When interest rates in the overnight lending market (known as the repo market) spiked in September, there was a real fear that it was a sign of something far worse. This was made more confusing by the complexities of the market itself. The good news is that while what happened in the repo market may sound alarming, there’s no need to worry. Let’s look at what happened, where we are now, and what to watch out for.
What Is the Repo Market?
The market for repurchase agreements (known as repos) exists so parties with significant assets but insufficient cash (e.g., financial institutions) can borrow cheaply from a lender for a very limited time. And this market is huge: about $4 trillion in outstanding loans. In practice, these parties are typically companies gaining overnight access to cash using U.S. government bonds as collateral. At the end of the term, the borrower repurchases the Treasuries at a slightly higher price than loaned (hence, the name repo). The cash lenders are often money market funds and other asset managers looking to park cash on a very short time frame for marginal gain and minimal risk.
On September 16, 2019, the overnight borrowing rate for cash spiked from about 2 percent to 10 percent. The initial blame was placed on a disconnect within the supply and demand dynamic, which was exacerbated by central bank reserves being too low. Namely, a 2018 corporate tax bill due and a Treasury auction settlement date put excess stress on the Federal Reserve’s (Fed’s) already shrinking balance sheet. This caused the New York branch of the Fed to jump into the repo markets and infuse the system with liquidity. And while this mostly calmed the markets, the question remained: what would happen the next time?
The Next Time: December 16, 2019
If the cash crunch in September was truly the result of the tax bill and Treasury auctions causing a surge in need, it seemed the next time it happened would be a good test of whether the Fed’s overabundance of supply served its purpose and assuaged the market. As it turned out, this was exactly the confluence of events that lined up on December 16, 2019. That morning, the rate was right in line with where it “should” be given normal conditions. The Fed’s actions were working.
Unlike in September, when the Fed was accused of being caught asleep at the wheel, it jumped in with overwhelming force and continually increased its lending operations through year-end, up to almost $500 billion. This included a new offering of longer-dated loans rather than the typical overnight terms. What is particularly interesting here is the demand difference between the two types of loans. The longer-term loans saw robust demand and were modestly oversubscribed (more demand than supply). Conversely, overnight loans were significantly undersubscribed in that same auction.
The overwhelming appeal for month-long cash (insurance) and the underwhelming need for overnight cash (emergency) suggest that the complacency experienced in September has been mostly taken out of the market.
Where Are We Now?
The next possible catalyst for a cash shortage was year-end liquidity needs at a time when the lending rate seasonally increases. Leading into the final day of the decade, the Fed’s increased offerings were mostly undersubscribed, with participants taking only a small portion of the amount offered, suggesting there was sufficient liquidity to meet the needs of borrowers. Since the start of the new year, most of the overnight auctions have been undersubscribed or only slightly elevated, with most of the longer-term loans winding down.
The Fed has put a lot of time and effort—not to mention money—into staving off any major turmoil in the repo markets. Still, the question remains: Where do we go from here? The Fed Vice Chairman Richard Clarida has stated that the bank will continue interventions at least through April, when tax payments will reduce levels of cash in the system. The Fed also started to increase the balance sheet in October to “get reserves up to the ample level. Once we get to that point, certainly we would not be expecting to have ongoing large repo operations as necessary.” In essence, the Fed is looking to address the market conditions that preceded the September spike in rates.
That fixed the issue. To solve the problem requires bigger solutions. Some of the permanent remedies bandied about include increasing the types of securities the Fed can purchase for reserve management and creating a “standing repo” facility. These solutions would allow the Fed to stay in the market permanently and supplement other financial lenders. To be clear, these ideas are in their nascent state—and any sort of solution is likely to take time to unfold.
What to Watch For
The Fed’s exit ramp will likely be telegraphed in one of two ways. The most easily recognizable one is the size of the offering. If the Fed thinks there’s sufficient funding available, it will start lowering the offered amount. This strategy is exactly the opposite of what the Fed did in the fall when it tried to instill confidence in the market by showing its willingness to respond with overwhelming force. The second and slightly more difficult signal to track is the borrowing rate. As of this writing, the rate to borrow from the Fed is the same as the rate to borrow from the market. If the Fed wants to disincentivize its participation, it could simply raise their cost to borrow.
This situation sounds scary, but there’s no need to worry. The main actors seem to have heeded the call to action: the Fed has jumped in as a major lender to the funding markets, and the borrowers have taken the longer view on their liquidity needs. Further, solutions have been proposed that may prevent this scenario from happening again. It’s certainly something we will be keeping an eye on. But for now, the markets seemed to have calmed.
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Authored by Nick Follett, manager, fixed income, at Commonwealth Financial Network. ©2020 Commonwealth Financial Network®