Plumbing Problem: Covenant’s Weekly Market Synopsis

September 23, 2019

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Financial Plumbing – What happened with short-term interest rates last week?
  • Better News Ahead? – Easier financial conditions globally, may lead to improved economic activity.
  • Behavioral Finance – Confirmation Bias, people like to believe what they believe.

Last Week Today. The Fed cut interest rates by 0.25% as expected. At the follow-up press conference, Fed Chair Powell did an excellent job of remaining vague about the direction of future monetary policy repeatedly stating the Fed will be data-dependent. Powell’s lack of specificity was a refreshing change from comments his previous comments like “We’re a long way from neutral” (last October) and “Low inflation is transitory” (May). Those comments suggested a preordained and hawkish path for interest rates, roiling markets. | The Bank of Japan elected to hold overnight interest rates unchanged at -0.1% and to continue its asset purchase program of 80 Trillion yen annually – yes, the BOJ is still engaged in Quantitative Easing. | The Organization for Economic Development revised its 2019 global growth estimate down from 3.7% to 2.9% (the lowest in 10 years).

It was a reasonably quiet week for equities despite news of the drone attack on Saudia Arabia’s largest refinery and the Federal Reserve cutting interest rates. Domestic equities declined by about -0.5% with Growth stocks slightly outperforming Value stocks, and small-capitalization stocks underperforming large-caps as the Russell 2000 fell -1.1%. Equities were cruising toward modest gains on the week when trade tensions once again intervened mid-day Friday as China announced its team was canceling plans to visit with farmers in Montana. The only bright spots for equities were Europe and Japan, which each posted weekly gains of +0.3%). Interest rates declined following the Fed’s announcement to cut rates, as investors were hoping for a more dovish message from the Fed. After wild price swings early in the week, crude oil settled into a +5.9% gain for the week, closing at $58.09 per barrel. For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

Financial Plumbing. A clog in the plumbing of the financial market led to a sharp increase in ultra-short-term interest rates early last week. Interest rates on overnight loans called repurchase agreements or “repos,” and money markets spiked making for scary headlines. Sharply rising rates in an obscure but vital part of the financial market’s plumbing system brought back bad memories from the Financial Crisis when the credit markets froze. Yet, last week’s event was mostly technical in nature and not reminiscent of the counterparty risk that prevailed during the Financial Crisis nor an indication that banks are insolvent. The cash squeeze came about due to a confluence of events:

  • Unintended consequences of post-Financial Crisis bank regulations and Quantitative Easing: 1)Since the Financial Crisis, new regulations require banks to hold more cash reserves, which reduces their ability to meet short-term spikes in demand for cash. In essence, the Fed became the responsible party for meeting liquidity demands in the banking system, but they responded too slowly on Tuesday. Ultimately, the Fed showed up with a $75 billion plunger (in the form of repurchase agreements) to clear the liquidity clog, but even that was delayed by 25 minutes due to technical difficulties. 2) As the Fed shrinks its balance sheet (i.e., Quantitative Tightening), it reduces liquidity in the financial system by not reinvesting proceeds from its maturing bonds. Operating in uncharted territory, the Fed has openly discussed the question of the appropriate size for its balance sheet to maintain a smoothly functioning financial system. It appears the Fed found its answer.
  • Treasury Auction. The U.S. Treasury recently sold a large block of bonds, and the transaction settled on Monday.  The cash required to settle the trades on Monday, further reduced the amount of cash banks had on hand.
  • Tax Day. U.S. corporations made an estimated $100 billion in tax payments on Monday, drawing cash from money market funds held at banks to pay the IRS. To meet short-term funding requirements, banks pledge U.S. Treasuries held at the Federal Reserve as collateral for overnight loans and pay interest for doing so. This so-called “repo rate” is typically in line with the Federal Funds Rate, but because of the high demand for cash, the interest rate jumped as high as 10% for some borrowers (more than 4x the Fed Funds rate).

