Aside from the attack on Saudi Arabia that shut down half of their oil exports and pushed the global price of oil higher, last week was relatively uneventful for stock and bond markets on the surface.
The S&P 500, which the C Fund tracks, chopped along sideways for the week, remaining about 1% from its all-time closing high of 3,025 set two months ago. It has broken to the upside out of a narrow range that it was stuck in for a few weeks, but still doesn’t have a firm trend in place.
The major line in the sand that a lot of market participants are looking for is around 3,040-3,050. If the S&P 500 convincingly breaks above that trendline which has marked the past three tops, a lot of traders and algorithms would likely consider that very bullish and might pile in. On the other hand, there are many traders and algorithms that would sell near that level, making it a resistance line that is hard to break, but if broken, could set up a sizable move up. It’s the key range to keep an eye on.
A simpler approach is to make sure you are appropriately diversified, perhaps in a Lifecycle fund, and then let your automatic rebalancing work its magic as the market does whatever it is that the market will do.
The Federal Reserve’s Action Week
On Wednesday, the Federal Reserve cut key interest rates by 0.25%. This was the second cut in a decade, after they initiated the first 0.25% cut six weeks ago during their previous meeting. The top end of the key rate has now been reduced from 2.50% to 2.00%.
This may indirectly lead to lower G Fund yields. However, G Fund yields are set by the longer-duration end of the bond market. The Fed’s short-term rates have an indirect effect on long-term rates, but do not control them directly.
The remarkable news for the week happened last Monday on September 16, but it was invisible to most people. A key overnight lending rate between banks suddenly spiked from 2% to around 7%:
The last time this happened was in 2008 during the financial crisis. Banks were beginning to fail and thus were afraid to lend to each other even for short periods overnight, and the whole banking system seized up.
Every night this past week starting on Tuesday, the Federal Reserve had to step in as a lender of last resort with $75 billion to inject liquidity back into the banking system and keep the overnight rate back down to where it should be, and the Fed announced plans to keep doing it daily through mid-October.
Fortunately, this time the cause doesn’t seem to be as severe was it was in 2008. There are a lot of immediate reasons why it might have happened now, including timing of quarterly tax payments and the Treasury issuing a few hundred billion dollars in extra debt to refill cash reserves ever since the debt ceiling was lifted this summer (which caused them to temporarily draw down their cash reserves), but the broader issue appears to be that the domestic banking system has been flooded with treasuries and doesn’t have enough balance sheet capacity to hold all of them at the moment.
Starting five years ago, foreign sources mostly stopped buying U.S. government treasuries. Around the same time, the Federal Reserve finished its third and final round of quantitative easing, meaning they stopped buying treasuries as well. That left domestic balance sheets (blue line on the chart below) including banks, insurers, pensions, and individuals to buy the $3 trillion in added government debt over the past five years:
U.S. federal deficits are now running at approximately $1 trillion per year, and domestic balance sheets are absorbing most of that.
Over the past few years, the bid-to-cover ratio of treasury auctions has been declining, implying that demand has been weak compared to the volume of supply. Starting this spring, the system began showing signs of weakness when the Fed’s key interest rate started to drift above the interest rate on excess reserves, which is not supposed to happen. Now, the overnight lending rate suddenly spiked.
The Fed’s ongoing $75 billion liquidity injection has stopped the leak for now. If foreign sources resume buying treasuries again, the issue might resolve itself for a while by taking pressure off of domestic buyers. If foreign sources don’t resume buying, the Federal Reserve might need to expand its balance sheet to take some of the excess treasuries.
Historically, if the Fed injects some liquidity and expands its balance sheet, it could weaken the dollar a bit compared to foreign currencies, which tends to be good for foreign assets such as stocks in the I Fund. For example, the I Fund’s outperformance in 2017 was driven in part by a 10% weakening of the U.S. dollar compared to I Fund currencies.
However, it’s too early to see how this will play out until more time passes and we see if enough sources keep buying treasuries.