COLLATERAL CRUNCH: HOW A SHORTAGE OF HIGH-QUALITY COLLATERAL IS AFFECTING FINANCIAL INSTITUTIONS

Apr 21, 2023

Understanding the current state of the financial market can be a daunting task, especially when it comes to deciphering the importance of various rates and indicators. However, the Reverse Repurchase Program (RRP) and T-bill rates are two key factors that cannot be ignored. In short, the RRP rate is the interest rate paid by the Federal Reserve to financial institutions for borrowing money and using Treasury securities as collateral. On the other hand, the T-bill rate is the interest rate paid by the US government to investors for buying short-term securities to fund its operations.

 

Currently, there are concerns over the significant difference between the RRP and T-bill rates, which suggests that large institutions are prioritizing safety and risk management over higher returns. This situation could potentially lead to a further shortage of collateral and negative impacts on the overall economy. In this article, we'll explain what these rates are, why they matter, and what they might be signaling for the future market and economy.

 

What are RRP and T-bill rates?

The Reverse Repurchase Program (RRP) is a tool used by the Federal Reserve to manage the money supply and short-term interest rates. In simple terms, the Fed borrows money from financial institutions and offers Treasury securities as collateral. The interest rate paid by the Fed to the institutions for this borrowing is called the RRP rate.

 

On the other hand, Treasury bills are short-term securities issued by the US government to fund its operations. These securities are considered low-risk, which makes them an attractive investment option for financial institutions. The interest rate paid by the government to the investors for buying T-bills is called the T-bill rate.

 

Why do RRP and T-bill rates matter?

RRP and T-bill rates are important indicators of the supply and demand for high-quality collateral in the market. Financial institutions, such as banks, need high-quality collateral to secure their borrowing and lending activities. This collateral is often required by regulators to manage the risks that financial institutions take on in their day to day operations. High-quality collateral, such as U.S. Treasury bills, is considered safe and low risk, providing lenders with assurance that they will be able to recover their funds in case of default.

 

When the demand for such collateral exceeds the supply, it can cause the rates to diverge significantly. This can indicate a lack of confidence in the economy and could be a sign of an impending financial crisis.

 

Moreover, these rates can affect the overall monetary policy of the Federal Reserve. If the RRP rate is significantly higher than the T-bill rate, it may cause financial institutions to prefer lending money to the Fed instead of investing in T-bills. This could lead to a shortage of T-bills in the market, which may negatively impact the overall economy.

 

Current concerns

Currently, there are concerns over the significant difference between the RRP and T-bill rates. As of April 20, 2023, the RRP rate was 4.83%, while the 4-week T-bill rate was 3.289%. This creates concern because it suggests that there is an underlying shift where large institutions are looking for safe investments. Let's take a look at how this works.

 

First, you need to understand how the relationship between the price and interest rates work for fixed income investments. In essence, the rate of return on a fixed income investment goes down as the price goes up. For example, bonds are a common fixed income investment and generally trade at $1,000 per bond. Therefore, a 4% yield on a $1,000 bond will generate $40 of interest. 

 

Now, if those 4% bonds are in high demand then you may have to pay $1,100 for that bond instead of the $1,000. That bond will still pay the $40 of interest (…hence the name fixed income. The interest payment is fixed). However, since you paid $1,100 for the $40 of interest your return of investment is now 3.63%. 

 

Intuitively, it should make sense that your rate of return will be less if you pay more for an investment that will produce the same amount of cash flow of $40. 

 

If you look at the chart above, you will see that 4-week T-Bill rate has been on decline since the beginning of April. This would indicate that investors are buying more of these bonds driving the price up which in turn drives the rate of return down. 

So why is this a concern? 

 

The main concern is that this significant difference may indicate a shortage of high-quality collateral in the financial markets. These institutions need collateral (like T-Bills) to meet their regulatory requirements and manage their risks. This is telling because it’s a sign that financial institutions are willing to make a lower return on their money to prioritize safety and risk management. 

 

We see an example of how T-Bills were used as a risk management tool in Silicon Valley Bank. They were forced to sell their T-Bills as the customers of the bank were starting to take their money out. Since the bank didn't have all the deposits on hand they had to create cash by selling their T-Bills. 

 

Another concern is that this situation could lead to a flight to safety by major financial institutions. If they perceive that there is a lack of confidence in the market, they may prefer to park their money in the safest possible option, such as US Treasury securities. This could cause a further shortage of collateral, which may negatively impact the overall economy.

