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An Interesting Week

Global markets survived an intense week colored by events and drama in many areas and yet ,as of this writing, it seems the S&P500 benchmark might land very close to the all-time high.

The trifecta of uncorrelated events that influenced trading since last week-end comprises an attack on Saudi oil infrastructures that was as spectacular as unprecedented, dramatic spikes in the overnight banking funding rates and a rate cut by the Federal Reserve.

Predictably, the attack on the world largest refinery, which caused over 5 million barrels of oil a day to go off line for an undefined period of time, resulted in an historically large jump in the price of oil when markets reopened on Sunday night. Prices have since calmed down but remain higher than the bearish pre-attack levels. Given the significantly high level of uncertainty in terms of the speed of recovery of the damaged installation, the ambiguity on the type of response to the perpetrators of the attack and of course the possibility of further terrorist actions, it is reasonable to expect the energy market to carry a risk premium for quite some time.

Problems in the Middle East may help our domestic energy sector as our production capability may now become a stabilizing force in an uncertain world.  Domestic midstream infrastructures would seem to be some of the more likely beneficiary given their strategic position, historically low valuations, and improved balance sheets.

The second element of instability this week was not as blatant and “explosive” as the attack on Saudi territory but nevertheless it had the connotation of a possible serious issue.  In the highly technical universe of banking reserves, we experienced a dramatic liquidity issue.  Reserves are used by banks, central bank and Treasury to settle transactions among them. Banks keep a certain amount of reserves to face liquidity requests by different sources and lend excess reserves to other institutions via short term repo transactions. In a repo transaction, the borrowing institution pledges Treasuries as a collateral for the loan of reserves and promises to buy back the collateral at a predetermined price which in effect establishes the lending rate for the loan.

It is a technical market and usually it does not hit the skids (and the news) unless something is terribly wrong in the system and liquidity dries up suddenly.  In this case, however, it seems it was a combination of minor factors against a backdrop of changing regulations.  In essence, the funding market succumbed to three factors: excess liquidity needs for corporate taxes, an unexpected increase in the cash balances at the Treasury, and excess funding needs by Primary Dealers to finance scheduled issuances of new Treasuries.  Apparently, the Fed also seems to be unclear on exactly how much banks need in reserves after the changing in regulations and the extraordinary monetary policy implemented in the last few years.  All this created a liquidity issue this week and overnight rates spiked to 10%, a far cry from the approximately 2% the Fed Funds target.  The Fed promptly stepped in and injected more reserves into the system. 

For now, it would seem this crisis can be filed under “an aberration and a technicality” but it underlines stresses in the bond market and rates in general. Definitely, this “technicality” is something investors need to keep an eye on.

And last but not least, we had the FOMC meeting which resulted in a second (and consecutive) 25 basis point interest rate cut.  While the rate cut was expected, the internal divisions in the committee on the decision create a level of uncertainty for markets as investors try to gauge the path of future policy.  The Fed seems caught between fear of international issues getting out of control (US-China trade war, Brexit, oil supply shock) and domestic indicators which still support a continuation of the economic expansion in the absence of inflation.

As of now, we think that the Fed will continue to err on the side of caution, and we will probably see at least another 25-basis point reduction in rates before the end of 2019.