The Plumbing of the Financial Markets Is Leaking.

In the last week of October, the plumbing of the financial system broke. And it’s still leaking as of the start of November. If it gets worse we might be heading for an epic economic meltdown. There is a staggering disconnect between the stock market and how the mainstream media is talking about the economy, and what’s going on behind the scenes at our major financial institutions and below the surface of the real economy. To contextualize this phenomenon, let’s set the stage with a macro view of the economy first.

Even though some data have been delayed due to the government shutdown, there are alternative data sources and private releases that give us an idea of where things stand at the moment. Again, as we’ve said many times, the stock market is not the economy so it’s important to look past what’s happening with equities. We know from Challenger, Gray & Christmas reporting that hiring for this holiday season is expected to be at 2009 levels. The literal peak of the Global Financial Crisis. We’ve seen mass layoff announcements from IBM, Target, Amazon, UPS, Meta, Google, Paramount Skydance, Intel. Baby Boomers continue to exit the job market at a rate of 10,000 per day. Despite the lack of data at the moment, the administration is able to claim that the unemployment rate isn’t problematic but it ignores how entry level jobs have been decimated by our zero immigration and mass deportation policy and baby boomers leaving the workforce.

Source: MacroMicro.me

Under these circumstances, wages should be increasing steadily due to decreasing supply. Instead wage growth among those currently employed is stagnating or declining.

Deepening consumer angst is the fact that inflation continues to trend in the wrong direction.

Source: MacroMicro.me

Inflation remains above 3%, which is above the Fed’s 2% target, and has many analysts beginning to wonder if this is the new normal and the Fed should adjust its mandate accordingly.

And yet, this has been celebrated by the Trump administration because tariff inflation hasn’t shown up in the retail sector as substantially as some thought it might. But it did show up.

Inflation has been hiding. In the raw materials and industrial sectors but not making its way into goods, which is actually a worse sign than we originally anticipated. The relative cost from tariffs isn’t being passed onto consumers because they can’t afford to pass it along. It’s blood from a stone.

This is similar to the way that crude oil can’t push past resistance levels. We literally bombed Iran this year, sanctioned Russia and anyone selling oil to them, and are threatening to invade Venezuela—these are all major petrostates. In any other climate, oil would be through the roof under these exogenous threats. Instead? Nothing. $60 oil.

The consumer is dead.

So how does this administration reconcile this fact? By saying the whole point of their economic plan is to move past a consumer economy toward a manufacturing economy. Essentially back to the future.

Yet manufacturing has contracted since Trump took office and manufacturing jobs have declined. Moreover, the broad based investments into renewable energy and infrastructure under the Biden administration has been shifted to data centers, traditional fuels and AI infrastructure all designed to support a new high tech AI and data driven economy, not manufacturing. One, by the way, that Wall Street and our government both acknowledge will reduce the demand for labor in the coming years.

Suffice it to say, the backdrop to our story today about the financial system is pretty bleak.

Understanding Money & Rates

The economy is an equation and a balancing act. Inputs and outputs. And we typically gauge the health of the economy by cycles and the flows of these inputs and outputs. And the biggest input is money.

After the Global Financial Crisis (GFC) and COVID we sent trillions of dollars into the system. Trillions. Some of it went to work in the economy, but most of it went to cover for losses. That was especially the case after the GFC. But after COVID the money went everywhere. Fast. And that’s the other part of the equation: It’s not just about money, it’s about the velocity of money.

When money is flowing you can more easily track the business cycles. It’s water flowing through the pipes. When money stops flowing it’s like sludge in the plumbing. Eventually it backs up and pressure builds up. And that’s when leaks occur. Left unattended, leaks turn to bursts.

There is a very important market that is overseen by the Federal Reserve called the repo market. Repo stands for repurchase. There are two sides of it. Repo and Reverse Repo, which just indicates whether financial firms are buying or selling in it. The names here cause a lot of confusion so here’s how you can think about it.

