Author: Adam Phillips
In light of recent events, I wanted to provide the following commentary to explain what is happening in liquidity markets and what this means for investors.
What is a Repo Rate?
A “Repo” rate is short for “Repurchase Agreement” and refers to a common funding tool used by banks and other institutions to satisfy short-term liquidity needs. For instance, a bank can use repurchase agreements to borrow money overnight (or longer in some cases) to ensure it has enough operating cash on hand to satisfy trading or lending activities.
In return for the funds, the borrower (e.g. the bank) provides the lender with collateral such as Treasury holdings and pays a low rate of interest. At the end of the term the bank returns the principal with interest, gets its collateral back and can start the process all over again if cash is still needed.
What happened?
Repo rates spiked earlier this week to more than 8% and brought back painful memories of the liquidity crunch experienced during the financial crisis. For perspective, repo rates are supposed to hover somewhere around the overnight rate set by the Federal Reserve, which was 2.00-2.25% at the start of the week and has since been lowered to 1.75-2.00%.
While we want to be careful about dismissing all scary headlines, the reality for now is that recent events do not pose a systemic risk to liquidity markets. Rather, this week’s surge in repo rates appears to be driven by short-term supply and demand issues. On the supply side, more than $300 billion in new Treasuries were auctioned last week. This is likely to continue in a world where $1 trillion annual deficits look set to continue into the foreseeable future.
On the demand side, we saw large outflows from banks and money market funds as corporations made their quarterly tax payments in advance of the September 15 deadline. Finally, these events coincided with quarter-end, when banks target higher capital levels to satisfy reporting requirements (i.e. “window dressing”) by reducing the size of their repo books in favor of keeping excess reserves at the Fed.
What’s Our Take?
The Federal Reserve has been quick to respond and stabilize liquidity markets by injecting $53.2 billion into the market on Tuesday, along with $75 billion over the last three days. In addition, the group today announced that it would be ready to provide daily support of $75 billion through October 10th, as well as funding three “term” Repos of $30 billion over the same period (table below).
Beyond that, the Fed will likely act as necessary to provide market stability. One option could be to bring back a standby repo facility, a move the group had already been considering prior to this week’s events. In addition, it is likely we will see further cuts to the interest on excess reserves (IOER) and possibly a return to QE to ensure control over short-term market rates. It is worth nothing that these Fed injections are simply being rolled over on a daily basis, so it is not a new $75 billion being “printed” every day.
Source: Federal Reserve Bank of New York
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