Yesterday and today, a spike in repo market rates had spillover effects into other short-term lending rates and made for some scary headlines. We thought we would provide an update on what is going on, as well as some perspective.
What is the repo market?
A repurchase agreement or “repo” is like a very short-term collateralized loan. Here’s an example: Party A has a portfolio of Treasury bonds but needs short-term cash while Party B has some cash not earning interest. A sells Treasury bonds to B temporarily, with an agreement to repurchase them later with interest. Repos typically have terms up to a couple of days but can also be rolled over indefinitely. The repo market is an essential component of banking, allowing financial markets to be more liquid. Repo positions (Party B’s position above) are in fact common holdings in money market funds and short-term fixed income vehicles.
So what happened this week?
Financial markets did not have enough cash to finance repo transactions, and consequently the going rate for that cash spiked: The rate of interest on these transactions jumped to 8.75% yesterday. So, at one point, it meant that it cost more than 8% annualized to borrow money for a single day. As you might imagine, these types of loans typically track closely to the Fed funds rate and other short-term market rates, and that kind of disconnect with other prevailing market rates is problematic for banks and other institutions looking to finance their short-term transactions and investment activities.
Investor and media reaction was swift because the last time we saw this kind of activity was in the midst of the 2008 financial crisis, as Lehman Brothers defaulted on these types of agreements and the repo rate spiked. In response (now as back then), the Fed jumped in and injected cash by taking up to $53 billion of these positions, and this drove down rates immediately. However, as the day progressed, rates began to rise again. Today, the Fed injected another $75 billion (which was still about $5 billion short of demand) but this seems to have had the desired effect: The repo rate is back down to around 2%.
Why did this happen?
The following probably all contributed in some way to the spike:
#1. Tax payments: Corporations (and banks specifically) needed cash to pay quarterly taxes due Sept. 16. While probably a contributing factor and the first thing referenced in the news, taxes are due every quarter so it seems unlikely to have been the driving factor alone.
#2. Higher Treasury bond issuance: Typically, when tax receipts are high, the US Treasury doesn’t come to market with a lot of new bond issuance. Given that a higher US government budget deficit is now requiring persistent bond issuance, much of it shorter-term, a glut of short maturities available for purchase exacerbated the problem.
#3. Much smaller repo market: Owing to some regulatory changes after the 2008 financial crisis, US banks are not maintaining the same flexibility in their balance sheets that they did historically. They cannot expand their balance sheets to offset demand during periods of stress because they have stricter capital requirements than before. Consider that the repo market once matched the size of the US Treasury market, but now it is only about 25% as big.
#4. Fed miscalculation: The Fed did not take the above factors into account when assessing the amount of interest to pay on excess bank reserves held at the Fed. In other words, the Fed is (and has been) paying too much, which is preventing some amount of cash from being available for these transactions.
What does this all mean?
In the short term, the situation appears to have been addressed by the Fed’s injections of capital. This doesn’t appear to be a harbinger of coming economic doom like it was back during the 2008 crisis. For one, the spike is not being caused by a material event, like a major default, and the Fed didn’t even see fit to acknowledge the events in today’s decision to lower the Fed funds rate. The Fed did lower the rate on its overnight repos and excess reserves by 30 basis points, which is slightly more than its 25 basis point rate cut.
Longer-term concerns have been mounting about the Fed’s ability to control its target interest rate post financial crisis. Recent events underscore that concern, since the effective Fed funds rate climbed 11 basis points as repo rates soared. A likely consequence of the repo rate spike is that the Fed will push forward with discussions about creating a “full allotment” repo facility. What this would do is make the Fed the lender of first resort in the repo market, which should ensure its ability to implement monetary policy and prevent what appears to be a false alarm that is spooking the financial markets.