Last week we saw an attack on the world’s largest oil facility, the Fed cut rates again and injected money into Repo Market. What does all this mean for the markets? Read on to get the details.
Attack on the World’s Largest Oil Production Facility – A missile attack last weekend on Saudi Arabia’s Abqaiq, the world’s largest oil production facility, sent ripples through crude oil markets on the first day of trading (Monday, September 16th). The global benchmark for oil, Brent Crude, shot up as much as 19%.1 But in the following days, investors were reminded that trying to trade an oil supply shock in the short term is often ill-advised. With the United States currently the largest oil producer in the world – and willing to release oil from the Strategic Petroleum Reserve to stabilize markets – and given that within a day Saudi Arabia assured markets that it could be fully back online by the end of the month, crude oil prices retreated. The shock was short-lived. Even still, at the end of the day, investors should also take note of the current vulnerability of oil markets to tension in the Persian Gulf, where risk of geopolitical conflict is rising.
Fed Cuts Rates Again, Even as Economy Remains Relatively Strong – As expected, and for the second time in two months, the Federal Reserve cut the benchmark interest rate by a quarter percentage point.2 This particular Fed meeting and rate cut stood distinctly apart from other meetings, for two reasons. The first was dissent among Fed officials – three voted against the decision to cut rates, with two of them arguing rates should have been left unchanged and the third supporting a bigger cut. In a statement, the Fed acknowledged the negative impact of trade policy uncertainty, but they also raised expectations for GDP growth in the summary of economic projections – making it clear that the Fed is trying to play offense now versus defense later. Meanwhile, a key economic indicator – U.S. industrial production – rose a seasonally adjusted 0.6% in August, well above expectations and underscoring resilience in the economy. Output at U.S. factories rose 0.5% from July, which measures approximately 75% of the nation’s total industrial output.3 On balance, there’s a base case for economic growth for the balance of 2019, in our view, yet the Fed keeps cutting rates.
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The European Central Bank (ECB) Takes More Action – Monetary easing is not happening only in the U.S. The ECB cut its key interest rate below zero, effectively penalizing customers for parking money at the bank, and they also set in motion a new package of bond buying which should put pressure on longer term rates – keeping borrowing costs and mortgage rates low for years to come. This new ECB policy is marketed as economic stimulus, but we believe a flaw in the policy logic is that lower long rates mean flatter yield curves, which actually dis-incentivize banks to initiate new loans (because loans are less profitable). The Bank of Japan and Bank of England are expected to hold rates steady as the ECB and Fed ease.5
Fed Injects Emergency Stimulus into Repo Market – Banks and large financial institutions have daily transactions where cash is traded for securities (as collateral), with the borrower eventually ‘repurchasing’ (repo) the securities with some interest tacked on. This is a basic overview of how the repo market works, and the interest tacked onto a cash loan generally coincides with the fed funds rate. That’s why when the repo rate spiked to 5% last week and then spiked again the next day, the Federal Reserve had to intervene with a cash injection to calm the markets. These stories matter because of the possibility that the cash crunch in this case was a sign of systemic problems in the marketplace. But we noted that Monday was the deadline for companies to submit quarterly tax payments, and it was also the day that $78 billion of cash was converted to recently auctioned Treasury securities.6 The shortage of cash in the system could have been tied to these events, in our view.
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