Money's too tight to mention
Is stress in the US repo market a harbinger of crisis or a plumbing issue?
Stress in overnight funding markets in the US has flared up recently. At face value, it is an unpleasant reminder of the strains that characterised the start of the 2007-09 financial crisis. On closer inspection, though, it looks like some leaky financial plumbing that has been hastily patched up by the Federal Reserve.
What has happened?
Over the past week or so, we have seen a spike in overnight repo (short for 'sale and repurchase') rates. Some intraday quotes spiked as high as 8%, with overnight rates settling at nearly 4%. That's a significant disruption to the normally orderly running of short-term lending markets.
Repo rates are the implied interest rates on overnight lending, secured against the highest-quality collateral. In a 'sale and repurchase' agreement, borrowers sell high-quality assets (normally US Treasuries) today and buy them back at a pre-determined price tomorrow. It's an effective way for financial intermediaries and investors to create cash in their portfolios to meet short-term needs.
The spike therefore suggests a high demand for (or reduced supply of) overnight lending. The average effective fed funds rate – the short-term interest rate that the US central bank targets in its monetary policy operations – jumped to the top end of the target range.
Consistent with the above indicators of funding stress, we have seen a huge jump in the spreads paid by marginal borrowers in the fed funds market. It's impossible to avoid the conclusion that, in the words of Simply Red, 'money's too tight to mention'.
There has been some commentary that the Federal Reserve has completely lost control of the short end of the yield curve. That's a bit of an exaggeration, given that a broader range of money-market rates (such as CP, CD, LIBOR, 1M OIS) have not reacted. This looks like a localised liquidity problem right at the short end of the curve.
Why has it happened?
Short-term liquidity in the money markets is a function of excess reserves in the banking system. These overnight claims on the Federal Reserve have been steadily shrinking since 2014. Following the financial crisis, there are good reasons to think that the effective floor for these reserves is a long way above zero. Nobody really knows where the biting point is, but there have been some estimates that the 'system minimum' level of reserves is in the region of $1.2 trillion (see, for example, the March Primary Dealers’ Survey).
System-wide excess reserves are currently running at $1.5 trillion, but there was a sharp drop earlier in the month due to corporate tax payments and Treasury bond issuance, both of which suck liquidity out of the private sector. Combined they are estimated to be worth up to $100 billion. The market reaction suggests that the 'system minimum' level of reserves is higher than $1.2 trillion.
What has been the Fed’s response?
The New York Fed has launched a series of repo operations, borrowing around $250 billion of US Treasuries, Agencies and Agency mortgage-backed securities, and injecting cash into the private sector. In the short term, that should act to cap repo rates between private-sector participants and stop the funding squeeze.
At the September Federal Open Market Committee meeting, the policymakers cut the interest paid on excess reserves (IOER). The IOER is the rate at which the most credit-worthy borrower is willing to borrow an unlimited amount overnight. Bringing this down within the target range is a tried and tested way to control short-term interest rates. There is no conceptual problem with bringing this down further to align it with the bottom of the target range.
More structurally, the Federal Reserve has been considering a standing repo facility for some time. At the moment, its control mechanism is asymmetric. The bank conducts reverse repos (absorbing liquidity) on a daily basis with a broad range of counterparties, and conducts repos with a limited set of counterparties on an ad hoc basis. In the minutes to the June Federal Open Market Committee, it was noted that a standing repo facility:
The market conditions of the past week are exactly the kind of conditions this facility would be designed to address. The Federal Reserve's thinking on this kind of backstop is evolving, but it is an obvious complement to its current toolkit. The two key unknowns are:
- Would such a facility would be at a tight or wide spread to other money-market rates? At a wide spread, it will be a rarely used backstop facility with little impact on banks' behaviour. At a tight spread, it could have a significant impact on their behaviour (e.g. their willingness to hold more Treasuries within liquid asset portfolios with a big impact on swap spreads).
- Who will qualify as an eligible counterparty? The broader the list of eligible counterparties, the more effective the market backstop but the greater the concerns about moral hazard. The Federal Reserve's backstop would effectively reduce the penalties for liquidity mismanagement in the private sector.
The clear signs of funding stress seen over the past week or so are a product of unexpected tightness in the short-term money supply, not due to concerns about counterparty risk. These concerns can be, and are being, fixed by the Federal Reserve.
The exact mechanisms used to fix the problem can impact the pricing of some more esoteric corners of the fixed income markets (such as swap spreads or basis swaps), but the overall message for risk markets is much less alarmist than some of the headlines suggest.