Why the repo rate's spike should not be compared to 2008
What has happened?
On September 17, rates in the repurchase operation market (repo) rose to 10% - four times higher than the usual levels. As a result the US Federal Reserve Bank (the Fed) has started to intervene for the first time since 2008 in order to bring repo rates and the effective fed fund rate down again.
Is the spike in yields an indicator of the next credit crisis?
The current spike in short term rates should not be compared to the infamous spike in unsecured lending rates back in 2008. Back then market participants witnessed a sudden rise in the so called Ted spread (spread between US Treasury bill yield and Libor yield). The widening of the spread was a result of higher rates in the Libor, which is the unsecured lending rate at which banks lend to each other. As such the widening demonstrated the rise of balance sheet concerns within the interbank market.
This time the spike occurred in the secured lending market with collateral being US treasuries. No question the spike in rates is a reflection of a liquidity imbalance partly caused by the Fed’s reduction in balance sheet but should not be taken as an indicator of credit stress.
Why is there so much focus?
While such a move should not be regarded as an indicator of financial stress in the system, it’s an illustration that the current environment in the US money market is imbalanced.
Settlement of a US coupon auction as well as corporate tax claims, which amounted to roughly US$100bn in one day, have been blamed for the spike in rates. This sudden demand for liquidity must be met by primary dealers who use the repo market to manage the fluctuating level of demand for cash. In this operation, a dealer borrows cash by providing securities like US treasuries as collateral, thus keeping borrowing cost lower compared to unsecured lending.
What has the Fed’s balance sheet to do with it?
Before and during the financial crisis the Fed constantly provided liquidity by entering into repo transactions to manage potential scarcity of liquidity. When the Fed started buying US treasury and mortgage-backed securities (MBS) in the market to implement its quantitative easing, the balance sheet increased to US $2.5trn treasuries and US $1.8trn in MBS. This led to substantial cash supply in the market –resulting in the repo operations by the Fed no longer being needed during that time.
But from October 2017, the Fed started the process of normalising its balance sheet. Banks’ reserves at the Fed today stand at just short of US $1.5trn which is almost 50% lower than at its peak five years ago. In addition, stricter regulations in the aftermath of the credit crisis have made it more difficult for intermediaries to enter into repo transactions whilst the market has become saturated with collaterals, e.g. US treasuries, on the back of the US fiscal expansion.
While supply of liquidity has decreased, demand for cash has naturally increased by roughly US $100bn a year – a typical pace when the economy is growing - contributing to the decrease in cash reserves.
Has the Fed not foreseen such a scenario?
This imbalance could be seen in the increase in the effective fund rate the average rate dealers have paid when borrowing. This rate historically sat right in the centre point of the desired fed fund range but in recent years started to creep higher due to the decrease in cash reserve. The Fed has tried to counteract by moving the interest on the excess reserves (IOER) lower in order to divert liquidity away from the Fed’s balance sheet into the financial system, thus lowering the average borrowing cost. But this in hindsight has not solved the scarcity of liquidity challenge.
What will happen now?
One way for the Fed to provide liquidity is to restart bond purchases again. At his press conference last week after the central bank’s rate decision, Powell said it’s “certainly possible that we’ll need to resume the organic growth of the balance sheet earlier than we thought”. The purpose this time would be to provide liquidity rather than to control the long end of the interest rate curve as it was the case in the aftermath of the financial crisis.
In order to make that differentiation clear to the market, the Fed could potentially focus on US T Bills only. The fact that the Fed has already committed to repo transactions until October 10 and given hints that they will provide a solution shortly should be seen positively. Going forward, it is likely the Fed will set up a standing repo facility to deal with peak cash demand.
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