader market tells us a different story. It’s important to keep in mind that the S&P 500 is a cap-weighted index which means that larger companies have a larger contribution to performance. To put that into perspective, currently over 22% of the S&P 500 index’s value comes from Apple, Microsoft, Amazon, Facebook, and Google. CNBC contributor Carter Braxton tweeted the following charts the other day, which show that it has been at least 69 days since most other indexes have posted a new 52-week high. It illustrates that most of the other indexes are below their 52-week highs by a much wider margin than the S&P 500. Another interesting note: the average stock in the S&P 500 is currently about -9.62% below its 52-week high. Ned Davis Research classifies a -10% pullback in equities as correction territory and the average stock is not that far off.
Figure 4: The time elapsed since the 52-week highs for a variety of indexes exceeds 69 days.
That said, our broad equity market models continue to be neutral to bullish. As always, we are monitoring them and will be quick to adjust our positions should they deem it appropriate to do so. If you have not yet walked through the financial planning and portfolio risk number process with us, please reach out. Our new Day Hagan Client Portal allows you to monitor your plan along with your account(s)’s performance and holdings (in addition to your Raymond James and Charles Schwab logins).
Sincerely,
Regan Teague, CFA®
Financial Advisor
Day Hagan Private Wealth
—Written 08.18.2021.
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