While everyone’s been busy focusing on FOMC meetings and the Fed’s benchmark interest rate, a four-letter word that hasn’t been in the news for quite a while has suddenly reemerged.
Repo (short for repurchase) markets were in turmoil last week as their interest rates surged by some 4x in a matter of days. Let’s dive in and find out what the repo market is, what exactly happened, and why it might be a harbinger of things to come.
What are the repo markets?
The repo market is where banks and other financial institutions that need overnight money for their operations go to borrow money. They go there because it’s cheap, interest wise.
The repo interest rate is supposed to mirror the Fed funds rate, which up until Wednesday, September 18 was 2.25% (subsequently reduced to 2%). These are overnight loans to aid financial institutions experiencing temporary liquidity shortfalls to meet their obligations.
How do repo markets work?
A repo agreement is a type of overnight loan with a bit of a twist. In the repo market, a lender supplies a borrower with capital in return for securities posted as collateral (these securities are usually treasuries, which are highly liquid and considered safe).
Both parties enter into a repurchase (repo) agreement in which the borrower is obliged to repurchase their collateral back the following day by paying back the loan, plus interest and a small fee.
So what happened recently?
On Tuesday, September 17, repo rates touched 2.3%, which, as indicated above, is higher than the Federal Reserve’s benchmark rate, suggesting a liquidity problem. In the following days, this rate surged by over 4x to as high as 10% (the highest it’s been in 11 years).
A massive rise like this in such a short period is an indication of a significant disconnect between the need for funds and the availability of those funds. When the rate increases so suddenly and rises so high, it’s often a sign of increased risk or uncertainty in the market.
It essentially means that the institutions who ordinarily fulfill these short-term needs either do not have the money to do so or are unwilling to.
This created a severe problem for FED policymakers because the rise in the repo rate had a knock-on effect on the Fed’s benchmark rate, causing it to rise to the upper bounds of 2.25%, just as FOMC policymakers were busy discussing their imminent rate cut from 2.25% to 2%.
This, in-turn, led the New York Federal Reserve to print $75 billion and begin auctioning it off into the repo market to calm the money markets down.
The surge in repo rates, coupled with the Fed’s response, is the main reason that repo is back in the headlines. What we have just described has not been carried out at such a large scale since 2008. Which understandably has many people spooked.
Why did it happen?
The short answer is that no one really knows, or at least a definitive explanation has yet to be given by the Fed. Analysts have attributed the event to several interrelated factors.
The most prominent of which is an ongoing reduction in reserves since the Federal Reserve curbed its asset purchasing program back in 2014, which means less cash to lend.
Add to this an outflow of deposits from banks by companies honoring their tax payment deadline, other market participants settling their treasury purchases and a public holiday in Japan further reducing available liquidity and you have the perfect storm for the squeeze that we’ve seen in the repo market. Or at least that’s what they are saying.
Is this a sign of another crisis in the works?
Now, that is the million-dollar question. The financial media are downplaying what happened, saying that it’s purely a money market phenomenon and nothing to do with anything even tangentially related to the events that led to the crisis of 2008.
However, many are beginning to question this narrative. In many ways, it’s a case of once bitten, twice shy. On the eve of the 2008 crisis the words coming out of central bankers, policymakers and the financial media were similarly agreeable and soothing. And we all know what happened next.
What’s worrying some market commentators is that this may be a sign of the financial system reaching a breaking point again and a sign that the Fed may have over-tightened, resulting in a liquidity shortfall that’s only going to get worse.
Conditions are different from those before the previous crisis, but there is a convergence of risk factors. The US-China trade war and the manifold knock-on effects for global industry as a whole. Renewed tensions in the Middle East. Cyclical pressures such as the fact we are overdue for another capitalist recession.
All the above and more may be combining to signal extreme uncertainty and strain in financial markets. For many, the question remains what, if anything, will be the straw that breaks the camel’s back this time?
What to keep an eye on
Interestingly, the New York Fed’s recent repo intervention was not a one off, in fact they have been adding $75 billion in liquidity every day this week and have committed to continuing to do so until October 10, at which point the Fed will “conduct operations as necessary to help maintain the federal funds rate in the target range, the amounts and timing of which have not yet been determined.”
Markets will be keeping an eye on these amounts beyond October 10 to try and ascertain whether this really was a flash in the pan, or evidence of more systemic issues.