Last month – I wrote an article highlighting the ongoing ‘fiscal tightening’ via the U.S. Treasury that’s negatively affecting global financial conditions.
Or – said another way – creating a global dollar shortage.
And since then – things have only gotten worse. . .
First – to give you some brief context: due to the suspension of the debt ceiling, the U.S. Treasury announced that they were aggressively building up their cash balance (significantly more so than previously expected) during a time when banks have limited reserves. (Aka spare dollars – thanks to years of Quantitative Tightening; i.e. sucking dollars out of the banking system).
(Why does this matter? Because when the U.S. Treasury needs cash – so that they can pay their bills on things like social security and military budgets, etc – they sell Treasury bonds and bills. Thus – banks use their excess dollar reserves to buy those Treasuries. This is how the process drains liquidity from the banking system).
Thus – putting it simply – there’s too many Treasuries needing to be absorbed at a time when the banking system has too little cash. . .
This lack of liquidity – meaning shortage of dollars – is happening at a time when the world economy’s weakening. Thus making markets much more fragile.
And because of this – I wrote that I believed the U.S. Federal Reserve could revive their Quantitative Easing (QE – money printing) program much sooner than many realize (by year end).
Why? Because they’ll need to re-supply banks with excess dollar reserves (keeping them liquid).
This is very important. Because as the U.S. Treasury’s liabilities soar – they will need more and more cash. Thus they’ll continue issuing bonds into a banking system that has less and less reserves. (Meaning: as the Treasury’s cash balance grows – bank dollar reserves will decline).
And this decline in bank reserves is already driving up funding costs. . .
For instance – just this morning – the rate of a key major U.S. borrowing market soared.
I’m talking about the interest rate on overnight repurchase agreements (i.e. the overnight repo-rate) surging to 3.80% – hitting its largest daily increase since last December (when markets were crashing).
(Keep in mind that the overnight ‘repo’ is a tool for short-term borrowing that dealers in government bonds use. For example – a primary dealer bank will sell the Treasuries on their books to investors on an overnight basis – then buy them back the following day. This is a quick, low-cost way for primary banks to raise cash; stay liquid).
Remember – the cost to borrow cash overnight is considered very low-risk (due to its short time-frame).
Thus – this sharply higher overnight repo-rate is a sign of growing fragility in dollar funding markets (i.e. there are dollar plumbing issues).
As Jon Hill – a rates-strategist at BMO Capital Markets – said: “secured funding markets are clearly not functioning well…”
This surge in the overnight repo-rate suggests that the next few months may be turbulent as the dollar shortage deepens.
To give you some perspective – the U.S. Treasury’s cash-balance is only $215 billion as of Monday.
But – like I wrote in my previous article – this isn’t even close to the $350 billion that the Treasury plans to have by quarter-end (Sep/30).
And making matters worse – the Treasury plans to raise another $381 billion in the next quarter (Oct-Dec 2019).
This means that the Treasury will ramp up their cash-grab over the next few weeks.
Or – putting it another way – the Treasury will flood the market with bonds and bills – further bloating the balance sheets of primary dealers (those who buy the bonds the Treasury issues), and continue depleting bank reserves. . .
So – in summary – the U.S. Treasury’s hefty cash-grab is tightening financial conditions severely (making market’s very illiquid). And it’s only going to get worse from here over the next quarter.
(Don’t forget – U.S. deficits are only growing – meaning the Treasury will need continuous funding. Sucking more and more dollars out of the already depleted banking system).
Thus – after Monday's surge in the overnight repo-rate – it appears that the Fed is now behind the curve.
I still expect the Fed will step in and begin aggressively easing via rate cuts and QE sooner than many expect in order to re-supply banks and ease financial conditions.
Until then – look for the dollar shortage to worsen. And for funding markets to grow more fragile.