REPO-20: The Real Virus That Stock Market Investors Should Fear
Summary
- Why Covid-19 is not the only virus that threatens stock investors.
- Are the central bank gurus losing control?
- What does it mean for stock markets?
I posted the following Dow Jones chart on another platform for the week of 17th February 2020 with the following comment:
(Source: Trading View/author)
If the market fails to hold above the support line marked, then a 7% fall is possible to the 50ma and previous support.
A bearish weekly close for the week led to the Coronavirus panic week, and we retraced over 7% on the Dow to the 50 ma. The market has managed to retrace some of the losses with a move above 26,000 and optimism is returning following coordinated central bank action. An expected rate cut in Australia was met with an "emergency" rate cut of 50 basis points by the Federal Reserve, and analysts expect the European and English central banks to follow suit as early as this week. Goldman Sachs has also predicted that the Fed will cut twice more next month.
Why Covid-19 is not the only virus that threatens stock investors
The real virus that traders should be concerned about is the one that has infected the overnight repo market since September.
Back in September, the Federal Reserve announced its first move in a decade to inject liquidity into U.S. money markets after a spike in the overnight repo market. The key short-term rates that are seen as the "plumbing" of the financial system jumped to 10% and threatened Treasury bonds and bank lending. The repo market was the scene of Bear Stearns and Lehman Brothers' downfall, and this market was flashing a warning that liquidity was tight and banks were not lending to each other with the same ease.
To address the short-term crunch, the New York Fed announced that it would supply liquidity by buying up to $75 billion in repurchase agreements, in which the bank buys up Treasury and federal agency debt and sells them back when the repo expires.
The move by the Fed calmed the market, but the problem is that it never stopped. The liquidity program was extended into year-end with the excuse that banks needed year-end funding related to tax requirements and the Federal Reserve has reversed its previous tapering to add $400 billion in assets to its books.
(Source: Federal Reserve)
Are the central bank gurus losing control?
The rally in stocks since 2009 has been massively fuelled by central banks. Trillions of dollars of assets have been bought by global central banks as they continue on a race-to-the-bottom in interest rates. The Fed's actions from September could have been a sign that a major bank was in trouble, or that they are beginning to lose control of the short-end of rates. The Coronavirus panic has therefore been a convenient excuse to extend the stimulus and liquidity provision by slashing rates towards zero.
Despite the rate cut, yesterday's G7 announcement to provide assistance was followed by the largest demand yet for repo liquidity.
(Source: Zerohedge)
We are now used to coordinated action by the world's central banks, but investors should be under no illusions that they are running out of room to stimulate and calm money markets.
What does it mean for stock markets?
The continual addition of liquidity and stimulus measures have been a boost to stocks over the last 10 years, but investors need to be careful in the months ahead with some of the weighty valuations that are in the market.
The Federal Reserve may be able to squeeze down short-term rates, but those lower rates won't likely translate to lower rates of lending in the real economy that could provide a meaningful boost. We have heard this "whatever it takes" rhetoric before, but the global trade and economies are collapsing, and the stimulus is not having the desired effect.
Markets are still unaware of the impact that China's virus lockdown will have on companies and economies. Most important here are economies such as Italy, with its 2.4 trillion debt pile and an economy flirting with recession levels. Italy has seen the worst virus spread outside of Asia and officials are still scrambling to contain the outbreak as they have announced a temporary closure of schools and universities. One of the worst hit regions in the country was Lombardy, which is a manufacturing hub and one of the country's wealthiest areas. The ripple effects of the virus on global supply chains are still a headwind and economic data over the next months will suffer.
Italy released GDP figures today showing 0.1% growth for the quarter and with Eurozone interest rates at zero already, where does the ECB go next?
Investors must tread carefully in the coming weeks and months. The virus impact is being used as a means to inject yet more stimuli into a world economy that has not responded well to stimulus and global trade has collapsed. The playing field is no longer level with some supply chain companies or sectors at real risk of a protracted downturn.
Most importantly, investors should read beyond the headlines and consider what's happening in the repo market. The Federal Reserve has quietly reversed the previous tapering to flood the market with liquidity, but the repo problems started before the Coronavirus was even heard of. Economic data or the impact of a further spread in the virus could bring a market shock in the months ahead.
For this reason, I am staying neutral on the stock indices until we see further clarification that the virus is contained and supply chains are in good shape.
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