Since the ‘Panic of March 2020’, the financial markets have enjoyed a period of relative serenity. Recently, however, this calm has been broken by the extensive use of the ‘reverse repo’ facility by the New York Fed.
What is going on in the financial markets? Is this a sign of bigger problems ahead?
In this blog-entry we delve deeper into the arcane and hidden world of the repo markets and explain why the QE programs of the Fed may be reaching the end of their rope both from a broader economic perspective, as well as that of the financial markets.
But first, let’s take a moment to review what the “repo-markets” are.
Repurchase agreements, or repo
The repurchase agreement, or “repo”, is a financial agreement in which the borrower agrees to buy back the security it sold to the lender at a later date for a higher price. A repurchase agreement is essentially a short-term loan backed by high quality collateral, most often 10-year Treasury bonds.
If the counterparty is unable to meet its obligations to the lender, the lender can liquidate the assets serving as collateral in the secondary markets. This makes the repo market a reliable source of short-term funding for institutional investors and market makers, which have short term liquidity requirements as the natural consequence of their daily trading activities.
Repos have a variety of maturities, the most common contracts being overnight repos. The vast majority of trades completed on the repo market are considered overnight repos. Longer-term repos are generally in the range of two days up to three months. Open term repos are also available for market participants.
Repo can also be used to borrow fixed income assets in order to execute trading strategies, such as arbitrage through the use of reverse repo contracts. Terms are often the same as in normal repo contracts, ranging from one day to three months. It is estimated that the daily volume of the U.S. repo market is around one trillion dollars.
Repo as a tool of monetary policy
Repo markets play a significant role in the smooth functioning of the financial markets, as they are used to finance large scale purchases in sovereign bonds, equities, and other similar assets. The Federal Reserve utilizes the repo market to conduct its monetary policy through open market operations.
The interest rate used in the repo contract can either be at a fixed rate or tied to a specific reference rate. The Federal Reserve publishes three different reference rates based on trading on the repo markets, which are updated daily on the Fed’s website. The most commonly-used repo reference rate is the SOFR-rate, which is derived from the Secured Overnight Financing Rate.
The reverse repo contract, which is the repo contract from the lender’s perspective, can also be used to invest cash. In a reverse repo, the investor buys collateral in the form of fixed income assets. So, in its reverse repos, the Fed has been a seller of repo contracts.
The New York Fed is authorized by the FOMC to conduct both repo and reverse repo operations in order to carry out the monetary policy directives of the Federal Reserve. The repo operations conducted by the New York Fed are intended to stabilize the financing conditions on the repo market. They are used to maintain the desired reference rates on the repo market, which are the basis for the vast majority of repo trading.
Reverse repo operations are primarily intended to temporarily reduce the quantity of reserve balances held by the banks. They are also intended to control short term interest rates, particularly the IOER-rate, or the Interest on Excess Reserves.
The spike in reverse repo usage
Recently, the New York Fed has been conducting unusually large reverse repo operations on the repo market (see Figure 1). Or, to put it precisely, other repo-counterparties, like banks and money market funds, have been seeking reverse repo contracts from the Fed en masse in order to earn minimal interest (currently around 0.06%).
Why are they doing this?
In principle, there are two explanations. Either the repo-counterparties lack collateral or they are ‘sterilizing’ the QE-program of the Fed, where the Fed buys Treasuries through its network of Primary Dealers.
The former would signal an increased demand and/or a short-supply of a good-quality collateral in the financial markets. As noted above, the main collateral used in the repo-markets are the US 10- and 5-year Treasuries, whose yields have been rising in recent months due to increased inflation expectations. At the same time, the Fed has been buying them (see Figure 2). Thus, there may be a shortage of 10- and 5-year Treasury notes in the markets.
The latter, on the other hand, would signal big trouble for the Federal Reserve. If the reverse repo facility of the Fed is used to ‘sterilize’ the effects of asset purchases by the Fed—by parking the increased liquidity back at the Fed—it would imply that institutional investors have become unwilling to invest the Fed-induced (artificial) liquidity. This, on the other hand, implies that quantitative easing has run its course, and that the Fed is trapped.
However, there exists a possible, and even more worrying explanation.
Is the U.S. reaching ‘debt saturation’?
Programs of quantitate easing have altered the balance sheets of banks in a fundamental way. Because the commercial banks were forced to hold a higher supply of reserves, their marginal benefit decreased. This bid up the prices of various securities, leading to additional loans issued until the balance of the marginal benefits was restored.
Since the pandemic and lockdowns hit, the U.S. government and the Fed have been pushing cheap debt and fiscal support to ailing firms and households. Both corporate and consumer debt are at record highs (see Figure 3), and interest rates are on the rise.
What if the U.S. consumers and corporations have simply reached the limit of their ability to absorb more debt, a point of effective debt saturation? This would mean that banks would also lose their ability to counter the effects of excess reserves through issuing additional loans.
Also, because successive QEs (and low policy rates) suppressed long term rates, many of the securities that the commercial banks can hold have became closer substitutes for their usual reserves. Now, as long-term rates have risen, Treasuries have become more profitable high quality liquid assets, or HQLA than reserves. Thus, banks may have started to prefer Treasuries as part of their risk management making them unwilling to accept more central bank reserves.
These trends have been reinforced by tighter regulatory pressures, which have limited the ability of banks to be “creative” in their balance sheet management.
The endgame nears
It is thus possible that real economic and regulatory developments may have made the banks shy away from reserves and to dump the extra liquidity created by QE back on the Fed through reverse repo. This would also imply that the real economy is unable to absorb any more QE. Simultaneously, there could be a shortage of good quality collateral in the financial system.
Alas, both the financial markets and the real economy could be signaling “the end of QE”.
Central banks have been battling the headwinds created by their own zero and negative interest rate policies, as well as quantitative easing, since the ‘taper tantrum’ of 2013, and we believe that the worst is yet to come. The global financial markets are so massively levered that even a hint of tapering and/or interest rate rises could send them into a tailspin.
One just has to remember how perilously close we were to a financial meltdown in September 2019 when rates in the repo-markets instantaneously spiked. The Fed had only managed to reduce its balance sheet by a meagre $700 billion (from approximately $4.46 trillion to around $3.76 trillion) and to raise interest rates to 2.5% before the system almost collapsed as a result of their carefully-orchestrated efforts. (So much for “watching paint dry”!)
Now, the balance sheet of the Fed stands close to $8 trillion and the Fed Funds rate has sunk to the low end of its 0.25 – 0% range. It may be instructive to recall, as we recently observed with Archegos Capital, what even relatively mild increases in interest rates may bring.
If the QE-programs are truly out of runway, the immediate future for financial markets and the real economy looks extremely perilous.
This post has been co-written with Lauri Kansikas.
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