November 2019 - Market Commentary & Research

Credit Markets: The cracks begin to show

Two major credit market events have occurred in 2019. The first was the harbinger of a recession, the dreaded 2-year to 10-year yield curve inversion in August. This was followed by a massive spike in short-term rates when the overnight repo rate shot up to 10% in late September. Many people reading this can’t or don’t remember the last time they saw a double-digit baseline interest rate. Seeing the best credit-market seize up in this manner was alarming and perplexing. This jump in overnight rates didn’t wipe-out billions of dollars of wealth but it garnered a lot of attention, and rightly so. The last financial crisis was centered principally around credit, and many crises begin as liquidity issues. 

Since the spike in the repo rate, the Federal Reserve has injected and will continue to inject cash in the credit markets, at least through the second quarter of 2020 (WSJ). Throughout 2019 the Fed has continued to lower interest rates and the major stock market indices have experienced increased volatility, albeit finding new record highs in October.

Remember, just a year ago, the stock market was flying high fueled by optimism surrounding the tax cuts, and it looked as if the Fed would continue to tighten. Then December 2018 happened. Future GDP growth came into question, the stock market took huge losses and the Fed quickly backpedaled on tightening credit. Thankfully for the Fed, the stock market has reacted in a fairly predictable way to monetary policy. The credit market on the other hand hasn’t been as conciliatory, the yield curve remains inverted and the repo market is now in need to major assistance.

The repo market is the Fed’s foray into reintroducing quantitative easing, despite declaring that everything is fine. At first reporting, the Fed’s response seemed natural. A collusion of factors, largely exogenous to the market were to blame for the spike in repo rates: quarterly tax payments coming due, settlement of a recent Treasury auction, and regulation requiring banks to keep additional liquidity (Reuters). But if so, why continue intervening through Q2 2020?

Trader Sven Henrich recently penned an opinion piece arguing simply everything is not fine in the repo market. As he goes on to argue, the Fed might be saying there’s nothing to worry about but injecting daily liquidity (e.g. quantitative easing) into the repo market says just the opposite (MarketWatch). How is the most liquid credit market in the world in need of billions of dollars of daily liquidity? This has become the confusing reality of the credit markets relative to the broader economy. 

To better appreciate how different of a credit market we are in, Chart I displays the Treasury Yield curve for all maturities for 2016 through YTD October 2019. The specific data points for each maturity, e.g. “1 Mo.”, are summary statistics, showing the high, low, 25th percentile, 75th percentile and median rates for the year. The Yield Curve has gone from its normal upward-sloping shape to a moving inversion.

Chart I

Taking a more granular look at 2019 by quarters (Chart II), the volatility implied in the 2019 yield curve spread takes shape. Growth concerns were cited as the principal reason to cut rates in Q2 2019 and leading to the first reduction on July 31, 2019 and the second on September 18th, 2019. Unable to control investor beliefs about growth, the rate cuts were not enough to prevent the yield curve from inverting in August 2019. The 2-Year (green box plot) and the 10-Year (gold box plot) are no longer inverted and their reversal is quite common.

Chart II

While recent GDP growth has not been superb, it has been strong enough to suggest more aggressive measures (e.g. continuing to provide daily liquidity) by the Fed are unnecessary. Little can be said today about the credit markets without mentioning the Fed, which is not good. In fact, little can be said of the major developed economies credit markets without mentioning central banking authorities. In an attempt to prevent another a credit crisis, central banking and federal government authorities might have created the problem they feared: fragile credit markets too reliant on outside forces.

This isn’t to say the Fed’s response to the repo market was unwarranted or wrong, but it does question the extent to which regulation and the Fed are preventing the natural price discovery of the market. We are in unprecedented times, both in terms of GDP growth and monetary policy. It’s easy to sit back and criticize ex post, these are not easy decisions being made. Regulation might be to blame for this recent repo rate spike, but continuing to provide additional liquidity to the market is concerning, especially when the U.S. economy is supposedly doing so well.

The Fed’s decisions must be examined with a greater timeline in mind; 1 year, 5 years or 10 years later. When quantitative easing was first introduced it was clearer the U.S. economy was performing sub-par relative to other recoveries. 10 years after the last recession, it’s not clear the economy will, if ever grow at historical levels. Such results have major implications for monetary policy.

Monetary policy has an important place in the credit markets and provides a very important safety net for the economy and the financial markets, but it shouldn’t be the credit market. Economic slowdowns are part of the price discovery process and should not be neutralized out of the economy. Providing very-short term liquidity to the repo market in response to possibly outside factors is one thing. Providing billions of dollars of daily liquidity when the economy is still doing fairly well, is another. Obviously, the repo market and the economy aren’t directly corollaries but they do respond to one another. For the Fed to intervene this late in the cycle and in this way suggests policies designed to keep credit markets well-functioning are having the opposite effect or intervening is silencing concerns the credit markets are trying to convey.