Outlook:

We now have the proverbial monkey wrench in the machinery. It is a breakdown in liquidity, meaning banks will not lend to one another so that banks with paying customers, aka borrowers, can make loans. A lot of the lack of liquidity affects the repo market, which is the "plumbing" whereby banks lend to one another to jigger reserves into regulatory shape.

People tend to think that if the central banks throw enough money at the dysfunctional machinery, it will magically fix things. Wrong. More money is like flooding the broken machine with oil. Nice for the machine's moving parts, maybe, but doesn't remove the spanner. Yesterday the Fed announced $2 trillion in new repo operations into next week "to address highly unusual disruptions in Treasury financing markets." When you add up this operation and that operation ($500 billion yesterday and $1 trillion per day for the upcoming week), the total could be $5 trillion. And don't miss that new infusions will not be limited to short-term bills only, but will match the maturity distribution of the outstanding Treasury debt. This is one inch from Japan's "curve control." Analysts are happy that banks took up only a portion of the money on offer, but it's not really comforting. The Fed felt the need to pour oil on the machinery—that's what is important.

The bond market is the linchpin in not only the US economy—the basis for mortgages, for example—but much of the rest of the world. Distress in the bond market is a blaring klaxon. As one BlackRock official said, "If you don't know where the safest asset in the world is, it becomes next to impossible to figure out where everything else is." The US government guarantees its bonds, the next best thing to cash itself. If investors refuse to buy the bonds or to lend them, what can they be thinking?!

The WSJ reported "On Wednesday afternoon, investors across Wall Street reported that Treasury debt, especially certain kinds of older bonds, was becoming hard to trade. Bond yields swung wildly. A huge gap emerged between what buyers of bonds were offering and what sellers were charging." And this is the most liquid market in the world. It's a crisis.

What will fix it is not central bank action, but the prospect of repairing and mitigating the pandemic. The stock market has been saying this all along and now the Treasury market is chiming in. As every decent economist is saying—to deaf ears in the White House—outright subsidies to the working and middle class are needed. Trump rejected a House plan because it gave away too many "ideological goodies," as he called it. Note that the beneficiaries are not the cohort that own any equities or care about the S&P. But the House is riding to the rescue with a big package designed with the help of TreasSec Mnuchin. Senate leader McConnell is oddly absent, although he postponed the planned exit so the Senate can vote on the new bill. It includes a slew of things not yet specific, but surely new tax cuts and new spending, and they will jar loose the grip of the monkey wrench so it can be removed.

All the same, unless things get fixed and PDQ, recession seems inevitable. Two things: sane people don't re-elect politicians who openly disdain their abject financial condition. They elect the other guy. Also, recession carves a giant hole out of tax receipts. The deficit will worsen.

Who funds the deficit? See the charts from The Balance. They are year old but the best graphics. Who funds the US deficit is mostly domestic US entities, but Japan, China and the Middle East are pretty big, too. When you see the source of buyers is the UK, Switzerland and tax havens, you can generally safely think "Middle East."

US

Okay, now remember the big losses in trade revenues and the taxes on them China is sure to be booking. Then remember the Saudi oil price war with Russia. Both China and the Middle East are going to have less cash to spend on US Treasuries. If those three groups own about one-third of the Treasury market and are about to hold less, or at least not increase holdings proportionately as the debt rises, who steps in? The Fed, of course. If you thought the Fed's balance sheet was shocking at $4+ trillion, hang on to your hat. How about double that, or almost half of the market?

What's wrong with that? A lot. When a government entity, and despite its weird ownership, the Fed is a government entity, owns a big chunk of any market, misallocations can occur. They may not, but the beauty of the free market is that prices get set according to supply and demand, not a government's need to provide liquidity. We are already seeing that in the repo market, where the Fed stepped in again just yesterday with a few hundred billion. A few hundred billion and few there and pretty soon you're talking about real money.

It's not just the US. In the eurozone, the new ECB "stimulus" includes special long-term loans for better than free, as much as 25 bp below the already negative deposit rate. So, borrow €100 and repay at €75 in five years. Add to that what you charge the customer, and you are swimming in profits.

Here's the problem: banks want cheap money. Savers and investors want yield/return. Three guesses who has the muscle to get the referee, the Fed, on his side? It's the banks. They throw a tantrum, liquidity dries up, and the Fed obediently forks over some more money. Is it craven? You bet. It's also absolutely necessary. The odd thing is that there is no shortage of money. There's a shortage of entities willing to put it on offer at really lousy rates of return given perceived risk. Offer higher rates of return and greater assurances that the money is safe, and some of it will come back out from under the bed. We don't even want to think about the unhappy fact that the repo crisis started last September, before the pandemic crisis.

To what extent is the risk so high that players just picked up their marbles and went home? We admit to not knowing. It's on the same wavelength as gold not flying to the moon. There must be a reason, but nobody seems to know what it is. We would mention the obvious—risk of default—but that's unthinkable in the US, whatever Trump's propensity to cure mismanagement by way of bankruptcy. The other classic risk is devaluation, which should be meaningless for US players.

Returning to the monkey wrench—the machinery is not totally wrecked but the wrench has to be taken out and the surplus oil wiped away in order for the machine to run properly again. We hate to use this word, but some kind of reform is needed. But reform of the biggest financial network in the world while it's under so much stress seems like a dumb undertaking. And yet we know how it should work. It's not working. It's hideously dangerous. Where is the Brain Trust to get this fixed? We were all wildly critical of the Paulson/Geithner crowd—remember the bailout plan in three handwritten lines?—but honestly, it's obvious Mnuchin is definitely not up the task, let alone Larry.

Now tell us why the dollar rallied on Thursday and has some momentum to rally some more. We have some technical reasons—deeply oversold, the eurozone dithered and delivered zip—but as a longer-lasting trend, we have doubt.

Let's assume the pandemic gets really much worse, as the epidemiologists tells us to expect. But it has tapered off in China and will eventually taper off here, too. Whether that's this summer only to resume next fall, like the Spanish flu in 1918, or some other time, it will go away. Eventually. When that outcome starts being remotely possible, markets will recover, and fast.

 


 

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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This morning FX briefing is an information service, not a trading system. All trade recommendations are included in the afternoon report.

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