Just what is going on with the US Fed?
Repo rate soars to a high of 10% from about 2%-2.25%
One of the most important sources of financial market lubrication came under severe strain this week, raising concerns the US Federal Reserve’s attempt to unwind post-financial crisis intervention may have gone too far.
Repurchase agreements are the grease that keeps the financial system wheels spinning, allowing different market participants to borrow and lend to each other to cover short-term cash needs.
On Tuesday, the wheels stopped turning. The so-called repo rate soared to a high of 10%, when it typically trades in line with the Federal Reserve’s target interest rate of 2%-2.25%. The New York branch of the Fed had to step in to restore order.
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 unwound the huge purchases of bonds it made to boost the economy after the financial crisis.
Why now?
Tax day for companies in the US is September 15. 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. 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 because of 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.
In simple terms, demand for cash is higher at the same time as the supply of cash is lower.
Bank reserves have fallen
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 after the financial crisis roll off. In turn, that reduces the amount of cash reserves banks hold at the Fed. In 2014, banks held $2.9trillion in “excess reserves” with the central bank. Since then, that number has dropped to about $1.3-trillion. Fewer cash reserves mean less money available at the banks to cover short-term funding stress.
“What is different this time is that it has followed a period of quantitative tightening,” said Jon Hill, a 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 $1-trillion.
Lorie Logan, head of market operations and market analysis at the New York Fed, said in a speech in 2017 that we will know that level when we see it.
“Upward pressure on overnight interest rates is the most direct indicator that reserves are becoming scarce.
“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,” she said.
The latest ruction in repo markets is highlighting that perhaps bank reserves are too scarce, jamming up the supply of cash in financial markets.
We might have reached the level Logan was talking about.
Could it get worse?
Yes. Since Logan’s speech, the Fed has 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, the 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 is 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 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.
What can be done?
A few things. The Fed could lower the interest rate it pays on bank reserves when it concludes its monetary policy meeting on Wednesday, as it tries to keep other short-dated interest rates in its target range.
The Fed could 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, it could 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. The New York Fed took drastic action on Tuesday when it stepped in to help alleviate pressure and it promised to do the same when trading recommences on Wednesday. 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 uncharted territories.”