Every night trades settle out from the day between buyers and sellers. Most of the major financial institutions—banking and nonbank firms alike—settle these through clearinghouses (triparty transactions) or directly (bilateral.) Sometimes there is so much money changing hands that the counterparty or clearinghouse that’s putting up the cash will borrow money to make sure there’s enough to go around. Because remember, these investments and trades are highly leveraged.

After the Global Financial Crisis the Federal Reserve created a new facility called the Standing Repo Facility. Essentially a rainy day fund with billions to hundreds of billions of dollars in it at a set rate of interest so financial institutions have a safe haven to access money.

Source: MacroMicro.me

As you can see in this chart, this facility was filled during the inflation crisis (post COVID) as institutions were working out their balance sheet issues and settlements. But today, that facility is empty. In a moment we’ll discuss where the money has gone, but this is the first important signal that we need to be aware of.

The rainy day fund is bone dry.

Now let’s talk about rates because there are misconceptions about rates in the market and who sets them. The narrative is always about the Fed rate as though it’s singular. Is the Fed going to cut rates at the next meeting? Did the market “price in a cut” already? Did anyone dissent? How did the markets respond!?? What does it mean for borrowers?

And then, the conversation stops only to be revisited the next time the Fed gets together. But rates tell a continuous and relentless story about the nature of the economy. For example, treasury rates tell us how other countries feel about the way we handle things.

Source: MacroMicro.me

You can see here that the Fed has been cutting rates—that’s the horizontal blue line—to where the high end of the Federal Funds Rate currently is 4%. Treasury rates (the instruments we use to finance our debt) typically track closely with the Fed Funds Rate. What we’ve seen in the past few weeks is a separation in the movement of yields. Despite the Fed lowering the Federal Funds Rate, the yields on treasuries have split across the board and moved higher.

In other words, the Fed and the Treasury are officially on different pages. The global marketplace is hedging against the U.S. at the moment and doesn’t believe that lowering rates will have a stimulating effect on economic activity.

At the consumer level credit card and auto loan rates tell us how the capitalist markets think consumers are doing. Mortgage rates are a reflection of consumer credit health and income. But who sets them in reality?

There are two competing narratives, totally at odds with one another when it comes to who controls rates. Sometimes the government likes to pretend that it’s completely in control of rates. Other times the government likes to pretend that rates are set by the invisible hand of the market place. The truth is somewhere in between. The Federal Funds rate- the one that everyone talks about - is more of a suggestion than a fixed rate but it certainly serves as a guide; or more precisely, a range.

When the Fed sets the Federal Funds rate it’s not a fixed rate of borrowing. It’s a range—a very small range of a quarter of a percent usually. This is the range it sets for overnight lending between banks. That’s it. It has nothing to do with you, your auto loan, student debt borrowing rate or mortgage. But the theory holds that this baseline cost of capital provides a benchmark for the market to set its expectations against. Now let’s get more specific about rates because you’ll be able to spot the leak with this under your belt.

Finding the Leak in the Plumbing

Every day banks, nonbank financial institutions and investors track rate movements across a spectrum. The Fed Funds Rate we just talked about. But there’s also the Secured Overnight Financing Rate (SOFR), which is important to our story today. We have the Reverse Repo Award Rate (RRP), Interest on Reserve Balances (IORB), the Discount Rate, Prime Rate and others, but these are the big ones.

The Federal Funds Rate range is important. I don’t want to suggest that it’s not. It’s a guide for the market. The Prime Rate is based upon it, for example, and this is extremely important in commercial real estate and for certain business lines of credit. In this way it’s important in practical terms and for optics. And when the actual rates in the banking system fall within this range the Fed has the ability to claim that it’s in control.

One of the most important rates is SOFR, which is a composite of market rates. It’s not a set rate. It’s where rates land during trading. When the SOFR rate exceeds the Federal Funds Rate it is sometimes interpreted as a sign of stress in the market; meaning that liquidity is tight so funding sources are looking for a premium. So if you’re the party lending money to others and you’re not comfortable with their collateralization, you will ask for a higher rate. When this happens, large financial firms that are eligible to transact with the Federal Reserve look to borrow from the Fed instead. So let’s look at SOFR this year.

