How the Federal Reserve could fix the repo market

The Federal Reserve is facing urgent calls to find a permanent fix to short-term funding strains that unsettled markets last month, and avoid another bout of volatility at the end of the year when the demand for cash is expected to rise again.

Traders were shocked in September when the typically staid market for repurchase agreements — where banks and investors borrow money in exchange for Treasuries and other high-quality collateral — went haywire. The “repo” rate jumped as high as 10 per cent, prompting accusations that the Fed had lost control of short-term interest rates.

A series of cash injections by the central bank brought the rate back down, but policymakers and investors are pushing for a longer-term answer to the market’s problems.

“[The Fed] is doing the right things right now with the short-term repo facilities, but it is merely buying time,” said Bill Campbell, a portfolio manager at investment firm DoubleLine Capital.

Market participants have coalesced around one answer: asset purchases. When the Fed buys Treasuries from the market, it simultaneously credits banks’ reserve accounts to pay for them, increasing the amount of cash in the financial system. But opinions remain divided on how much debt the central bank should buy and at what maturities.

There is, at least, general agreement that something fundamental needs to be done. At the worst of the market stress, a series of daily $75bn cash injections morphed into $100bn overnight operations and three two-week loans, with banks’ appetite for funding initially outpacing what was on offer from the Federal Reserve Bank of New York.

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The ad hoc intervention eased funding constraints, but the sheer scale of the New York Fed’s operations — with roughly $200bn of cash on loan for the final day of September — emphasised to the market the need for a more lasting solution.

Fed chairman Jay Powell nodded to this idea at a press conference last month, saying the central bank will “over time provide a sufficient supply of reserves so that frequent operations are not required”, in keeping with the “ample reserves” policy it adopted in January.

He did not offer further hints on what a sufficient supply would be, other than to say the Fed was considering resuming the “organic” expansion of its balance sheet by buying Treasury assets to keep up with the growth in physical currency, which counts as a liability. Currency growth has been about $90bn a year since the recovery. But some analysts think the Fed — which is also exploring the role played by regulation in the repo market’s problems — will have to make more substantial purchases.

Kelcie Gerson, a rates strategist at investment bank Morgan Stanley, said the Fed would need to buy $315bn of shorter-dated Treasury bills between November and May to increase reserves to a level high enough for funding markets to operate normally.

One advantage of this approach is that it distinguishes itself from post-financial crisis quantitative easing, which focused asset purchases on longer-dated Treasuries to help lower interest rates.

Former Fed officials Joseph Gagnon and Brian Sack, now at the Peterson Institute for International Economics and hedge fund DE Shaw respectively, believe the Fed should snap up $250bn worth of Treasuries over the next six months.

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Meanwhile, Priya Misra at TD Securities calls for $300bn worth of outright purchases of varying maturities over the course of 2020, and roughly $215bn to replace the run-off of maturing mortgage-backed securities previously held on the Fed’s balance sheet.

Some market-watchers think that the Fed should announce asset purchases in tandem with a tool that makes its recent temporary cash infusions permanent. Through a so-called standing repo facility, the Fed would pre-commit to doing repo operations on a daily basis with various counterparties so that Treasuries become “cash-like,” according to Praveen Korapaty, chief global rates strategist at Goldman Sachs.

The facility garnered much attention at the Fed’s meeting on monetary policy in June, with Fed officials discussing at length how the facility could serve as a “backstop against unusual spikes” in various money market rates as well as flagging potential design pitfalls. But on Friday, Philadelphia Fed president Patrick Harker said discussions are “still in their infancy”.

At issue is not only the rate at which the facility would swap Treasuries for cash, but also which financial institutions would be involved.

These parameters could take months to figure out, said Mr Korapaty, adding “now is not a time for experimentation”. If the Fed buys enough Treasuries, a standing repo facility may not be necessary.

“If you increase your balance sheet to a certain size, you don’t need to worry about the minimum level of reserves and you don’t need the facility,” he said. “If they want to operate with abundant reserves, the cleanest way to do it is through asset purchases.”

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Zoltan Pozsar, an analyst at Credit Suisse, believes there is a third option. If the Fed were to cut interest rates aggressively — pushing short-term yields below longer-term ones — it would buoy flagging demand for Treasuries from both foreign and domestic buyers and alleviate pressure on the big banks that are obliged to buy the securities.

“The mother of all solutions is more aggressive rate cuts,” he said.


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