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It was a huge night on markets, although you wouldn’t have noticed by looking purely at the modest net change in US trade in bonds, FX and equities, or the limited moves seen today in Asia. Certainly, oil traders would have seen a higher volatility front and centre, and they don’t need to be told how volatile things are, where the mere hint that Saudi production could reach 11m barrels in September, caused a 6.2% reaction in the barrel into $58.24 – although, at this stage, price is holding Monday’s low and I’d imagine many will be leaning against this level for their stop placement.

The USD is the currency to watch, with the FOMC meeting due at 4 am AEST, with Powell speaking 30 minutes after. We saw the USD index (USDX) close -0.4% yesterday, giving back most of the gains we saw on Monday, and for a second day, the USD took its direction from the drama unfolding in the US repo, and funding markets. This is an area where outside of a community of rates and repo dealers, many would claim to have a basic understanding, but a limited number would genuinely call themselves ‘experts. I don’t claim to be an expert either, but consider we are effectively talking about the plumbing in the US financial system and arguably the most important area of finance.

Perhaps this is where everyone should start when they are cutting their craft in economics and finance.

Watching the US repo and funding channels

We’re talking about the roots of market liquidity, the very essence of the oxygen that saturates the metaphoric lungs of financial markets. If markets are a sentiment game, then liquidity is the sum of all fears. This aspect of finance drives the cost of money and has a deep impact into so many areas of central bank policy. The fact then that we saw a huge move out of the gates in the general collateral repo market resonated in the fed funds markets, with the effective rate, the rate by which the Fed is supposed to maintain between a target range of 2% and 2.25%, pushed up to 2.25%, with some talk on the floors it could move to 2.5%. That would have been a big issue, and the Fed had no choice but to act, so it was no surprise that the NY Fed had to execute a massive $53.2b reverse repo program taking collateral out of the market – the first time the NY Fed has acted like this in a decade.

The reason? Well, the underlying issue is the growing scarcity of excess reserves in the system and the idea that commercial banks need funding. Consider we saw around $100b drained from the system earlier in the week due to US companies taking cash out of short-term markets to pay tax bills, as well as other considerations like note refunding. The crux of the issue is the Fed like a reserve buffer above $200b, and that is no longer the case, especially as the US Treasury department is going to further increase its cash holdings, which means even lower excess reserves in the weeks ahead.

So, what does that mean for those not involved with the short-term rates market? Well, a market that feels the Fed has lost control of the funding channels is a market that will have a far higher implied volatility. We are not there yet, but it means the Fed has to convince us they still have the firepower and that starts tonight at the FOMC meeting.

This adds a whole new dimension to the central bank meet and what traders should intently focus on. This is, therefore, my checklist to navigate:

1) A rate cut – the market is pricing a 16% chance of 50bp cut, so a 25bp is all but assured and while a low risk, we simply can’t rule out a 50bp cut. I don’t see this myself, but a 50bp cut would steepen the yield curve and have big implications for the USD and equities

2) The outlook and risks to the US and global economy – With the market pricing 45bp of cuts by December (inclusive of the 25bp cut tonight), will the outlook and the tone in Powell’s voice meet this pricing?

3) The Fed “Dots Plot” projection – While we are likely to see Rosengren and George dissent, how will the ‘dots’ portray the dispersion of opinion with the voting members?

4) The narrative around the Fed’s balance sheet. Any strong views the balance sheet is going to start expanding again will be taken as Quantitative Easing (QE) lite and should be good for risk.

5) Any commentary about influencing the repo market on an ongoing basis to help keep ST rates in a desired range.

6) A cut to the Interest On Excess Reserves (IOER), which is an essential tool for the Fed to control the fed funds effective rate. The market expects this to be cut to 1.85%, which, again, should help subdue volatility in the USD funding markets if we see it.

As you can see, there are many focal points for market participants to be across, so it could be a hard one to trade if you are inclined to trade news. The liquidity aspect is a new dynamic and could be a real driver of assets, while the market will also key off the tone of the Fed.

If you put a gun to my head, it feels like the risks are skewed for USD downside, which implies a bid in US Treasury’s and equities. Could we see a new all-time high in the S&P 500 tonight? Gold, as the second derivative of real rates, would naturally benefit here, but it’s a hard one. If I look at USDJPY overnight implied volatility, unsurprisingly, we can see this moving into 15% and the top of its 12-month range and subsequently this implies a move of 75-pips on the session (with a level of 68.2% confidence). I expect this to push a little higher as we head into European open, with higher vols likely seen across G10 FX, rates and precious metals.

Published by Chris Weston, Head of Research, Pepperstone