In this commentary I am going to cover some very unfamiliar territory for most readers: The machinations and inner workings of short term monetary markets.
Short term monetary markets, particularly those relating to overnight repurchase agreements (REPOs), are not everybody’s cup of tea. However, recent events in the overnight REPO market has affected the outlook for all our markets. This commentary is broken into four parts:
1. Why we care about the REPO market?
2. What actually happened?
3. Why did it happen?
1. Why we care about the REPO Market
Banks lend money to each other every night. They exchange cash for collateral at a price – an overnight interest rate. They actually sell the collateral and promise to repurchase it the following day at a slightly higher price equivalent to the overnight interest rate. The collateral is generally made up of AAA rated risk free government paper. This is the REPO market. It is a barometer of interest rates that gives us an indication of how much cash is available for lending in that overnight market and at what price.
The REPO market is generally monumentally boring and does not require a second glance unless something spectacular or unexpected happens.
2. What Actually Happened
The fire alarm just went off! Repo rates hit 10% in September and caused a panic in the Federal Reserve (Fed). This is a Trillion Dollar marketplace. One day the interest rate is 2% and the next day it reaches 10%!
3. Why Did Rates Rocket Higher?
Unfortunately there is no definitive answer to this question. However there are two narratives dominating these events:
A. Just a minor technical Issue
This is the official government story. Banks are the main supporter of the REPO market. However they have partly withdrawn from the market due to new restrictive regulations. The spike in rates occurred at a particular moment in time when bank cash was in short supply as major companies needed to drawdown cash to make tax payments.
I find the technical arguments put forward here all very plausible. It is important to note that the market never actually failed, there was always a deal available for lenders and borrowers. And more broadly speaking we can say that the world is truly awash with liquidity. Beyond the USA, markets are actually trading at negative yields.
B. Out-of-control Wildfire
The argument here goes like this. The Fed is not really in control, it doesn’t really understand what is going on much less how to fix it. We are headed for a long overdue crash in the market. This is an understandable viewpoint. There is no doubt that the Fed was surprised by the spike higher in REPO rates. They literally scrambled to inject cash into the system.
This scramble is best understood using some comparative numbers for its previous Quantitative Easing and subsequent Quantitative Tightening programs. During its QE programs the Fed grew its balance sheet from $800Bn to $4,500Bn. At its peak the Fed was injecting $80Bn per month into the system. Quantitative tightening was an attempt to reverse this process. It ended in failure earlier this year. It brought the Fed's balance sheet down to around $3,760Bn before it was halted. At its peak the Fed was unwinding a rate of $50Bn per month. It is difficult to ascertain the exact level of support that the Fed has given to the REPO market. They are lending various amounts over various terms.
However the above chart shows that the balance sheet at the Fed increased by $260Bn in six weeks! That is moving at a $173Bn a month pace. Clearly those who call this a wildfire have some evidence to back up their arguments.
It is not so much the unexpected element of these events that is interesting. It is the profound disagreements as to why this is happening and whether the problem is fixed or not that is interesting.
Those that think ‘technical / regulatory’ issues caused the problem believe that problems in the REPO market have been largely resolved by the Fed pumping more cash into the system. However analysts, like Bank of America's Mark Cabana who first correctly predicted last month's REPO fireworks, are warning that money-market stress is likely to get much worse despite the Fed’s attempts to fix the problem.
The chart below demonstrates why the REPO problems may not be fixed. I appreciate that most people are not used to looking at complex charts but I would strongly encourage you to study this one. Prior to all of this excess cash being pumped into the system by the Fed there were no problems in the REPO market.
The green line shows the ‘excess reserves’ held by major banks that are deposited back with the Fed. Through its Quantitative Easing mechanism the Fed pushed an extra $3,700Bn into the economy. However $2,700Bn of this money found its way back to the Fed as bank deposits.
The salient question is will the Fed’s new money pumping program solve the problem? Is it effective? And if not, what happens next?
My guess would be even more money pumping.