Why did the repo market’s wheels stop turning?

A perfect storm hit the repo market this week, highlighting the fragility of one of the most important sources of financial market lubrication and raising concerns that the Federal Reserve’s attempt to unwind post-financial crisis intervention may have gone too far.

Repurchase agreements are the grease that keeps the financial market’s wheels spinning, allowing different market participants to borrow and lend to each other to cover short-term cash needs.

Effectively, they are short-term loans that banks and investors make to each other, exchanging cash for collateral, often just overnight.

On Tuesday, the wheels stopped turning, with the repo rate soaring to a high of 10 per cent, when it typically trades in line with the Federal Reserve’s target interest rate of between 2 per cent and 2.25 per cent.

But what exactly is going on? The answer lies in both idiosyncratic short-term issues and big, structural changes in financial markets that have occurred in recent years as the Fed has embarked on unwinding its unprecedented post financial crisis interventions.

Why now?

September 15 is tax day for companies in America. Some companies prepare by pooling the cash they need and placing it into money market funds — short-term investments that use the repo market to lend out cash for a brief period, earning a small return. Now tax day has passed, that cash has been yanked from the market, reducing the supply of dollars.

At the same time, roughly $54bn of Treasury securities have flowed into the market due to the settlement of a host of previously auctioned debt. This has created a wave of demand from people wanting to borrow cash to finance the purchase of these Treasuries.

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In simple terms, demand for cash is higher at the same time as the supply of cash is lower.

Over the longer term, bank reserves at the Fed have fallen

The problem is, analysts say these two things alone should not cause the deep cracks in the repo market that we have seen this week. The underlying issue is more structural.

The Fed has been reducing the size of its balance sheet, letting the Treasuries and mortgage bonds it bought following the financial crisis roll off. In turn, that reduces the amount of cash reserves banks held at the Fed. In 2014, banks held $2.9tn in “excess reserves” at the Fed. Since then, that number has dropped to about $1.3tn, where it has hovered all summer.

Fewer cash reserves means less money available at the banks to cover short-term funding stress.

“We have had tax payments in the past. What is different this time is that it has followed a period of quantitative tightening,” said Jon Hill, an interest rate strategist at BMO Capital Markets. “Companies sucking cash from the market was just the tripwire that brought things falling down.”

Reserves may now be too low

The Fed doesn’t know, exactly, the minimum level of reserves that banks need to hold now to operate efficiently. A paper by the New York Fed in June suggested the minimum level could be about $1tn.

Lorie Logan, head of Market Operations and Market Analysis at the New York Fed, said in a speech in 2017 that we’ll know that level when we see it.

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“Upward pressure on overnight interest rates is the most direct indicator that reserves are becoming scarce,” she said. “Although brief increases in rates might not be materially adverse, a longer-lasting rise in rates would be a sign that reserves had already become scarcer than needed to maintain interest rate control.”

The latest ruction in repo markets is therefore highlighting that perhaps bank reserves are too scarce, jamming up the supply of cash in financial markets.

That is: we might have reached the level Ms Logan was talking about.

Could it get worse?

Yes. The Fed has since ended its balance sheet reduction and is now holding it constant.

Effectively, its assets are now at a stable level. On the other side of the central bank’s balance sheet sit a few big-ticket items. Bank reserves are one, but how much cash the US Treasury holds is another.

The US Treasury used to hold as little as $5bn in its cash account at the Fed. But since 2015, Treasury has held enough cash to cover a week of outflows — about $400bn. On September 11, Treasury secretary Steven Mnuchin only had $184bn on hand, which means that right now he’s under pressure to get the balance in his checking account back up.

Another is the simple growth of cash currency in circulation, which tends to grow roughly in line with GDP, said BMO Capital Markets’ Mr Hill.

As these two things grow, something has to fall to keep liabilities matching assets. That is putting further downward pressure on the level of bank reserves, draining even more cash out of the market.

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What can be done about this?

A few things. The Fed could lower the interest rate it pays on bank reserves when it meets this week, as it tries to keep other short-dated interest rates — like repo — within its target range.

The Fed could also start to grow its balance sheet again more quickly than expected to keep up with the pace of currency growth and US Treasury cash increases.

Finally, the Fed could to set up a standing repo facility.

Essentially, this would be a permanent pressure valve able to take some of the air out of the market to avoid things blowing up. It reflects the drastic action taken by the New York Fed on Tuesday, when it stepped in to help alleviate pressure. A standing repo facility would be this but on a more regularly scheduled basis.

“Obviously, it is a tool they need to have in the tool shed,” said Janaki Rao, a portfolio manager at AllianceBernstein. “These are somewhat unchartered territories. Monetary policy was made up on-the-go during the crisis, and we are dealing with a changed paradigm where the Fed has to work to understand and come up with new solutions to deal with it.” Additional reporting by Colby Smith


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