Since September, the Federal Reserve has been involved in Repurchase Agreements, also known as repo's. To understand why they are important, first it is important to understand exactly what they are and how they affect the market.
What are Repurchase Agreements?
In simple terms, a repo is the process of one financial institution lending money to other financial institutions/investors that are in need of short-term liquidity with the agreement to be paid back at a slightly higher rate, usually the next day. The "lender" lends money to the borrower by purchasing the borrower's government securities (bonds, t-bills). Since the borrower is selling bonds to the lender, they receive their short-term liquidity for the day that they will pay back the next morning. This is why it is often called the "overnight" market.
How Repo's Have Been Affecting The Market
When the Federal Reserve stepped in to save the repo market (liquidity was drying up as banks did not have enough money) they started pumping billions of dollars a day into the repo market. They did this by buying government securities from other banks which provided them with that temporary "overnight" liquidity discussed above. Essentially, the Fed bailed out the banks. Without this capital injection, banks would have no liquidity and they would be insolvent.
This sounds bad right? It is. It's terrible. But this was a blatant buying opportunity in October when Repo's started ramping up and we think it still is a short/medium-term buying opportunity now. To give ourselves some credibility for this statement, here was our prediction from October 7th and a follow up on October 15th (and we've been bullish ever since). Also, we knew the Repo operations would be extended for much longer because the system would simply fall apart without it.
Why is it a buying opportunity?
Because all this Fed action shows just how much they are willing to support the market to keep it propped up for as long as they can. They support the market to the tune of billions of dollars a day of liquidity injected into the overnight system. The Fed also started buying $60 billion worth of bonds per month since October. That's $60 billion of fresh money injected into the system every month. This bond buying puts downward pressure on bond yields; making them less attractive investments and as a result, it forces money into other assets like equities. That is why the stock market has been soaring. Bond yields have been dropping (meaning bonds themselves are rallying in price).
We predicted this scenario when the Fed cut rates in July. Here's a link to the article and a quote from it:
"What you can expect going forward from the economy is even weaker numbers. That is the most likely scenario in our opinion. These weaker numbers will cause the FED to act and cut rates even further. Stocks and bonds will continue to rally until they crash (they are in a huge bubble), and precious metals will continue to gain as well...Historically, the stock market performs very well the following months after a 25 basis point cut, and we think the same thing is going to happen this time around as well and new all-time highs will be hit soon despite the sell off. This rate cut sent a signal to investors that the FED has their backs, and that they are willing to do anything to "support the expansion" for as long as possible."
Needless to say, that's exactly what has happened.
Why This is a Major Cause For Concern
Quite Simply, the Fed wouldn't need to cut rates, and buy billions of dollars worth of bonds to force cash into stocks if the economy was in good condition. Although Fed chair Powell claims this is "Not QE", that's exactly what it is, QE (which is only done in emergency situations).
The Verdict in a Few Words
The market is a ticking time bomb. Although it is a short to medium-term buy, there is no knowing when the Fed will pull the plug and let everything fall (so keep that in mind when buying!). But for now, stocks and bonds will continue to get inflated until they crash. Gold will continue to do well because the economy is doing poorly and because of interest rate suppression. Same verdict as the quote from above...nothing has changed, except that the economy has gotten even worse.
Follow us on twitter @stockbrostrades