Something really scary happened during the hours of Monday night and early Tuesday morning.
The Federal Reserve lost control of its interest rate.
I bet you didn't know that could happen.
But it can, and it did.
You see, overnight periods are actually important times for banks, hedge funds, and other major financial institutions.
What these firms do in that time, essentially, is sell U.S. Treasuries to the Federal Reserve with the promise of buying them back later.
So it's basically a short-term loan. And the interest rate for that loan is generally tied to the Fed's target interest rate. That rate was cut on Wednesday to a range of 1.75% to 2%, though earlier in the week, it was still at a range of 2%-2.25%.
Regardless, that overnight lending rate - known as the "repo rate," short for repurchasing - spiked to more than 4%, well above those Fed targets.
Mind you, this is a rate that typically moves in increments of hundredths of a percent. And yet, it exploded by more than 200 whole percentage points.
And if you still don't think that seems significant, consider that this is a $2 trillion market we're talking about. So even a fraction of a percent equates to millions of dollars in capital that's affected.
It's a big deal.
It's such a big deal, in fact, that the Fed had to spring into action to address it. (Imagine getting that call at 4:00 am.) The central bank conducted what's called a "market operation" in which it steps in to bridge lending shortfalls. When it does this, it makes money more readily available, thus lowering rates.
On Tuesday, the Fed offered $75 billion through such an effort, covering $53 billion of demand. But on Wednesday the same thing happened again. This time, the repo rate spiked as high as 5% and demand exceeded the Fed's offer, with $80 billion in bids.
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The last time anything like this happened was 2008 when the financial crisis obliterated banks' reserves and lenders stopped offering money to institutions, unsure of whether or not they'd go bankrupt.
But what makes this different is that this time there's really no definite explanation for what's occurring.
Just look at what Drew Matus, chief market strategist at MetLife Investment Management, told CNBC:
"I can't pinpoint what happened. And I'm not sure anyone can. I'm not sure the Fed knows because he said he's going to learn over the next six weeks. I'm taking away from that that the funding markets are going to be more volatile over the next six weeks. They don't have a solution because in part, they're still learning. The market is very different than it was before the crisis. When we began the restart of normalizing policy, this is one of the things that was going to be a learning experience."
That sounds... not good.
Here are some of the potential explanations I've seen...
Corporations were seeking dollars for quarterly tax payments. The attack on Saudi Aramco spurred demand as oil spiked and investors feared a Middle East conflict.Banks and investors who bought $78 billion of U.S. Treasury notes and bonds issued last week had to settle up.It could be any or all of these things.
But it could also be something worse.
It could be that the U.S. government is soaking up liquidity to cover its enormous debt burden.
The U.S. government's budget gap has widened 27% as compared with the first 10 months of fiscal 2018 and spending has risen 8% while receipts have grown by just 3%. The federal fiscal year runs October through September, with the Trump administration recently forecasting a $1 trillion full-year shortfall.
So, last month, the Treasury laid out plans to borrow $814 billion.
That money is needed first to cover the government's trillion-dollar fiscal deficit, and second to rebuild the Treasury's cash balance, which was used to pay the government's bills when the debt ceiling was hit in May.
Basically, this means the U.S. Treasury is cannibalizing the dollar by borrowing all of the money it prints.
If that's the problem, then this liquidity crunch isn't going away any time soon.
We're going to be carrying trillion-dollar deficits for years going forward. And it looks like the Fed is going to be the one picking up the slack.
For as long as it can anyway.
That should definitely scare you, but it might also delight gold bugs, because that's the asset that really stands to benefit here.
And there are some really good opportunities to be found in that arena.
Fight on,
Jason Simpkins
Jason Simpkins is Assistant Managing Editor of the Outsider Club and Investment Director of The Wealth Warrior, a financial advisory focused on security companies and defense contractors. For more on Jason, check out his editor's page.