It started last week with a strange spike in overnight lending rates. Though most investors don’t pay much attention to it, the repo market is one of the most critical pieces of “plumbing” in the financial markets.
Repo, or “repurchasing agreement,” is a form of short-term debt transaction.
When large corporations and banks need short-term funding, they tap into the repo market, selling securities as collateral in exchange for a cash loan–similar to a pawn shop.
Borrowers typically buy back their securities the following day, but at a higher price that includes interest–typically between 2.00-2.25%.
The repo market usually functions like a well-oiled machine. But last week, the repo market hit a liquidity crisis as borrowing costs skyrocketed to levels near 10%.
There wasn’t enough cash in the system to keep the repo market going at its usual rates.
To ameliorate the situation, the Fed injected $128 Billion into the repo markets–a short-term solution to what they thought was a short-term anomaly…
After a week had passed, the Fed quickly realized that they were dealing with a much longer-term issue, and so they scheduled a daily liquidity injection of $75 Billion for the following week.
Additionally, the Fed will introduce 2-week term repos the size of around $30 Billion.
The last time the Fed intervened at this level was in 2007–the year before the financial crisis leading to the Great Recession.
It’s important to understand why the repo market seized up. Furthermore, it’s important to understand the dangerous long-term implications of the solution.
Among several contributing factors, the demand for cash by US corporations was so exceptionally large that it nearly depleted the amount of available cash from the financial markets.
Hence, repo rates (borrowing costs) shot up tremendously, as there wasn’t enough supply to satisfy demand. This is similar to what happened in 2007 before the housing crash that led to the Great Recession.
So, why wasn’t there enough cash in the Trillion-dollar repo market this time around?
Simple: Quantitative Easing or QE for short ended five years ago. Total bank reserves have been decreasing from that point on.
The Fed typically uses open market operations to address these funding pressures. But it’s now becoming clear that it’s not enough. Hence, the continuing Billion dollar injections into the repo market.
Goldman Sachs expects the Fed to reintroduce Permanent Open Market Operations (POMO) in November.
This means more bond purchases–in short, a restart of QE.
According to Goldman’s estimates, the strategy would add around another $180 Billion per year to the Fed’s current balance sheet.
Fed intervention into the repo markets signals that the dollar funding shortage may end up a much longer-term problem.
The main concern, of course, is that the Fed’s liquidity injections may be insufficient to boost liquidity and quell fears in the repo market.
In total, their intervention would release as much as $165 Billion by the end of next week.
Add this to Goldman’s POMO calculation of $180 Billion and you’ve got another massive round of money printing going into the financial system.
The market has somehow become reliant on the Fed’s ability to boost reserves–an expectation that just may force the Fed (as per Goldman’s prediction) to restart Permanent Open Market Operations.
And should we face another sudden crisis in the repo market in the coming weeks, perhaps deeper than what we just witnessed last week, then that may be the tipping point leading to the official start of QE4.
In terms of practical implications–or how this may impact your money–the risk of another QE is immense. It erodes your purchasing power while raising the price of goods and services. Ultimately, it’s the value of your wealth that’s at stake.
Remember, the massive QE policy was an experimental measure to prevent the US economy from collapsing in the aftermath of the housing crisis.
Apparently, the economy now cannot seem to function on its own without the steady stream of easy money–not a good sign.
Before the next round of QE, and the potential damage it can do to the economy and your hard-earned wealth, be smart and hedge the risks by allocating some of your portfolio to gold and silver.
They are the only two assets that gain when the dollar falls, they are also the only two assets that can retain their values while all other asset values are collapsing.
Unless you feel comfortable gambling on the value of your money, you may want to follow the diversification steps that many central banks, financial institutions, and other large investors are doing–investing in gold and silver.
Don’t allow the Fed’s printing presses to dilute the value of your “wealth” even if it significantly dilutes the value of the “dollar.”