Does A Correction Need A Fundamental Catalyst?

Given the extent to which the US stock market is stretched in both momentum and sentiment terms, there doesn’t have to be a news-related catalyst for a significant correction. However, the mainstream financial press tries to link every move in the stock market to the current news. If a correction began last week or gets underway this week it’s likely that many fingers of blame will point to the Wuhan virus.

The situation is ‘fluid’, but at last count 13 Chinese cities had been placed under full or partial lockdown in an effort to prevent the virus from spreading. Furthermore, the number of countries with confirmed cases of the virus is growing.

In terms of global economic impact, we think that the Wuhan virus will prove to be a minor issue, but if the number of confirmed cases continues to rise then many market participants could sell first and ask questions later. Based on what happened with similar viruses in the past, the number of confirmed cases might not peak until March.

Blame for a correction also could be directed towards the Fed, largely due to a misunderstanding of the Fed’s “repo market” operations.

The net amount of ‘liquidity’ provided by the Fed to the repo market has declined over the past couple of weeks, but not because the Fed has stopped supporting this market. The money provided to the repo market is a very short-term loan that often matures within one day, so the amount of repo money provided by the Fed will reduce over time unless the Fed adds new money (makes new loans) at a rapid pace. For example, the Fed ‘pumped’ (loaned) $74 billion into the repo market last Thursday, but there was a net decline of $10 billion on the day due to the expiration of $84 billion of previous loans.

Also worth mentioning is that the amount of money provided by the Fed to the repo market cannot exceed the demand for short-term loans in this market.

We assume that the Fed intends to withdraw from the repo market over the coming months, with the very short-term money it provides via this market steadily being replaced by the semi-permanent money it adds via the asset monetization program — the program that we aren’t supposed to call QE, even though it is mechanically identical to QE — introduced last October. If this happens it will result in a large decline in the “Repurchase Agreements” line on the Fed’s balance sheet and could result in a small decline in the total size of the Fed’s balance sheet, but it won’t be a sign that the Fed is tightening or even becoming less easy.

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