Yellen Opens Six-Month Gate

Includes: DIA, QQQ, SPY
by: Lawrence Fuller


Janet Yellen's reference to a six-month time frame for increasing short-term interest rates sent the stock market reeling.

The consensus has concluded that the continued selling pressure in stocks that followed is a result of slowing economic growth in China and the ongoing crisis in Ukraine.

The real reason that stocks are under pressure is the increasing amounts of reverse repos being conducted by the Fed under its Reverse Repo Facility.

Janet Yellen suggested last week that short-term interest rates might rise as soon as six months after the completion of the Fed's current bond-purchase program (QE3). Those two words sent the stock market reeling. The futures market bumped up the expected date for the first rate hike to April 2015, which is three months sooner than previously expected. The damage control that followed, and which is ongoing, has been a spectacle to watch. Wall street pundits have used the excuses of slowing economic growth in China and the ongoing crisis in Ukraine as reasons for the decline in US stock prices since Yellen's statement, but it is clear to me that the selling pressure in recent days is due to the mention of this six-month time frame.

It appeared as though the Wall Street Journal's Jon Hilsenrath was hastily dispatched by his Fed handlers last weekend with an article attempting to refocus the debate. He wrote that "Wall Street might have glossed over news of greater consequence," stating that the Fed "planned to keep short-term rates below what it sees as appropriate for a normal economy even after the unemployment rate and inflation revert to typical levels." This telepath's calming words didn't seem to have their desired effect, as the Russell 2000 index (NYSEARCA:IWM) was drubbed on Monday morning, declining 1.3%, and the red hot biotech sector (NASDAQ:IBB) lost nearly 3%. Concern suddenly arose that small cap stocks were in bubble territory with recognition that the index now trades at 49x earnings, which fell short of analysts' estimates by 13% in the most recent quarter and grew at a rate less than that of the S&P 500. There was no apparent concern for these figures a week ago, a month ago or even at the beginning of the year. What changed?

St. Louis Fed President James Bullard was the first to comment after Yellen's apparent gaff, saying that her reference to a six-month period was simply reiterating the views already held by the consensus of investors and analysts. Minneapolis Fed President Kocherlakota followed with a statement that the Fed was not trying to signal a move toward a more restrictive policy with respect to interest rates. San Francisco Fed President Williams then attempted to sooth markets on Monday by stating in an interview that he didn't see "anything of what we said as suggesting that we're going to tighten monetary policy sooner rather than previously." Philadelphia Fed President Charles Plosser followed, stating on CNBC that he didn't understand the market's negative response to the reference of a six-month time frame for rate hikes after the bond purchases end, claiming that this time frame was already expected by the markets.

Regardless of these attempts to calm investors, the higher-risk segments of the stock market were bludgeoned this week, with small caps falling nearly 4%, and many of the market-leading momentum stocks pummeled for double-digit losses. Market weakness of this nature is the sniffle that could eventually turn into a nasty cold if momentum picks up to the downside.

Common sense dictates that a normalization, in this case an increase, in short-term interest rates would be a good thing. Higher short-term rates would imply a healthier level of inflation, closer to the Fed's 2% target, which implies a faster rate of real economic growth, closer to the Fed's 3% target. Faster rates of economic growth result in faster rates of corporate revenue and profit growth. An increase in profits that is driven by revenue growth results in the job creation that the Fed has been striving for these past five years. In fact, everything indicates that a normalization in short-term interest rates signifies a strengthening economy. That should be bullish for the stock market. It would also validate some of the meteoric increase in small-cap stock valuations, which are considered more of a proxy for the health of the domestic economy than their large-cap brethren.

One problem is that the Fed is tapering its bond purchases and intimating an end to its zero-interest-rate policy shortly thereafter, based on the expectation that economic conditions will improve along the lines of its rosy forecast for this year and the next, but its track record on forecasting is not a good one. In reality, the Fed's policies have had a minimal impact on economic growth. I recently wrote about the evolution of quantitative easing over the past five years, starting as a policy intended to work through the lending channel, but then transforming with QE3 into one that specifically targeted the stock market. The Fed was obviously successful in that capacity, as stock prices have soared since the onset of QE3, but far less successful in achieving the second derivative objectives it desired - full employment and stable prices.

So we could conclude that the stock market is declining out of concern that the Fed is reducing monetary stimulus and planning to slowly normalize short-term interest rates prior to conclusive evidence that its real-world economic forecast is coming to fruition. In other words, the economic recovery is not yet sustainable. This is a plausible rationale, but I think a more significant catalyst for the recent spate of selling, as well as the flat to modestly negative returns for the market indices year-to-date, relates to the Fed's increased use of its Reverse Repo Facility. In order to connect the dots, let me define a few key terms, provide some background on this new Fed tool, and show how it operates today.

Our financial system consists of regulated banks that accept traditional bank deposits, and non-bank financial institutions and entities that provide similar services, but which are not regulated (in the shadows) and do not accept traditional bank deposits. Examples of these non-bank entities are hedge funds, securities broker-dealers, investment banks, private-equity funds and money market mutual funds. These non-bank entities, working in the same capacity as commercial banks, make up what is known as the shadow banking system, which in combination with the regulated banks, are responsible for the creation of credit across the global financial system.

