It's not the economy, stupid
The sudden liquidity squeeze in the United States, where repo rates (nowadays the method of choice for overnight borrowing and lending) peaked at 7.5%, wasn’t exactly what we were expecting to happen. But we were looking, as regular blog readers will know, at exactly the right part of the financial system. The weak spot today is the shortage of collateral for repo lending.
It explains why bond yields have gone down: demand for high quality collateral. It explains why the Federal Reserve has twice cut rates: nothing to do with Trump or the economy, everything to do with the need for liquidity in interbank and corporate borrowing. And it explains why markets remain jumpy.
The underlying problem is not lack of cash either; there is plenty hoarded away in institutional investors and corporate balance sheets. The problem is that liquidity is not fungible: you may have cash, and I may need it, but that doesn’t mean you’re going to lend it to me.
Last week’s repo rate spike seems to have been caused by a spike in demand for cash from US corporates - presumably different ones from those with cash. But it is a clear illustration of the difficulties many corporates will have when they need to refinance. If readers need a couple of other very different examples of the difficulty of (re-)financing today, look at Metro Bank in the UK this week and WeWork in the US last week.
In our view the Federal Reserve at least is well aware of the problem and is doing what it can to be proactive. However, that alone does not remove the risk. It is quite possible that whatever the Fed. does is insufficient to avert another financial crisis.
It is not an easy position for investors, because the outcome is in our view close to binary. If the liquidity squeeze results in corporate failures, markets should expect something like a repeat of 2008-9. If the Fed is able to provide sufficient liquidity to finance those who need it, then the current not unfavourable market environment continues. Our base case is the latter, but if we are wrong, by the time you know that, it will be too late to take much sensible action.
Systemic risk should be the focus for investors and not the prospects for an economic downturn, as commentators like to burble on about. It’s not the economy, stupid.
Find out more about the data behind our view by contacting us.