 

These concerns should not be a surprise as we see an uptick, from commercial real estate to the US government, of people struggling to meet their loan obligations. 

 

Conclusion

In conclusion, the significant difference between the RRP and T-bill rates is currently a cause for concern in the financial market. While it is not necessarily a sign of an impending financial crisis, it does indicate a shortage of high-quality collateral in the market, and leads us to believe that there are significant concerns about the markets and the economy. Abundance is here to help you prosper regardless of what happens next in the economy. Our Directional Portfolios aim to build a portfolio that will adjust with the business cycle. If you'd like to learn more, you can call or text at 678.884.8841 or email us at connect@findabundance.com.

[Chart sources: RRP rate and 4 week T-Bill Rate]

EXPLORING CENTRAL BANK DIGITAL CURRENCY (CBDC): THE FUTURE OF MONEY

By Tom Hermann (Chief Investment Officer) • 14 Jul, 2023
The financial landscape is evolving rapidly, and central banks worldwide are embracing the concept of Central Bank Digital Currency (CBDC) as a means to modernize their monetary systems. CBDCs are digital currencies issued by central banks with their value linked to the issuing country’s official currency. The idea of CBDCs is gaining traction globally, with 87 countries actively exploring their implementation [1] . These 87 countries represent over 90 percent of global GDP. In this week's update we will delve deeper into how CBDCs will work, their benefits, and the unnerving risks they present to privacy and freedom. How Will CBDCs Work? In theory, CBDCs have the potential to digitize and replace physical currency. They are digital representations of a country's official currency, and will be issued and regulated by that country's central bank. The main goal for digitizing traditional money is to make it more accessible, efficient, and secure. The emergence of cryptocurrencies like Bitcoin and the growing importance of digital payments have propelled the exploration of CBDCs as a modern financial tool. CBDCs have the potential to revolutionize financial transactions by streamlining processes and reducing costs. In the current financial system, each bank operates its own payment tracking system, resulting in delays and inefficiencies when multiple banks are involved in a transaction [2] . However, since CBDCs would be handled by the central bank it would allow for all the transactions to be consolidated onto a single ledger, enabling instant clearing of payments and universal acceptance, regardless of the payment method or platform used [2] . Ultimately, if this idea comes to fruition, it will eliminate the need for banks that are not the central bank. Benefits of CBDCs CBDCs would require a complete overhaul of the financial system. Therefore, CBDCs must offer several significant advantages to justify that type of overhaul. Here are the some of the most prominent benefits for CBDCs: Reduced Costs - One key benefit is the potential for reduced costs. By shifting focus from physical infrastructure to digital finance, financial-service providers could save an estimated $400 billion annually in direct costs [3] . Increase speed - CBDCs have the capacity to enhance the speed and efficiency of electronic payment systems, benefiting both individuals and businesses. Appeal to the unbanked - CBDCs offer a solution for people who do not have access to a bank account. According to a survey from 2016, 1.6 billion people around the world did not have a bank account. Another statistic shows that less than 5% of adults do not have a bank account [3] . CBDCs have the potential to increase financial inclusion, empowering those without bank accounts, but adoption isn’t a guarantee as many underbanked people may favor the total anonymity that comes with using cash. Heightened Security - This is a byproduct of the speed and single bank ledger. Private key cryptography could be implemented for users to "sign off" on transactions digitally, and they would become finalized and unalterable in a short period of time [3] . Risks and Concerns While CBDCs offer numerous benefits, they also come with risks and concerns that must be carefully addressed. One major concern is the potential for increased governmental control. Although no central bank currently plans to restrict CBDC usage, the hypothetical possibility of the government deciding which purchases are permissible raises privacy and individual freedom concerns. Additionally, the traceability of digital currency may lead to increased taxation, as every transaction becomes easily traceable. Technological stability is another challenge, as evidenced by the temporary shutdown of the digital version of Eastern Caribbean DCash due to technical issues [4] . Let's take a moment to go more in depth on the potential for governmental control. The following is a quote from professor Eswar Prasad. Prasad is a professor at Cornell University and the author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. Prasad made this statement while speaking at the World Economic Forum's annual meeting of the new champions. “You could have, as I argue in my book, potentially better and some people might see a darker world, where the government decides that unit, so central bank money can be used to purchase some things but not other things that are deemed less desirable, like, say, ammunition or drugs or pornography or something of the sort. And that is very powerful in terms of the use of a CBDC and I think also extremely dangerous for central banks” [5] Prasad noted that he was only speaking hypothetically and said, “No central bank is contemplating any such uses for its CBDC but, as an academic, it is important for me to point out all the possibilities and potential—both good and bad—of a world in which all payments are digital and anonymity might be limited (relative to the use of cash).” [5] This is possible because CBDCs are programmable. For example, a CBDC could be programmable where it can only be used for certain items or even have an expiration date – which would ultimately force spending. This allows for CBDCs to make it much easier for a centralized authority to dictate and control human behavior because they can restrict the flow and opportunities if you are not behaving in a