In recent weeks, short-term U.S. lending markets have been in turmoil, requiring emergency shore-up actions from the Federal Reserve. The nickname for it on Wall Street is “repo madness,” because the problems involve the “repo market” and the overnight repurchasing rate.

On Sept. 17, a crucial lending rate briefly spiked above 10%, more than four times its expected level, due to a shortage of cash reserves in the system. Among other response measures, the Fed will be injecting $75 billion a day into the U.S. lending system between now and Oct. 10. They are prepared to do more if the volatility and rate spikes continue.

This is frightening because short-term markets are supposed to be boring — they are the “plumbing” of the U.S. financial system, and they are supposed to work without incident.

Some observers are alarmed by this volatility and see bigger problems ahead. Others say it’s just a small glitch, nothing to worry about and nothing the Federal Reserve can’t handle with a few technical adjustments. So, what is happening and who is right?

On the one hand, it’s true that the Federal Reserve can handle these issues with a few adjustments. On the other hand, there are political risks and sentiment risks to consider.

For example, if the Federal Reserve appears to be losing control, that perception could turn into a self-fulfilling prophecy as investors and lenders start to worry.

Another problem is that, in their attempt to shore up the short-term lending market, any additional measures the Federal Reserve takes could look like a new round of quantitative easing, or “QE” for short. Bank of America analysts estimate the Fed might have to buy $400 billion worth of treasuries, injecting new cash reserves into the system through their purchases — to fix the repo market’s liquidity issues. It would sure feel like QE to have numbers like $400 billion bandied about again.

Investor worries over a new QE program — even if the Fed pinky swears it isn’t actually QE, but something else — could thus fan investor fears of currency debasement or touch off new worries of financial meltdown risk. Either of those would be bullish for gold.

To explain what recently happened in short-term lending markets, we have to talk about the Federal Reserve’s balance sheet, which tells you the type and dollar amount of assets the Fed is holding.

Before the global financial crisis in 2008, when the financial world was more normal in comparison to now, the Fed’s balance sheet was around $800 billion and mostly consisted of short-term government securities. As a result of the 2008 financial crisis, the Fed dramatically expanded its balance sheet, in order to hoover up bad assets and inject large amounts of cash into the system.

They did this by purchasing trillions of dollars’ worth of assets for its own account, including “toxic” mortgage assets, which had the double impact of taking those bad assets off the hands of the banks (taking away their risk of insolvency) and simultaneously putting trillions of dollars in new cash into the system because, when banks or other entities sell assets directly to the Fed, they get cash in return.

By 2015 or so, roughly seven years after the 2008 crisis, the Federal Reserve’s balance sheet had ballooned to a peak of roughly $4.5 trillion, a more than 460% expansion from the prior “normal” state. At the same time, tough new financial rules made the banks more cautious on the short-term lending side, with tougher requirements for bank reserves in the post-crisis environment.

At a certain point, the Federal Reserve decided to unwind the QE (quantitative easing) expansion it had conducted to get through the financial crisis, and to start shrinking its balance sheet down to more “normal” levels. This was done through a process dubbed QT, or quantitative tightening.

To quickly recap, before the 2008 financial crisis, the Fed’s balance sheet was relatively small. As a result of the 2008 crisis, they expanded it to more than five times its original size, paying cash for bad assets to quarantine the asset and inject trillions’ worth of cash into the system. Then, nearly a decade after the financial crisis ended, they decided to start reversing the process, making the balance sheet smaller.

This is where the turmoil in lending markets comes in. It appears the Federal Reserve tried to shrink its multi-trillion balance sheet too quickly, which led to a lack of cash reserves in the short-term lending market.

Normally the banks would step up and fund any short-term lending gaps out of their cash reserves, in order to turn a quick profit. But now the total amount of reserves in the system are running low, and the banks are stingier and hoarding their reserves for regulatory reasons.

The banking situation in 2019, in other words, is very different than it was pre-2008. Banks need a far larger amount of cash reserves these days, in part because of post-crash legislation and in part because they are more cautious. This is why multiple observers warned the Federal Reserve, “Don’t shrink your balance sheet too quickly” — but it looks like they did.

To put it even more simply, as the Fed shrinks its balance sheet through QT (quantitative tightening), there is less funding in the system, which becomes a problem when there are short-term funding gaps.

The quarterly tax date of Sept. 15 triggered one of these gaps, as a result of corporations pulling a big chunk of cash out of short-term lending markets to pay the tax man. At the same time, $54 billion worth of new U.S. treasuries (USTs) soaked up additional cash as banks sought to buy the USTs. These factors led to a funding shortage in the system. When the banks failed to step up, the shortage triggered a bizarre interest rate spike.

The general consensus is that the lending rate spike on Sept. 16 would not have happened had the Fed not shrank its balance sheet too much and too quickly. The basic charge here is that the Federal Reserve removed too much liquidity.

It might be that, in order to keep things functional, the Federal Reserve will have to start expanding its balance sheet again, making it larger than the current size of about $3.8 trillion (still multiples bigger relative to a decade ago).

But that is where the political dangers come in. If the Fed goes back to making its balance sheet look bigger, that smells like QE, even if they say, “oh no, it’s not real QE; we are only doing this to help short-term lending markets.”

We are also in a strange new world where bank trading desks are perhaps overly cautious, and don’t step in to smooth lending market hiccups in pursuit of a quick profit like they used to. That reality threatens to create an environment of yet more hiccups, more mini-breakdowns in the short-term lending market, and more Federal Reserve interventions, unless some hefty new QE-type measures are created.

It’s a circumstance likely to make investors nervous almost no matter what happens, which is probably a good thing for gold and Bitcoin.

None of this means a 2008-style financial crisis is about to hit out of nowhere. But it does mean that the Federal Reserve is becoming more and more likely to take “extraordinary measures” or even “emergency measures” — like the $75 billion they are pumping daily into markets now — on a routine basis, which is favorable for gold and other safe haven assets that do well in times of currency debasement or inflation.

TradeSmith Research Team