Source: MacroMicro.me

SOFR is almost always within that Fed Funds range. It’s important to remember that the Fed has lowered the range twice in the past couple of months. So the green line here is showing the upper limit of that range— 4.25% in September and 4% as of October. These are the rate cuts you hear so much about. The yellow line is that composite of market rates, the SOFR rate. You can see that on the eve of the first rate cut SOFR briefly exceeded the upper limit. Then again in mid October. Since the last week of October and in the beginning of November it hasn’t come back down.

This means the market is consistently looking for a premium. And here’s where you can see the money being supplied by the Fed as a backstop.

Source: MacroMicro.me

Those tall blue lines represent the repo agreements from the Fed. In other words, certain lenders weren’t happy with the rates offered by the market so they sold securities—either mortgage backed securities or U.S. Treasuries notes to the Fed in return for cash. (Another thing we’ll touch on in a minute.)

This is highly unusual.

It happened once in 2019 and it set off a global panic in bond and equity markets alike until the Fed stepped in and pumped tens of billions of dollars into the system in a single night.

This means one of two things. Financial institutions think their counterparties might not be as healthy as they’re saying or…They don’t have it.

This has led observers to note that the Fed has “lost control” of interest rates in the market and that we might be on the verge of a massive liquidity crisis. The real story probably lies somewhere in between. But the bottom line is that this facility isn’t supposed to be used in this way and is rarely, if ever used outside of quarter-end periods when banks are looking to shore up their reserve requirements ahead of reporting.

If money is leaking out of the system, where’s it all going?

Because Donald Trump decided to blow out our deficits by maintaining spending levels and cutting taxes on the wealthy and corporations, liquidity is being sucked out of the markets by the U.S. Treasury to fund our debt.

Source: MacroMicro.me

The yellow line is that Reverse Repo market we talked about—the rainy day fund—plotted against bank reserves in red and the treasury general account (TGA) in green. The TGA is the government’s checking account. That’s where we pay our bills out of. Bank reserves are declining and the rainy day fund is dry because the Fed and banks are being forced (nicely) to buy our own treasuries to fill the country’s checking account.

A couple of fun facts before I bring this home. When Janet Yellen was the Fed Chair, Scott Bessent criticized her for rolling over long-term debt into short term instruments because they had a lower interest rate. And now, he’s doing the same thing to the extreme.

The other fun fact is that the Federal Reserve quietly announced in the footnotes of its last memorandum that it’s going to stop purchasing mortgage backed securities from banks and only purchase treasuries with the money it has on hand. That’s because they want to keep demand for treasuries high and suppress the yields.

Now if you’ve made it this far you get a gold star, because this is both confusing and depressing. So let me briefly recap what’s going on without the charts, graphs and jargon.

Back to the big picture. Recently, a Harvard economist named Jason Furman estimated that if you took all spending on investments into data centers to fuel AI growth that U.S. GDP would have only been .1% in the first half of this year. That money didn’t go into your pocket or even the government’s. It went to Wall Street.

Wage growth has been declining and unemployment figures have only remained stable because of a zero immigration and mass deportation policy.

Subprime defaults are rising and so are bankruptcies.

High profile private credit bankruptcies have revealed shaky lending practices among all those counterparties in the financial markets that we can’t see. That has led the banks that we can see to increase the rates they’re charging these firms despite the Fed’s attempt to lower interest rates by cutting the Federal Funds rate. That’s why people are saying the Fed has “lost control” of rates.

Inflation is stuck above 3% despite slowing demand and slumping consumer confidence to the point that retailers have announced holiday hiring will barely meet 2009 levels. In other words, we’re broke. The country is broke and consumers are too. And the people who have all the money are beginning to hoard it.

The banks that have money are being forced to invest in treasuries because the deficits are increasing more than projected. The Treasury is retiring old long-term debt with short-term debt that’s a little cheaper, even though short-term rates are starting to creep up as well. That’s the equivalent of rolling over your credit card debt to a zero interest card. The debt doesn’t go away.

All to protect tax cuts for corporations and the wealthy.