22# Signal 2 Noise

In today’s issue:

• PPI let’s take a closer look

• The lack of spread worries me

• REPO and Reverse REPO

S2N Updates

No updates today.

Performance Review

To learn a bit more about the Z-Score, which I use for the signal, read this blog post.

Chart Gallery

Economic News Today

New Signals

My plan, when I am ready, is to present at least one in-depth signal after the table of new signals. That way, you can walk away with an actionable insight after each letter.

Mike’s Thoughts

“Greatness comes from character and character isn’t formed out of smart people – it’s formed out of people who suffered.” Jensen Huang, CEO of Nvidia.

Reading this quote today resonated with me. It is very easy to see suffering as a waste and unfair. If one is able to see the benefits that come with suffering, it brings a whole new meaning to the pain associated with it. Naturally, this is all very easy to say but much harder to put into practice. This is a framework, and having a solid framework is what we all need. It doesn’t matter whether it is for the way you lead your domestic life or how you approach trading and investing.

I meant to mention yesterday that I saw an interesting comment from a Wells Fargo analyst who said that Tesla would not achieve any growth in sales over the next year. Wow, that was big news for me. I would have thought the market would react more negatively than the -4% drop in Tesla.

PPI lets take a closer look

Let us start with a Bloomberg heading: US Producer Prices Jump, Adding to Signs of Persisting Inflation. Reading that headline, I thought things were looking really bad. As you can see, producer price inflation is running at 1.5%, which is well below its mean of 4.81% (remember, I said on Wednesday I would add a label of the mean to the chart; it’s my pleasure).

The lack of spread worries me

I am not referring to my peanut butter sandwich this morning; I probably overdid it. If you look, investors in corporate debt are not paying much risk premium. This is a worry given that a lot of the expected pain from higher interest rates has not yet been seen with an increase in bankruptcy’s. I am still a believer that there will be a lot of business failures in the coming months and years.

In the chart above, I have plotted the two series on separate axes, so you can see how closely they are correlated. Take note that I have inverted the blue spread line.

I have thrown in the chart below, which I pulled from the New York Fed’s database. It was last updated 3 weeks ago, but you can see the trend. IG = investment grade, and HY = high yield, otherwise known as junk.

This is actually a good segue into the reverse repo rate I promised you yesterday.

REPO and RREPO

In the charts above, you saw close to record low spreads. This is an artefact of investors chasing yield in a low yield environment (sometimes zero and sometimes negative yield). Another reason for the low spread is the sea of liquidity pumped into the economy. Central Banks have been the major protagonists in this regard. I am not suggesting there isn’t a role for their alchemy. I am rather suggesting they overdid it and also contributed to an incredible moral hazard. This means the people who were responsible for the debt crisis were deemed to big to fail and therefore were bailed out and, in many cases, made an absolute fortune. That is simply not fair.

I don’t want to go into an in-depth explanation of what REPO and RREPO (reverse REPO) are. I always think the best way to explain a complex subject is with a chart. So let me present both charts and then explain what you should be looking out for. Just for your info I update these charts daily from the NY Fed database on the research portal under Macro Tools.

The repo (repurchase agreement) rate is the interest rate that the central bank charges commercial banks for borrowing money from the central bank, in this case, the Fed. You can see the green line is the rate the Fed sets to either drain or increase liquidity in the system. The higher the interest rate, the more expensive it is to borrow money and, therefore, the less economic activity, leading to a reduction of liquidity in the system. When the repo rate is low, commercial banks can borrow from the Fed cheaply and then make cheap loans to fire up the economy.

Unfortunately, I don’t have the data in the chart above, but in September 2019, the repo market had a near-heart attack. There was a shortage of cash, which resulted in a massive spike in interest rates from 2.43% to 5.25%, with the Fed forced to inject $75 billion into the repo market. After some time, they figured out the cause. Economists later identified a temporary shortage of cash available in the financial system because of the deadline for paying quarterly corporate taxes and the issuing of new Treasury bonds, which sucked cash out of the system. In essence, you can see the REPO market is usually quiet but has sudden spikes when cash is urgently needed.

The reverse repo rate is, as you guessed, the opposite. This is when banks deposit money with the Fed.

The Fed uses the rate on the RREPO to attract commercial banks to deposit money with the Fed. This causes money to be drained out of the system. The higher the rate, the greater the incentive for banks to deposit money at the Fed. For example, if the bank is receiving 5.3% from the Fed and paying a depositor 4%, they are making 1.3% free money. This is part of QT, which is the Fed’s quantitative tightening exercises to reign in inflation and reduce its balance sheet to allow capital markets to behave more normally (i.e., without artificial intervention). The reverse repo market got to +$2 trillion of deposits daily at the Fed. That number has dropped to $483 billion a day. The intention is to drop the reverse repo operations to $0. We should keep a very close eye on this to see how the markets handle the drop in liquidity.

Happy weekend.

Mike

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