Full Throttle

The restrictive starting point of monetary policy suggests that there is room for policy to effectively pivot and push against recessionary pressures.

Monetary policy was stuck at 0% after the 2008 crisis, but it is now at 5.5% with plenty of room to move lower. Higher rates had kept bank loan growth to a standstill, but the anticipation of rate cuts is spurring bank loan growth. This is a concrete channel where lower rates could boost the moderation in economic growth. At the same time, private lending continues to boom and fiscal spending remains historically high.

The economy is slowing, but there is much reason to think that it is softly landing.

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PPI 0.1% MoM, Exp. 0.2%
PPI Core 0.0% MoM, Exp. 0.2%

PPI 2.2% YoY, Exp. 2.3%
PPI Core 2.4% YoY, Exp. 2.6%

CPI 0.2% MoM, Exp. 0.2%
CPI Core 0.2% MoM, Exp. 0.2%

CPI 2.9% YoY, Exp. 3.0%
CPI Core 3.2% YoY, Exp. 3.2%

Ran into some problems related to mass reporting and other insane behaviors by miscreants, which is why the original group chat with all the members was detached and some other things have been rearranged. Hopefully we can get that resolved.

In the meantime, these are our favorite posts:

> The Mother of All Pain Trades (the hard landing) by Gerhard Schrader July 2023. A lot has changed in the 13 months since he wrote this, however, that we nor he could anticipate. If there's interest we might revisit this.
> Restoring Credibility — what motivated the recent interest rate hiking cycle (and what could motivate interest rate cuts)? Hint: it's not all about inflation.
> Dissecting US hegemony (the dollar)
> How the Chinese bloc's monetary divorce from the US bloc is supportive of the price of gold for years to come.
> Repo, Treasury market leverage, and the Basis Trade.
> The End of Unemployment: looking at how demographic trends will reshape economies in the future.
> Examining the Yen carry trade and how asset purchases by foreign non-officials are often funded in depreciating currencies. The carry trade is unhedged, which exposes them to losses when the funding currency appreciates against the investment currency.
> The government of Japan is itself arguably involved in a giant carry trade.
> How monetary and fiscal policy could change under a Trump administration.
> How mass immigration prolongs shelter inflation.
> The importance of energy and what "peak EROI" may mean for our future (and perhaps our recent past).
> Why is "this time different"? Because of the fiscal picture.
> Reasons why the US skirted recession (at least in official terms) in 2023 and 2024
> In many ways, we did have a recession in 2022.
> The Politics of Recessions and how a government shutdown could lead to contraction in the fiscal deficit (and thus recession).
> Learn about how money works and makes the world spin

And many others that I've left out.

We have some other ideas in the bag. For example we still want to cover more of China and the US-China trade war.

Feel free to leave a suggestion in the comments.

The Repo Market Dislocation

As financial markets have experienced widely unforeseen turmoil, dollar funding markets have remained surprisingly subdued.

Out of the numerous events that triggered the unwinding of leveraged positions across various asset classes, the so-called reversal of the Yen carry trade has been touted as the major causality. Yet the $/¥ (yen-dollar) cross-currency basis — a sharp downward turn of which implies severe market stress — has barely dipped (see above), while other cross-currency bases have traded flat, signaling that the most recent "crisis" was forced selling & balance sheet deleveraging — not a funding panic.

The JPY/USD cross-currency basis (XCCY basis, or simply the basis) is the premium/discount associated with swapping yen for dollars in the FX swap markets. A more negative (tighter) basis indicates that the world is hungry for dollars (see: March 2023 bank panic above, which compelled the Fed to open its global dollar swap lines like it did during COVID).

The XCCY basis is structurally negative for dollars, meaning that there is always a "shortage" of dollars. The extent to which it is negative measures the degree to which dollars are needed.

Onshore money market rates for repos and Fed Funds continue to trade in their semi-zombified state. Compared to volatile FX and equities, money markets have been living in a parallel universe.

That is except for the most perplexing move in a repo rate benchmark since the infamous September 2019 "repocalypse". This time, instead of all major repo averages exploding through the upper limit of the Fed’s target range (as it did in 2019), just one has breached the U.S. central bank’s lower boundaries.

Recall that the Fed's ceiling on rates is generally fixed as the central bank can supply an unlimited amount of dollars as repo loans, but the rates floor remains leaky by design as the Fed does not control the supply of or demand for collateral.

That's pretty significant.

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Since July 18th, the two prominent benchmarks for measuring triparty repo rates — the cost at which the Fed’s primary dealers borrow dollars via repos from cash investors such as money funds — have dislocated.

The Federal Reserve’s average triparty measure, TGCR, has printed in its normal tight range. Yet the TPR rate, the triparty benchmark published by the OFR (The Office of Financial Research), has descended rapidly (as shown above in yellow).

TGCR = triparty general collateral rate

The OFR’s triparty rate has fallen so far so fast that, initially, it appeared someone large had been willing to lend cash below the Fed’s risk-free repo rate. Why a major cash lender, the only entity with enough size to suppress a benchmark, would lend at inferior yields to what they’d receive at the Fed’s RRP facility (reverse repo facility) remained a mystery.

At first glance, the most compelling theory was that cash lenders were trying to front-run a greater certainty of rate cuts — and potentially emergency cuts as the early August turmoil in markets unfolded.

If repo rates were about to drop by 75 bps (0.75%) or so, sacrificing a few basis points would beat losing a few rate cuts worth in yield. Cash borrowers might have consequently been able to persuade cash lenders to lend cheaply below the overnight rate that the Fed pays on its RRPs (i.e. O/N RRP) or even under the lower bound of the U.S. central bank’s target range.

But as the Fed’s triparty benchmark and other Treasury repo rates failed to exhibit a similar descent, something else must have been afoot.

