I have been confused lately. As shown in the chart below, the bell-weather banks all reported earnings and revenues that were in line with, or above, street expectations and flat with the same period in 2018.

In addition, some of the banks paid record dividends and repurchased billions of common shares. This fact pattern should imply that the banking system is sound and functioning well. If that is the case, why has the Federal Reserve (the “Fed”) pump over $2 trillion in cash into the banks through its Repurchase Operations (“Repo”).

When the Fed wants to increase liquidity in the banking system it enters into contracts, called Repurchase Agreements (“Repos”) with banks in which it agrees to purchase treasury (or other) securities for cash provided that the banks agree to repurchase those securities in a short time, typically one-day.

When the Fed wants to reduce liquidity it enters into the mirror image transaction called a Reverse Repurchase Agreement (“Reverse Repo”.)

The chart below shows the Fed’s Repo Activity for the last two months in which injected over $2 trillion into the banking systems (more than twice the amount allotted for the Troubled Asset Relief Program).

In a vacuum, this is an extremely scary chart!!! BOO!

Source of Data: The New York Federal Reserve
Note: The Finance Lab converts a Repo amount to a positive number and a Reverse Repo amount to a negative number.

Some of the explanations for the liquidity need are:

  • Corporate needs for cash to make quarterly tax payments;
  • Stringent reserve requirements, causing banks to hoard cash; and
  • The Fed’s over-correction in its Quantitative Tightening Operation over the last two years.

The first reason was poppycock. If corporates are paying high taxes, that means they also have high profits.

The second reason would make more sense if the banks were not reporting excellent earnings and repurchasing their own common shares.

The last makes the most sense. The following chart expands the time horizon of the Fed’s repo activity from just the fall of 2019 to the longer period of January 2018 through October 2019:

Source of Data: The New York Federal Reserve

Note: The Finance Lab converts a Repo amount to a positive number and a Reverse Repo amount to a negative number.

This data set shows that the Fed’s Reverse Repos in early 2018 were essentially offset by the Repo operation in the fall of 2019. On a net basis, the Fed reduced liquidity in the banking system by over $1.6 trillion over the 22-month period. As a result, we can expect the Fed to continue to add liquidity to the system.

Conclusions

Companies should monitor this situation closely. Liquidity crunches are like earthquakes. The longer they last, the greater damage they cause. In the meantime, when planning for their capital expenditure needs, companies should assume that banks will be tightening credit in the foreseeable future.

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Equities Contributor: Jonathan Burklund

Source: Equities News