September saw Equities attempt a breakout and continue up the Wall of Worry. That breakout isn’t confirmed as yet; this time the move doesn’t feel too strong, as the causes for worry are quite substantial. Brexit and global trade wars are the usual suspects, add to that Trump impeachment news hitting the tapes. These are still external sources of uncertainty ( that could very well affect risk assets) however, we have started seeing hard economic data now slowly move to weakness: both US manufacturing & services numbers’ latest releases were quite weak along with weak expected German GDP coming under the spotlight. Another factor that the market is overlooking is the REPO rate spike that occurred late in September. We don’t think it’s as negligible as the media would make it out to be. Global capital markets are intertwined to a degree no one fully understands, and short term US dollar liquidity is the lifeblood that flows through the system. Pressure on that front cannot mean all is well. Do we feel this would force the US FED to reduce rates even further and probably start monetary easing operations, maybe also call it QE4? Fixed-income assets seem to think so, but September saw a pause and retrace in the bond rally. Our fund being overweight bonds gave up 1.3% due to the retrace. We made a small addition to investment-grade bond ETFs by further lightening our position in US Large-Cap and Technology Equity ETFs. Our portfolio is once again quite defensive. As always, asset allocation is as per our price momentum based strategy.

Sep 2019 Momentum and Volatility scores for the Passive Allocator Universe

Since our fund is overweight US Treasury ETFs (mainly short and medium-term), we decided to focus this month’s commentary on central bank machinations with a focus on the US FED.

US Bank’s aggregate reserves over 2 decades. Source: Bloomberg Professional

Money held within the bank network is known as reserves. Banks are required to maintain specific reserve amounts with the central bank, and anything over this amount is known as excess reserves. However, Basel rules require banks to hold certain levels of capital and also face restrictions on the growth of their assets. Thus most of these excess reserves that banks own are now used to fulfil these regulatory capital requirements. Simply put, a lot of bank liquidity is locked up due to regulation. These reserves are not really ‘free’ or ‘excess’ anymore. Second, the rate of interest offered on excess reserves parked with the Fed is also quite high

So what is Repo? Repo stands for repurchase agreements, basically collateralised transactions between institutions like banks, central banks and even big asset owners. When a central bank does Repo, they can create reserves “out of thin air” to put it crudely – this is how they generate liquidity and transfer it to banks. Banks are free to do what they please with these reserves: lend it out as loans to the real economy, or trade them amongst each other in the market for these reserves, known colloquially as the Fed funds market.

In mid-September the USD Repo rate spiked. The FED had to step in and create reserves to calm the situation. But why did this spike occur in the first place? Banks are either unable or unwilling to lend out in the short term Repo markets. This in turn is tightening short term liquidity supply – there just aren’t as much bank reserves sloshing around for the market to clear at lower rates. Only a central bank can create more supply of reserves, or put another way, create more money supply. That is what the FED did in September by entering the market and shepherding the repo rate lower.

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities

Now arises the question- is this enough or will the Fed have to act more, and act long term? We think so they do. Short term rates seem too high, there needs to be some action on that front. We’re holding our breath for the end of the year, hoping to see further monetary easing very soon. This should fuel a further rally in fixed income assets.

Happy Investing,
PA fund team.