manner that they're requesting. This is very evident in China's social credit system. Use Cases for CBDCs It's important to balance the potential benefits of CBDCs with concerns related to individual privacy and governmental control. This is highlighted by China's social credit system. The China social credit system is a broad regulatory framework intended to report on the ‘trustworthiness’ of individuals, corporations, and governmental entities across China [6] . China’s “Social Credit System” rates its citizens based on their behaviors, and those who score well get privileges; those who score poorly do not. A citizen with a high score is likely to enjoy various privileges—high-speed internet, the ability to travel freely, access to the best restaurants, golf courses and nightclubs—that fellow citizens do not [7] . There are many ways to lose points and lower one’s social credit score, depending on the city where the offense takes place. Some of the more trivial score-lowering actions include: not visiting their parents on a frequent basis, jaywalking, walking a dog without putting it on a leash, smoking in a non-smoking zone, and cheating in online videogames [6] . A citizen with a poor social credit may experience one of these forms of punishment [6] : Travel bans Reports in 2019 indicated that 23 million people have been blacklisted from traveling by plane or train due to low social credit ratings maintained through China’s National Public Credit Information Center [6] . School bans The social credit score may prevent students from attending certain universities or schools if their parents have a poor social credit rating. For example, in 2018 a student was denied entry to University due to their father’s presence on a debtor blacklist [6] . Reduced employment prospects Employers will be able to consult blacklists when making their employment decisions. In addition, it is possible that some positions, such as government jobs, will be restricted to individuals who meet a certain social credit rating [6] . Increased scrutiny Businesses with poor scores may be subject to more audits or government inspections [6] . Public shaming In many cases, regulators have encouraged the ‘naming and shaming’ of individuals presented on blacklists. In addition, flow-on effects may make it difficult for businesses with low scores to build relationships with local partners who can be negatively impacted by their partnership [6] . CBDCs can also allow the government to be more targeted in their efforts to manage economic growth. One such case is the ability to combat inflation effectively. With the flexibility of CBDCs, central banks can implement different interest rates on specific balances or accounts, allowing for more precise monetary policy implementation. CBDCs also have the potential to support targeted stimulus efforts by directing funds to designated sectors or implementing expiration dates to encourage spending [8] . Implementation Timelines The timeline for CBDC implementation varies by country. In the United States, the Federal Reserve is already taking steps to address transaction inefficiencies by launching the FedNow digital payments system by the end of July 2023. This system aims to provide low-cost bill payments, money transfers, paychecks, government disbursements, and other consumer activities [9] . Time will tell when this will be fully implemented in the United States, but many see the implementation of FedNow as the first step toward a CBDC. Globally, a recent survey suggests that by 2030, approximately 24 central banks will have implemented digital currencies. This projection highlights the increasing global adoption and recognition of CBDCs as a fundamental part of future financial systems [10] . It is not a foregone conclusion that CBDCs will be implemented as there is plenty of opposition to the idea. Senator Cruz from Texas and Governor DeSantis from Florida have both introduced legislation to prohibit the Fed from establishing a CBDC [11][12] . If CBDCs take over the financial system, it appears there will be minimal options for those who do not want to participate in the system. Some of those options may include: using bitcoin that is established on a decentralized platform with options for privacy and anonymity, using physical precious metals like gold and silver, and/or exchanging value for value like in an archaic bartering system. Conclusion Central Bank Digital Currencies have the potential to revolutionize the way we transact and interact with financial systems. By leveraging digital technologies, CBDCs can offer reduced costs, increased speed, improved financial inclusion, and heightened security. However, careful consideration must be given to the risks associated with potential governmental control, privacy concerns, and technological stability. As countries progress toward a digital economy, CBDCs will play a pivotal role in shaping the future of money, transforming financial systems and enhancing economic efficiency on a global scale. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situati on. Sources: https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-central-bank-digital-currency-cbdc https://www.forbes.com/advisor/investing/digital-dollar/ https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-central-bank-digital-currency-cbdc https://www.bloomberg.com/news/articles/2022-02-21/eastern-caribbean-dcash-outage-is-test-for-central-bank-digital-currencies?sref=YMVUXTCK https://apnews.com/article/fact-check-world-economic-forum-cashless-society-false-cbdc-592718364311 https://nhglobalpartners.com/china-social-credit-system-explained/ https://fee.org/articles/china-s-social-credit-system-sounds-pretty-dystopian-but-are-we-far-behind/ https://financialpost.com/fp-finance/cryptocurrency/central-bank-digital-currency-inflation-fighters-best-friend https://www.forbes.com/advisor/investing/digital-dollar/ https://www.reuters.com/markets/currencies/twenty-four-central-banks-will-have-digital-currencies-by-2030-bis-survey-2023-07-10/ https://www.cruz.senate.gov/newsroom/press-releases/sen-cruz-introduces-legislation-to-prohibit-the-fed-from-establishing-a-central-bank-digital-currency https://www.flgov.com/2023/03/20/governor-ron-desantis-announces-legislation-to-protect-floridians-from-a-federally-controlled-central-bank-digital-currency-and-surveillance-state/