While the Fed stepped in to provide funding and calm the markets, it wasn’t until Friday the Fed announced an interim solution. Technically, they will provide three separate 2-week term repo facilities of at least $30 billion and $75 billion in daily liquidity through October 10th. You can think of it as a “short-term liquidity injection,” while the Fed contemplates a longer-term solution. As the chart of overnight repo rates shows, though late to the game, the Fed’s actions calmed markets.

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Better News Ahead? The outlook for global growth remains tenuous, and global economic news flow is as negative as it’s been since the Financial Crisis, a topic we covered last week. However, governments and central bankers are responding to the weak economic conditions with various monetary and fiscal measures. As a result, Global Financial Conditions are once again “easy” as measured by market-based indicators such as interest rate levels and credit spreads.

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If past is prologue, easy financial conditions should catalyze economic activity in the coming quarters. Trade tensions and geopolitical events can counteract some of the effects of easier financial conditions, but this is one reason to believe we can avoid a global recession. Perhaps the economic surprise indices, which compare actual data to expectations, are an early indicator of increasing economic activity:

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How the Mind Works Against Successful Investing – Confirmation Bias

(Entry #8 in a series on Behavioral Finance)

Psychologically, people are hard-wired to want to be correct in our beliefs, our decisions, and our perspectives. Indeed, the human mind has evolved with a natural ability to convince ourselves of whatever it is we want to believe. In other words, people see what they want to see.

The simplest way to achieve this objective is to emphasize data and events that support our thinking and ignore or reject that which is contrary. Researchers call this behavior confirmation bias, and it relates to the concept of cognitive dissonance we discussed in the last entry. Confirmation bias arises because of the psychological stress (i.e., dissonance) people encounter when a decision or belief is challenged by conflicting information. For example, who hasn’t acted like the guy in the comic below at some point?

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For investors, confirmation bias can reduce one’s wealth through poor investment decisions. Because the natural tendency is for humans is to seek out information that confirms their existing opinions and ignore any information that refutes them, investors are vulnerable to reducing the value of their research and, as a result, the accuracy of buy and sell decisions. At a broader level, this phenomenon explains why perma-bulls and perma-bears hold onto their belief that the market will rise or fall, respectively, regardless of the facts and circumstances. Each side is guilty of ignoring relevant data resulting in an irrational market view. On the bright side, irrational human behavior leads to mispriced securities and a market that is not perfectly efficient, providing opportunities for skilled investors.

When investors fail to address confirmation bias, it can lead to sub-optimal situations, such as:

  • Failing to diversify portfolio risk. For example, a mutual fund or stock that performs exceptionally well over a several year timeframe can create an unbalanced portfolio. Even when presented with information that the prospects for that holding are waning, naïve investors ignore the negative data and look for other data supporting their view that the position will continue to perform.
  • Employees over-concentrating in their company’s stock. The energy and enthusiasm about the company, often reinforced by other employees at work, can cause investors to ignore negative news about the company’s prospects. It’s much easier to believe what you hear around the watercooler than to accept an outsider’s perspective, no matter how well researched, especially when it paints an adverse scenario about the source of your livelihood.

The good news is remedies for confirmation bias are well known. The bad news is that the corrective actions are not easy to implement and require critical thinking. Furthermore, they involve subjecting yourself to the mental stress of seeking out opinions and data that disagree with your view and impartially analyzing the information.

One method for combating confirmation bias is for investors to ask questions that would disprove their thesis rather than confirm it. For example, an investor interested in buying a stock because it has a cheap valuation (e.g., a low price-to-earnings ratio), shouldn’t ask his advisor about the valuation of the company. Instead, he should ask for information about the company’s operations, the potential for new product launches, and competitive threats. Answers to these questions are unlikely to directly affirm your existing belief that the stock is “cheap” and provide a broader perspective on the stock’s potential.

Another effective countermeasure is to surround yourself with people of different backgrounds and diverse opinions. Listen openly to dissenting views to determine if you’ve missed something in your research, the revelation of which may allow you to avoid making a poor investment decision.

Again, intentionally subjecting yourself to psychological stress is something that most people avoid because it’s uncomfortable. Yet, operating outside of one’s comfort zone is how people grow intellectually and make better decisions.

Be well,

Justin