A repurchase agreement (REPO) is one of the most common transactions between banks, central banks and non-bank financial institutions and entities. It is an important source of liquidity for money markets and financial institutions, serving as the primary building block of credit creation in the shadow banking system. A repo is a very short-term (typically one day) collateralized loan between two parties. The borrower puts up securities (Treasury bill) as collateral for cash it receives from the lender, promising to repurchase the collateral at a higher price, which constitutes the interest.

When a lender pledges the collateral it has received from the borrower to another lender in order to replenish its cash and reinvest to generate incremental returns, it is called rehypothecation, or re-using the collateral. It is completely legal. Regulators have no idea how much credit is created at any one time through this process of pledging the same collateral over and over again to borrow larger and larger sums, because it is happening in the shadow banking system. JPMorgan serves as one of the two primary collateral agents in the most common type of repurchase agreements known as tri-party repo agreements. It acts as the intermediary between the borrower and lender, handling all of the operational aspects of the transaction. The size of this market is nearly $2 trillion. JPMorgan promotes the rehypothecation of securities collateral, for a fee of course. The company's brochure states, "unlock the value of assets held in tri-party by re-using collateral."

It is easy to see how an excess of credit can be created in the shadow banking system by the bank and non-bank participants through the repo market and the practice of rehypothecation. Since the majority of these activities are self-regulated, it is also easy to see the potential for systemic risk. This shadow banking system was the source of the securitization and excessive leverage in mortgage-related securities that led to the financial crisis in 2008. The difference today is that the unknown amounts of leverage in our system, which is awash with liquidity, are being invested in a broad array of risk assets.

Last September the Federal Reserve announced that it would be testing a new tool aimed at soaking up some of the excess liquidity in the banking system and gaining more control over the short-term interest rate that prevailed at that time in the repurchase market. Due to the amount of excess liquidity, that rate was virtually zero. Through its overnight Reverse Repo Facility, a select group of bank and non-bank participants would lend cash to the Fed in exchange for US government securities (collateral). This is considered a reverse repo, because the Fed is typically the lender and not the borrower. The program now has 140 participants made up of money market mutual funds, banks, primary dealers and government-sponsored enterprises (GSEs). The maximum amount of cash each participant could lend started at $500 million at an overnight interest rate of just .01%, but the amount has steadily increased to $7 billion and the interest rate is now .05%.

As the Fed increased the limit that each counterparty could lend, as well as the interest rate it pays, which is the floor under short-term interest rates that it is setting, the daily volume of reverse repos under this program has surged from less than $10 billion to more than $100 billion a day.

What makes this facility unique is that the Fed is delving into the shadow banking system to take a significant role in the repo market with non-bank institutions. Its stated objective is to gain more control over the short-term overnight rate that operates within the Fed's target range of zero and .25%. If it offers a risk-free overnight investment rate for participants that is higher than other counterparties are offering in the repo market, then participants will be unwilling to lend elsewhere. It is important to recognize that the majority of the participants in this facility are money market funds, which are one of the primary lenders in the shadow banking system.

I believe this facility is having an impact on risk assets that has gone largely unrecognized, and which could be a key factor in the muted returns we have seen in the stock market indices year-to-date. The reason is that the collateral being used in this reverse repo program with the non-bank institutions cannot be rehypothecated, or re-pledged, to create additional liquidity for reinvestment. It is shrinking the amount of credit available in the shadow banking sector. Therefore, it is operating in the same way that an increase in margin requirements would affect the retail investor. Perhaps $100 billion doesn't sound like a large figure, but if that sum is collateral that is being pledged and re-pledged in a daisy chain of loans and investments, the multiplier effect is enormous.

If my supposition is correct, then it would seem that Yellen's reference to a shorter time frame for an increase in short-term interest rates than originally expected is being construed as a further increase in reverse repo activity by the Fed even sooner than that. This creates fear that additional liquidity/credit, which has been used for leveraged investing in the financial markets, will be pulled from the plumbing of the financial system. What results is a reduction of leverage in risk assets now, initially in those assets that carry the greatest risk, and I think that is what we are seeing play out in financial markets at the moment.

Another less transparent motive of the Fed could be to reduce the ever present systemic risk in the shadow banking sector as it is withdrawing stimulus through the tapering of QE3. It obviously has an incentive to protect the money market mutual fund industry, which serves a dominant lender, as well. In a research paper published by the New York Fed last year, one of the remaining challenges identified in the repo market subsequent to the financial crisis is the potential for "run" risk. What happens if participants in the repo market want to sell collateral all at once? The daisy chain is broken and credit collapses. Perhaps the Fed is establishing itself as a backstop to such risk.

It could also be that the Fed is concerned about asset bubbles in segments of the financial markets where speculation has obviously run rampant, like junk bonds or small-cap equities. Having clearly met its objective of asset price inflation, it may want to cool further speculation by constraining the creation of credit in the shadow banking system.

Unfortunately, much like the last crisis, there is no way to know how much leverage is in the system and where it exists. My greatest concern is the fact that we have had very low borrowing costs for a very long time, which has incentivized risk taking. Couple this with the certainty that the Fed has provided shadow banking participants through its forward guidance that those rates will stay low for a long time moving forward. Now there is an element of uncertainty that could be in the early stages of unwinding the Fed's great wealth effect experiment before a legitimate economic recovery takes hold. If we are in the midst of a global high-stakes game of musical chairs, as I believe we are, then it is possible that Janet Yellen's reference to a six-month time frame for interest rate increases is the swan song starting to play.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.