THE WARNING SIRENS: RISING INTEREST RATES AND SLOWING BUSINESS PERFORMANCE ARE HARBINGERS OF ECONOMIC CHALLENGES

By Tom Hermann (Chief Investment Officer) • 07 Jul, 2023
The global economy is facing increasing pressures, and there are growing concerns about a potential recession on the horizon. Two significant indicators that have historically foreshadowed economic downturns are an inverted yield curve and Purchasing Managers' Index (PMI) readings below 50. Over the past couple of months these two indicators have continued to point in the direction of an impending recession. In this week’s update, we will explore the historical context and significance of these indicators and analyze their current implications for the economy. Understanding the Inverted Yield Curve: An inverted yield curve occurs when short-term interest rates exceed long-term rates, typically reflected in the inversion of the two-year and 10-year Treasury yields. An inverted yield curve is often viewed as an indicator of a troubled economy because it deviates from the normal yield curve shape, where longer-term interest rates are typically higher than shorter-term rates. In an inverted yield curve scenario, short-term interest rates exceed long-term rates, implying that investors have lower expectations for future economic growth and inflation. This phenomenon has been a reliable recession predictor in the past, and suggests that the global economy is headed toward a recession despite the stock market trading near all-time highs 1 . The Fed chose to pause rate hikes during their June meeting, but many expect the rate hikes to continue in the future 2 . Persistently raising short-term rates in an inverted yield curve environment can increase the risk of an economic slowdown or recession. The inversion of the yield curve itself is often seen as a reliable predictor of economic downturns. By continuing to tighten monetary policy in this scenario, the Fed may unintentionally contribute to a deeper and more prolonged recessionary environment. PMIs Indicating Economic Contraction: PMIs, or Purchasing Managers' Indexes, are widely used economic indicators that provide valuable insights into the health and performance of various sectors within an economy. They are based on surveys conducted among purchasing managers in manufacturing, services, construction, or other sectors. The purpose of PMIs is to gauge the prevailing business conditions, sentiment, and trends within a specific sector or the overall economy. When a PMI reading falls below 50, it indicates economic contraction. The US manufacturing sector's recent contraction, raises concerns about the overall economic health and suggests a challenging road ahead 3 . The ISM Manufacturing PMI came in at 46 in June, down from 46.9 in May. This is the lowest reading since July 2020 3 . The manufacturing sector is followed closely due to it strong linkages with other sectors of the economy. Changes in manufacturing activity can impact supply chains, employment levels, and the performance of related industries. Manufacturing job losses can have a cascading effect on the economy, impacting consumer spending and business investment, and further contributing to the likelihood of a recession. Analysis of Current Economic Indicators:

RESILIENCE AND VULNERABILITIES: DECODING THE GLOBAL ECONOMY'S STORY

By Tom Hermann (Chief Investment Officer) • 30 Jun, 2023
Amidst upwardly revised GDP growth and declining jobless claims, underlying risks such as banks prioritizing financial stability and a decline in global manufacturing cast a shadow of uncertainty. In this week's update, we delve into crucial economic factors that are currently shaping the global landscape. By examining manufacturing PMI, banks' defensive stance, and the resilience observed in the US economy, we aim to provide valuable insights into the current state of affairs. Manufacturing PMI and Recession Signals The S&P Global Flash US Manufacturing PMI™ is a widely recognized economic indicator that measures the performance of the manufacturing sector. In June 2023, the PMI dropped to 46.9 [1] , raising concerns about a potential recession. The PMI measures the performance of the manufacturing sector based on surveys conducted among purchasing managers. It provides an overview of various aspects, including new orders, production levels, employment, supplier deliveries, and inventories. A reading above 50 indicates expansion, while a reading below 50 suggests contraction. This decline from 51.0 in May marks the lowest reading since February 2020. The contraction in the manufacturing sector is primarily driven by a slowdown in new orders and production [1] . Manufacturing PMI is an important indicator as it reflects the overall economic health of a country. The slowdown in new orders and production can be influenced by various factors such as changes in consumer demand, supply chain disruptions, labor shortages, trade policies, and global economic conditions. However, in this instance, the largest contributors are a drop in consumer demand and global economic conditions. Historically, there is a correlation between manufacturing PMI contractions and economic recessions. For instance, during the global financial crisis of 2008-2009, the PMI readings dropped significantly, signaling an economic downturn. Similarly, the PMI contraction in 2020 preceded the economic recession triggered by the COVID-19 pandemic. This makes it an important signal for investors and businesses to monitor [1] . Defensive Posture of Banks Worldwide Banks worldwide have been adopting a defensive posture, which further signals potential trouble ahead [2] . A defensive posture means that banks are taking measures to mitigate potential risks and ensure financial stability. Specific actions can include increasing capital reserves, tightening lending standards, reducing exposure to high-risk assets, enhancing risk management practices, and diversifying their portfolios to minimize vulnerabilities. The cautious approach of banks reflects their awareness of potential risks in the economy. By adopting a defensive posture, banks aim to protect themselves from financial shocks, economic downturns, and uncertainties. This cautious approach contributes to overall economic stability by reducing the likelihood of systemic risks and enhancing the resilience of the financial system. When banks take this defensive posture, it becomes a greater priority to be fiscally stable than make loans - which are the main revenue source for banks. In my opinion, this is something to watch as many commerical real estate loans come due in the next 12-18 months. As interest rates have significantly increased over the past 12 months, it will be challenging for businesses to renew those loans which will negatively impact the banks and their revenue [3] . Signs of Resilience in the US Economy Despite concerns highlighted by manufacturing PMI numbers and the defensive posture of banks, positive news emerges from the US economy. First-quarter GDP growth has been revised up to 2.0% from 1.3% [4] , indicating ongoing economic expansion. The revision of first-quarter GDP growth from 1.3% to 2.0% indicates that the US economy is expanding at a slightly faster pace than previously estimated. This upward revision suggests stronger economic performance and reflects positive momentum. Additionally, weekly jobless claims in the United States fell to their lowest level since October 2021 [4] . The decline in jobless claims to their lowest level since October 2021 signifies a that the labor market is showing signs of resilience. In previous weeks we've discussed the impact of labor hoarding and how it could be affecting these weekly numbers. The revised GDP growth and the decline in jobless claims reflect the resilience of the US economy. However, it is important to note that the economy is growing at a slower pace compared to previous quarters [4] . The Federal Reserve's efforts to combat inflation may influence future economic growth. While positive indicators exist, rising inflation and external factors such as the war in Ukraine could impact the possibility of a future recession [4] . Conclusion In summary, considering the manufacturing PMI numbers, the defensive stance of banks, and the positive indicators in the US economy, the outlook for the next 6-12 months remains uncertain as we are getting mixed signals across the global economy. There are some encouraging signs for the US economy as the labor market appears to be resilient. However, there's an undertone of vulnerability that warns of potential risks that could lead to a sharper downturn if not carefully managed. Our Directional Portfolios aim to build a portfolio that will adjust with the business cycle. If you'd like to learn more, you can call or text at 678.884.8841 or email us at connect@findabundance.com . The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situati on. Sources: https://www.pmi.spglobal.com/Public/Home/PressRelease/6e8efbfbddde43f29eb12c5193939625 https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230302~41273ad467.en.html https://fortune.com/2023/06/26/commercial-real-estate-office-downturn-outlook-goldman-sachs-morgan-stanley-ubs-pwc-bofa/ https://www.reuters.com/markets/us/us-weekly-jobless-claims-fall-first-quarter-gdp-revised-higher-2023-06-29/
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