• Risk markets rebounded in September with less negative headlines on the trade front, but many questions loom entering Q4
  • A supply/demand imbalance in overnight funding markets forced the Fed to intervene and inject liquidity into money markets
  • The Fed cut the fed funds target range again in September, but there is a growing divide among the FOMC hawks and doves

We enter the fourth quarter with more questions than answers as it pertains to the trajectory of the economy and financial markets. U.S./China trade concerns continue to weigh on sentiment, but these concerns gave way in September to liquidity imbalances in money markets and political uncertainty surrounding the commencement of impeachment proceedings by House Democrats. Both events should present marginal downward pressure on Treasury yields, but for different reasons. The Fed chose to lower the fed funds target range again in September, but there was a clearer divide among committee participants regarding both current and future interest rate policy. In addition to rate policy for the remainder of 2019 and beyond, Fed leaders must also decide what they will do with regards to open market operations (repo) and bank reserves, which will be discussed in more detail below. 

Trade tensions still present the greatest headwind for both global and domestic growth. The recent chatter between China and the U.S. was less contentious in September relative to the August fireworks. Staffers from both countries met in Washington in recent weeks setting the table for formal negotiations in early October by senior officials. According to a Politico article on September 6, Chinese officials submitted a “mini deal” where China would increase purchases of U.S. agricultural goods in exchange for delaying the October 1 tariffs and easing restrictions on Huawei. Such an agreement wouldn’t be the comprehensive deal that many are hoping for, but it may be enough to buy some time while negotiations continue. However, as we have learned on multiple occasions, everything can change quickly with one tweet from the president.

Money Market Volatility
Overnight funding markets catapulted to the forefront of financial market headlines during the last two weeks of September. A mismatch between overnight funding supply and demand on the morning of September 16, combined with a reduced supply of cash/reserves, pushed overnight rates north of 5%. The sudden reduction in overnight funding supply coincided with corporate cash being pulled from money market funds and with corporate tax day. At the same time, dealers were left to finance a relatively large amount of new Treasury debt settlements, fueling the funding mismatch in repo markets. Banks are typically the marginal buyers of repo in times of temporary cash shortages, but Fed balance sheet normalization has left banks with less excess reserves to take advantage of such opportunities (more on that later). These liquidity mismatches are not uncommon, but they have been more prevalent at quarter- and year-ends driven by regulatory limitations on some dealers, which can temporarily limit cash availability. This scenario was more unique in that it was not related to one of these calendar events, which sparked greater uncertainty in those markets.

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