In a previous article, I explained that the yield curve would revert to positive territory when the Treasury runs out of money in September 2019. That prediction is slowly coming to fruition.
Earlier this week, the repo market showed symptoms of liquidity problems where the Federal Reserve needed to inject tens of billions of dollars into the banking system three days in a row. The Secured Overnight Funding Rate, also known as SOFR, spiked to 5%, much higher than the Fed funds rate of 2% (see chart from FRED below). The reason for this spike was probably due to tax payments to the Treasury in September and due to the issuance of huge amounts of debt (U.S. government debt has spiked from $22 trillion to $22.6 trillion as of this writing).
This interest rate spike also occurred in 2008, when the Federal Reserve resorted to a series of rate cuts and started its Quantitative Easing program. What is happening today is very similar, as we're seeing another liquidity crisis in the repo market. I expect that QE4 will be announced somewhere later this year, and it will be very substantial considering the fact that debt and deficits are now much larger than in 2008.
You might wonder why the banks aren't using their $1 trillion in excess reserves to supply the liquidity (see chart below from FRED).
The reason is very simple; they are restricted in doing so. Basel III imposes banks to have a Liquidity Coverage Ratio or LCR of 100%.
The LCR was implemented and measured in 2011, but the full 100% minimum was not enforced until 2015. The liquidity coverage ratio applies to all banking institutions that have more than $250 billion in total consolidated assets or more than $10 billion in on-balance sheet foreign exposure. Such banks, often referred to as "Systematically Important Financial Institutions (SIFI)," are required to maintain a 100% LCR, which means holding an amount of highly liquid assets that are equal or greater than its net cash flow, over a 30-day stress period. Highly liquid assets can include cash, Treasury bonds or corporate debt.
At a press conference on Wednesday, Federal Reserve Chair Jerome Powell disputed the idea that the LCR needed to change. "It's not impossible that we could come to a view that the LCR is calibrated too high, but that's not something we think right now," he said.
So the banks cannot use this money and that was the reason why they needed to go to the repo market to get the liquidity. Moreover, banks still get interest on these excess reserves (IOER) of 1.8%, so they are very reluctant to pull the money out.
What we are seeing now in the repo market is actually the start of QE. You can call it differently, but it is in essence the same. The Federal Reserve buys up Treasury bonds and supplies the market with cash. Jeffrey Gundlach calls it "the first baby steps to QE". I agree with that; the signs of a crisis in the credit markets show us that the Federal Reserve has no other choice than to restart QE.
This brings me back to my prediction of a reversion of the yield curve into positive territory. When QE is implemented, we generally see a cut in interest rates as well. So the lower end of the yield curve will decline. Due to the printing of money into existence, inflation will start to appear and this will show itself in a rise in the higher end of the yield curve. High maturity bond yields go up and low maturity bond yields go down.
On the following chart from Yardeni, you can see a visualization of the periods of QE against the yield curve. Periods with QE go hand in hand with a rise in the yield curve and that is exactly what will occur next year when QE4 will have started. The U.S. dollar generally weakens during this time.
Investors need to position themselves for this rise in the yield curve. These are periods with high inflation rates as the Federal Reserve increases the money supply. Let's also not forget that the ECB has also restarted QE at a pace of 20 billion euro per month in Treasury purchases in November 2019. The worst places to be in are cash and Treasury bonds, while real estate, stocks and precious metals will outperform.
Disclosure: I/we 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.