The Federal Reserve has gotten itself into trouble. Leading into last week’s scheduled meeting of its Open Market Committee, the financial markets were put into crisis. Short-term interest rates shot up to levels that were way above the FOMC’s target range for Fed Funds — the rate at which Fed member banks lend to one another.

The so-called overnight repurchase or “repo” rate shot up as high as 10% or more. But what are Fed repos? In a repo transaction, holders of U.S. Treasurys and other bonds sell their securities to other institutions. But, they have an agreement to repurchase those securities the next day at a set price. The difference between the sale price and the repurchase price is the effective borrowing interest rate, or the Fed Funds effective rate.

The repo market is at the core of financing all sorts of entities — from banks and their general cash and credit management to other financial institutions. And this is crucial for the liquidity of the U.S. markets and the economy.

All About Repo Rates

Now this effective interest rate is set by the markets and will vary by institutions and their counterparties. But the Fed, and its FOMC, does participate in the repo market. The Fed’s Bank of New York is assigned to trade and position bonds and manage repo transactions.

Through participating in the repo market, it works to target short-term interest rates and liquidity in the economy. Most just look at the FOMC for its target rate setting for Fed Funds. But the target rate is just a guide for the effective rate set by those engaging in repo transactions.

You’ll see in the graph above that the repo rates were soaring in the summer of 2007. This occurred as the mortgage markets and other pooled debt securities markets were imploding. Financial institutions including Bear Stearns, Lehman Brothers and many others were caught as debt securities were marked down in value with rising credit concerns. This in turn meant that their portfolios were worth less.

Financing covenants were breached, bringing margin calls. To meet those calls, they had to sell debt securities which brought lower prices and more write-downs for the rest of their portfolio. The ensuing waterfalls led to their demise.

Repos were hard to come by as counterparties questioned whether a financial institution would be good to repurchase the bonds. So, rates soared. This didn’t end well — the stock market and the economy fell into 2009. The Fed and other central banks bought trillions of dollars of all sorts of bonds from Treasurys to corporate bonds — all to pump cash into the market and stabilize still-standing financial institutions. And nearly all U.S. banks had to borrow from the U.S. Department of Treasury under the Troubled Asset Relief Program.

The FOMC set its target range for Fed Funds to zero. Through 2017, it began raising the rate closer to to 1%.

The Personal Consumption Expenditure Index

Now, here is where the Fed began to get itself into trouble. Along the way, the Fed and the FOMC stated that they would remain neutral in overseeing the Fed Funds and other short-term interest rates until inflation, as measured by the core Personal Consumption Expenditure Index, remained below 2%. The PCE measures all consumer spending, not just a contrived basket of implied goods and services like the Consumer Price Index. In addition, the FOMC said repeatedly that it wanted to see the PCE actually move into the mid-2% range for a healthy economy.

But the PCE barely edged higher in 2018, seeing only a brief blip above 2% and then falling through into 2019. The current release shows a PCE of only 1.6%.

Core Personal Consumption Expenditure Index

But counter to its statements, the FOMC hiked its target range for Fed Funds four times in 2018. And it also began to allow its bond buying program to roll off as it stopped reinvesting maturities and interest payments. So, counter to its goal of working to normalize interest rates gradually with the added goal of normalizing inflation, we got tightening. This happened right as many were questioning corporate revenue and earnings growth, particularly into the fourth quarter of 2018.

And the repo market ran into similar spikes in rates, thanks to the Fed pulling liquidity.

Next, the Collateralized Loan Obligation Market

The impacts to the credit markets can be seen in the Collateralized Loan Obligation market. CLOs are individual corporate loans or pooled loans made by financial institutions outside traditional commercial banks. This market, along with other alt-financial lending, has been taking over commercial bank lending over the past decade as regulations post 2007-2008 stomped on banks.

The CLO market plunged in the later weeks of 2018 as the Fed signaled a pause in tightening and actively worked to add liquidity to the market. And it worked. The credit markets rebounded along with the economy.

But while the FOMC has admitted its mistakes in tightening and has eased its target for Fed Funds twice in its last two meetings — there is dissent within the voting and non-voting members. This is where the so-called Dot Plot comes in.

The FOMC Dot Plot

The Dot Plot was initiated as part of the forward guidance by the FOMC. The dots represent both voting and non-voting FOMC members’ bias (yellow dots). The green line is median of the bias and the white line is the Fed Fund Futures market pricing.

The dots show a very divided FOMC — and this makes the credit markets very nervous. Playing into this worry is the word that the Organization for Economic Cooperation and Development has further downgraded its outlook for global growth to 2.9% in 2019, the lowest level since 2009.

The U.S. economy for now remains in growth mode despite trade concerns. Consumers are spending, which supports the economy. Home sales for the most recent reported month is at a 12-month high at 12.3% with permits (forward-looking) at 7.7%.

And consumers remain comfortable with this week’s Bloomberg Consumer Comfort Index at a 62.7%.

But institutions including financials are increasingly concerned. The Fed saw massive issuance and bond sales coming the week before by the U.S. Treasury along with opportunistic issuance announcements by major U.S. corporations. This pulled out hundreds of billions of dollars from the market to buy those bonds, wreaking havoc on liquidity. Add in municipal bond issuance announcements, and there is a lot of cash being sucked out of the markets.

Demand for U.S. dollars is surging from foreign financials — thanks to the nation’s status as a global safe haven. This only adds to liquidity trouble.

And so, the Fed appears to have been caught flat-footed. Now it must do the job that it should have been doing in advance. It has been forced to step in for the past several days with billions of dollars in bond buying for overnight repo transactions, trying to meet market needs.

What to Own and How to Profit

I am increasingly concerned by liquidity and the Fed. Banks were hobbled from participating the credit markets with limited trading ability and capital requirements. So, the Fed is increasingly becoming the Bank for the markets.

The Fed started with daily actions though the Federal Reserve Bank of New York and its trading desks. It has been entering into daily reverse-repo transactions for financials needing to repurchase bonds for cash. This has been running at rates of $75 billion. And it has expanded that to include longer-term repo transactions for $60 billion. In addition, there is word that it may well establish a permanent open-market operation for repos. Once again, this would shove the Fed into the role of money center U.S. banks.

And it is also set to resume quantitative easing by buying bonds for its portfolio. This QE has built the portfolio to over $4.5 trillion. And now the program is coming back.

For stocks, investors need to continue to focus on reliable sectors of the markets. Think defensive stocks with U.S. focus such as utilities and real estate investment trusts.

And for bonds, quality U.S. bonds inside exchange-traded funds such as the SPDR Portfolio Intermediate Term Corporate Bond ETF (NYSEARCA:SPIB) and closed-end funds including a favorite of mine, the BlackRock Credit Allocation Income Trust (NYSE:BTZ) should be the go-to for all portfolios — particularly as the Fed’s buying activities should bolster overall bond market prices.

And lastly, I added a gold investment months ago in my model portfolios of Profitable Investing with the gold royalty company, Franco-Nevada (NYSE:FNV) and that is a must-own right now.

Now that I’ve presented my concerns for the Fed as well as some protective assets to own including gold, perhaps you might like to see more of my market research and recommendations for further safer growth and bigger reliable income. For more – look at my Profitable Investing.

In addition, I have recently had a book published titled Income for Life. It is nearly 400 pages of income-producing investment strategies for all weather economic conditions as well as additional income-producing ideas that anyone can use successfully.

Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine … one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.