Weekly Comment - September 30, 2019

Sep 30, 2019 | Nick Foglietta


My promise was to keep these posts to under 750 words. I am nearing my limit at 741.

Keynesian Economics on the Ropes

There has been a very complicated story about the “overnight repo” markets that I want to BRIEFLY comment on below.

A “repurchase agreement” or repo is designed to create funds to offset illiquid overnight interbank funding transactions.

After 10 years of smooth sailing, all of a sudden the US Federal Reserve has been injecting about $75 billion a day into the overnight repo market to keep it operating smoothly.

Why is this happening?

There are many reasons the Fed needs to do this. The most benign seems like the most logical to me.

Since the US Fed stopped Quantitative Easing (QE), the bond markets have become significantly less liquid.

It was all of the foreign buyers of US Treasury bonds that helped keep things running smoothly. It would seem however, that a large set of purchasers have dropped out of the market for the most part.

Countries like China, Japan and India have stepped away from US Treasury purchases. Many Euro nations have too. At the same time, the US government deficit is skyrocketing and, therefore, the US is issuing more and more fresh Treasury bonds.

The American banks have always been large Treasury bond buyers and they have ramped up their pace of buying in 2019, to try and close the gap between the number of bonds the US needs to issue to fund the deficit, and the lack of traditional buyers. 

But those purchase amounts have not been enough.

Therefore, overnight repos have been necessary to calm the process.

Financial media tends to make a big deal out of these repos, but they are not a big deal; they are not symptomatic of some grand collapse in financial markets.

They are however, another marker showing how global financial markets no longer function on their own. They require constant central bank attention…hence, why I say Keynesian economics are on the ropes.

They are also the precursor to another Quantitative Easing program by the US Federal Reserve…but for readers of my weekly comments, that is not news.

We already knew we lived in the financial Hotel California

German Savers

I thought the chart below was worth a quick presentation. It is counter intuitive to what one would expect with lower and negative interest rates.

Savers are more concerned with the return OF their capital than the return ON their capital.

Notice as the light blue line representing German government bond (bund) yields goes lower, the savings rate of the citizens has actually diverged away from the direction of interest rates and stayed high.

Would that same thing happen in North America if our interest rates get down to the levels? My guess is yes, but we will have to wait and see.

Index Funds and Passive Investing

The chart below shows the growth in “actively managed funds” and “index funds” in the US. Notice here that for the first time ever, index investing has surpassed active investing in the total amount of money invested.

The assumption I am making is that much of the money invested in index based investments, is also “passive” in nature: It will likely not try to anticipate the next market downturn.

The question I am asking is: Will passive investors in index investments have enough courage to ride through the next BEAR market cycle to watch their investments regain value after the stock markets bottom?

If the answer to the question above is yes, then passive investors will not aid and abet the next market correction. If no, many passive investors will exacerbate the next BEAR market cycle by adding selling pressure to markets already under pressure.

I understand how investor psychology got here. As I was writing this my phone rang and a friend who works with retail advisors started telling me just how locked into the idea of passive investing and the expectation of 7% rates of return really are…everywhere he goes.

Yet, global manufacturing economy has been slowing for a while and many other economic indicators are signaling recession.

Sure, services indexes are relatively flat and real estate is hanging in there, but the global economy is at best late cycle.

My promise was to keep these posts to under 750 words. I am nearing my limit at 741.

My message is stay engaged in the investment process. Megan and I are always happy to hear from you and answer your questions. Don’t hesitate to call or email.