This month also gave investors something else to worry about. The general collateral repo rate in the US suddenly spiked and the Fed had to eventually step in with repo operations to stabilize this overnight lending rate. Many explanations were presented for why the spike happened with technical aspects such as corporate tax payments overlapped with large Treasury auctions. But the sustained pressure on the repo rate forced the Fed to begin two-week repo operations and former Fed president Narayana Kocherlakota recently raised concerns about dynamics unfolding in the repo market.
One of the root causes behind the repo rate spike is post financial crisis regulation forcing banks to hold more liquid assets on their balance sheet and a prohibitively charge on balance sheet. This regulation forces banks to utilize and optimize their balance sheets to a degree where they cannot easily commit risk capital in a market segment to arbitrage away inefficiencies or capture an opportunity. The four largest US commercial banks also have increased their balance sheets to a degree where they will all see a surcharge by Q4 if they don’t reduce their balance sheets. In effect US banks are incentivized through regulation to reduce balance sheet which will constrain USD liquidity even more.
In our upcoming Q4 Outlook this week we analyse the USD and what it means for asset classes and the economy. The overall conclusion is the USD strength is killing global growth and with monetary policy maxed out the next policy move will have to be that of weakening the USD. Part of that exercise is to cut USD rates more aggressively and also begin expanding the Fed’s balance sheet which has been shrinking since late 2017 (see chart).