McClellan Chart In Focus: Fed Pulling Back from Repos at The Wrong Time – By Tom McClellan

 

 

Chart In Focus

The Federal Reserve decided in September 2019 that it would start to insert itself into the market for “repurchase agreements”, or repos.  The reasons why the Fed honchos decided that they needed to do that will be an interesting subject for future historians.  For current market historians, the important point about the Fed’s intervention in the repo market is that it was beneficial for stock prices to have the Fed adding liquidity in this way.  And the Fed’s gradual departure since early January has meant a withdrawal of liquidity from the banking system, and from investment accounts, which has put downward pressure on stock prices. The novel coronavirus has only amplified that downward pressure.

To understand the repo market, I suggest that you read What Is A Repurchase Agreement? from the folks at Investopedia.  The short version is that a repo is a loan to a hedge fund.  So if the Fed (or anyone) makes more of those loans, then the hedge fund honchos have more money to pour into the stock market.  If you reduce such lending to hedge funds, then they have to find other sources to borrow from or close out positions to pay back the loan, and stock prices tend to fall.

The stock market has been falling here in late February as investors worry about the Covid-19 virus, which has been expanding its reach around the world, and worrying everyone.  That worry has helped to amplify every other concern that investors might have about anything.  The Fed’s job is arguably to act as a dampening force, providing a counter-cyclical input to the financial markets.  They should be stimulating when everyone is worried, and retarding when everyone is giddy.

That does not appear to be what they are doing.  Instead, the Fed is following its predetermined plan to reduce its repo holdings, irrespective of what the stock market is doing. The Fed is providing a pro-cyclical amplification of liquidity force swings rather than a dampening force.

The Fed’s forays into the repo market have been episodic.  Here is a chart showing the full history:

Fed Repos

The Fed first got involved in the repo market back in 1999, as they were worried about liquidity problems related to the Y2K issue (remember that?).  They held minimal levels of repos after that, until ramping up again right after the 9/11 attacks.  Their next big involvement came in the 2008 financial crisis, and the Fed’s intervention helped the stock market for a while.

But then the Fed inexplicably pulled back just as Lehman was starting to collapse, and they pulled out completely in January 2009, hastening the final push downward by stock prices to the 2009 bottom.  Here is a look at that era:

Fed repos 2007-09

It is pretty evident that the two plots are well correlated.  So having the Fed withdraw from the repo market tightens liquidity, and has a depressing effect on stock prices.  They are doing it now, too, just as stocks are having their most rapid drop ever from an all-time high, and I have to wonder, what are the Fed honchos thinking?  Are they thinking?

Here is a closer look at the 1999-2003 period, and once again we see a general correlation between the Fed’s repo holdings and the movements of stock prices.

Fed Repos 1999-2003

The Fed has stated that it intends to continue to reduce its repo holdings.  If they follow through with that, then we can see in this week’s charts what the effect should be on stock prices.  But if the corona virus selloff gets the Fed to start rethinking its policy (as it should do with interest rate policy as well), then this historical perspective can help you know how to interpret any Fed announcements about their future plans in the repo market.

Tom McClellan
Editor, The McClellan Market Report

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About the author

Sherman and Marian's son Tom McClellan has done extensive analytical spreadsheet development for the stock and commodities markets, including the synthesizing of the four-year Presidential Cycle Pattern. He has fine tuned the rules for interrelationships between financial markets to provide leading indications for important market and economic data. Tom is a graduate of the U.S. Military Academy at West Point where he studied aerospace engineering, and he served as an Army helicopter pilot for 11 years. He began his own study of market technical analysis while still in the Army, and discovered ways to expand the use of his parents' indicators to forecast future market turning points. Tom views the movements of prices in the financial market through the eyes of an engineer, which allows him to focus on what the data really say rather than interpreting events according to the same "conventional wisdom" used by other analysts. In 1993, he left the Army to join his father in pursuing a new career doing this type of analysis. Tom and Sherman spent the next 2 years refining their analysis techniques and laying groundwork. In April 1995 they launched their newsletter, The McClellan Market Report, an 8 page report covering the stock, bond, and gold markets, which is published twice a month. They utilize the unique indicators they have developed to present their view of the market's structure as well as their forecasts for future trend direction and the timing of turning points. A Daily Edition was added in February 1998 to give subscribers daily updates on their indicators and also provide market position indications for stocks, bonds and gold. Their subscribers range from individual investors to professional fund managers. Tom serves as editor of both publications, and runs the newsletter business from its location in Lakewood, WA.