Did Wall Street & The Fed Ignore A Potential Market Crash?

It’s business as usual after a significant liquidity panic rocked funding markets not seen since the Global Financial Crisis of 2008. Overnight Repo — the rate at which a central bank repurchases government securities from commercial banks — spiked 7% after remaining steady for over a decade.

A surge in repo rates shows shrinking confidence among dealers who — for some unknown reason — aren’t willing to lend, even though it’s in their best interests to do so. If the Federal Reserve offers an overnight rate of 1.8% but a commercial bank raises its bid to 10%, why wouldn’t you choose the latter option?: If you don’t believe you’ll be paid back the following day.

Markets expected tighter liquidity conditions during a period of seasonal bottlenecks as the US Treasury attempts to rebuild its cash balance over the coming months, but here’s the perplexity: despite everyone knowing a squeeze was imminent, the Federal Reserve still had to step in and provide liquidity.

During summer, China experienced similar difficulties resulting in the destabilization of sentiment within the economy and currency: Starting in May; Baoshang, Jinzhou, and Heng Feng Bank fell into administration which ended in the Chinese government bailing them out to limit any systemic risk, highlighting notable funding issues in the Asia Pacific region.

You’d expect Wall Street’s response during the U.S repo rate fiasco to be panic, but no, flash crashes in key funding markets are a bullish signal for equity & debt as bank stocks and risky high yield credit accelerated higher. Although most financial media did cover the story, you got the impression risks were being downplayed by the majority of pundits. Let’s be realistic, the repo rate spike is a big deal. It validates the contrarian view that without an abundance of liquidity pumping through the system it starts to fall apart. No credit supply equals no economic growth.

In the next few months, economists will be required to ask a controversial question: will the Fed contemplate another round of quantitative easing now they’ve been forced to inject billions of dollars back into the system until October 10th? Insiders are starting to wonder if it’ll be permanent; which is no longer a crazy idea but almost a reality based on historical periods of economic pressure. Disorder in repo markets signal to officials that the end of quantitative tightening and two rate cuts haven’t eased conditions at all, rocking Fed Chairman Powell’s assessment of policy as a “mid-cycle adjustment”.

Markets recognize that the Fed is dead wrong and by a big margin, so to restore confidence, short term rates must move significantly lower, fast. Being overly optimistic is dangerous in a time where caution should be taken; an art which Federal Reserve members never seem to master: Investors always think back to the subprime era where then-Chairman Ben Bernanke stated those famous two words, “subprime contained.” Hopefully, we aren’t going to see a “Lehman Moment” anytime soon but investors may think twice about moving into risky assets in the near future.

If funding markets gain stability once again the next dilemma facing officials is the need to restore risk appetite, despite lackluster consumer confidencea contraction in manufacturing, and a global slowdown. Can the Fed print their way out of a mess and in the process manage to convince the majority that this time really is different? It’s a hard sell for sure.

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