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Instead, the mystery lay within how these benchmarks varied in construction, with the major difference involving the type of collateral backing each repo loan. The Fed’s TGCR measures the average rate of borrowing cash in the triparty repo market but only when secured against U.S. Treasuries on an overnight basis.

The OFR’s TPR benchmark, however, measures the rate on all triparty repos backed by any type of collateral — from U.S. Treasuries to agency MBS to CDOs — that cash lenders are willing to accept from borrowers, provided it’s compatible with the Bank of New York Mellon’s triparty platform (the only one to exist).

The OFR calculates TPR by combining the rates on triparty repos secured against various types of collateral, namely U.S. Treasuries, U.S. federal agency securities, corporate bonds, and “other collateral” — the latter being a euphemism for the riskiest securities.

On closer inspection, only the rate for triparty repos where the cash borrower pledged “other collateral” has tumbled, but it’s been enough to suppress the OFR’s entire TPR benchmark. Repos secured against collateral outside the “other collateral” category have been trading at ordinary rates, rendering other OFR rates — and the Fed’s TGCR — stable. What’s more, the volume of repos backed by “other collateral,” which could be anything from private-label MBS (mortgage-backed securities) to even equities, has rocketed by $50 billion.

If the data is accurate — and that’s a big if — some large lender with access to the triparty market and supposedly the Fed’s RRP has been willing to lend cash against the riskiest collateral from the largest dealers at a big discount for days, earning increasingly lower returns.

That's a very unusual development in the most systemically important market on the planet and, if it sounds absurd to you, you’re not alone.

This type of trading reflects the opposite of the true dynamic that plays out in the triparty repo market, where safety is everything. Only the prominent financial behemoths — mostly the Fed’s primary dealers — have gained admission to borrow in triparty because the major triparty lenders, MMFs, have learned their lesson from previous crises. They will only lend to entities too big to fail.

No considerable triparty lender, out of the blue, would likely loan $50 billion in cash against risky securities at a lower rate than lending against safer collateral, let alone avoid lending at a higher rate to the Fed, risk-free, via its RRP facility.

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In the secured standard — where financial entities are forced into accumulating U.S. sovereign assets — the overwhelming majority of triparty repos involve large dealers and banks borrowing cash secured against U.S. Treasuries and securities issued by GSEs (government-sponsored enterprises), such as Freddie Mac and Fannie Mae.

The latest spike in “other collateral” in OFR’s benchmark seems more of a bug than a feature. Whether the OFR’s triparty benchmark has gone haywire due to a technical blunder or not, this repo rate puzzle remains unsolved. Either way, the fact that the riskiest collateral is distorting the entire TPR benchmark suggests that officials will intervene.

Coincidentally, just as one repo benchmark has experienced a disconnect, the Fed’s major repo measure, SOFR (the Secured Overnight Financing Rate), which estimates the average rate across all repo segments, is about to turn slightly defective, according to its architects at the U.S. central bank.

As a major shift in repo market structure has commenced, arising from the transition to a centrally cleared era, the Fed has had to respond. Officials have proposed to remove an increased number of centrally cleared repos that will find their way into SOFR as this transition intensifies. Without modification, these repos will cause volatility in future SOFR readings due to where centrally cleared repo rates trade inside the Fed’s target band.

Even so, with the unsecured standard based on LIBOR about to fade entirely, SOFR will remain the undisputed king of money market benchmarks. But the new monarch is overdue for his first “major” rework, which history suggests will be the first of many to come.

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Kamala unveiled some very interesting economic solutions...

"many Fed cuts-a-coming"

Michael Hartnett on fiscal dominance driving interest rate policy:

"US national debt up >$1tn YTD to >$35tn;

interest payment on debt set to rise to $1.4tn by Jul'25 given debt dynamics if rates unchanged… even if Fed cuts 200bps (2%) interest payments rise to $1.2tn;

reversal of fiscal impulse (US govt spend -5% YoY) + cost of debt = many Fed cuts-a-coming."

🔗 BofA (Hartnett)

Grocery stores have razor-thin profit margins and people are talking about them price gouging. 🤷‍♀️

🔗 Lyn Alden

Kamala Harris wants to "ban the price gouging" of groceries. A first-ever initiative authorizing the FTC to impose fines on grocery stores for “excessive” price hikes.

Kamalanomics

Vice President Harris’ proposed economic plan essentially guarantees stagflation by both subsidizing demand and discouraging supply.

While Harris has been shy about her economic platform, her recent speech and prior campaigns suggest she would favor measures that discourage supply such as higher taxes and price controls. It also seems she would like to increase demand by subsidizing housing and forgiving some types of loans.

A combination of stronger demand amidst lower supply suggests a stagflationary economy, which has historically been bad for equities and - more importantly - bonds. While Harris should need the cooperation of Congress to realize her aspirations, the recent expansion of executive power implies she may have more influence than expected.

This post highlights the two aspects of Harris’ economic plan including subsidizing demand & discouraging supply, and suggests a Harris victory in November would be a market negative event.

Broader Presidential Power

The policy proposals of Harris reflect a belief system that has historically been negative for the economy and markets.

While much of Harris’ aspirations should require the cooperation of Congress, recent history indicates a broadening of Presidential power. For example, the White House has been able to increase the population by several million by neglecting to enforce immigration law. Similarly, the White House first paused repayment of Federal student loans and then cancelled the debt of some borrowers.

The willingness to selectively enforce laws or creatively interpret them has greatly expanded the power of the President, so a President Harris may be able to implement more of her plans than expected. Increasing demand while decreasing supply is a reliable recipe for stagflation, which is historically a bad backdrop for equities and bonds.

A Harris victory in November now looks to be a market negative event.

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