If you have been in the bond market for a long time, you know that simple things are actually quite complicated. Whether it is a new issuance, hedging, yield and return calculations, or curve shapes–even simple stuff ends up being quite involved.
But even for veteran bond market participants, the inner workings of the money markets–where hundreds of billions of dollars get moved around each day before you have finished your morning coffee–is as big an inside baseball story as any. Get a repo trader going and he will regale –and bore — you to death–with stories about the inner workings of the money market. And within 10 minutes, you will be talking about the repo market during the financial crisis as if it happened yesterday.
The reality of the money and financing markets is that it is all very important stuff for the normal functioning of the market–as secured lending is the lubricant that makes the world of securities function. But it is sausage making in the extreme, and you are better off not knowing all the details. Nothing much has happened in the money markets since the financial crisis.
It is no wonder that investors who are not money market people are getting all worked up when they hear overnight rates hit 10%. Their first assumption is something totally sinister is going on, but they have no clue what it really means and how it will end. So, you can’t blame them for concluding that another financial crisis is upon us.
Of course, 10% clearing rates in repo* is not normal. But it is not a crisis either. The US Federal Reserve has the tools to solve the problem and it will. In a few weeks, all of us will have forgotten about this spike as the Fed takes some concrete and long-awaited actions. The real question is why they didn’t anticipate it and take preemptive measures because this outcome was far from a surprise for people who have been following the repo market.
If you want to stop reading here, be my guest. But if you want to know why it happened and why it isn’t a big deal, keep reading.
There are quite a few events that got us here:
- A while back, the Fed started a quantitative easing (QE) program and created bank reserves. To ensure the federal funds market didn’t collapse, it started paying interest on excess reserves. Years later, the Fed started unwinding the QE program and draining some reserves.
- Banking regulators created all sorts of new regulations that required banks to hold high quality liquid assets and large amounts of liquidity reserves to meet their obligations. Interest bearing reserves were a perfect tool for that, even more so than longer dated US Treasuries. As a result, there was an incentive for the large banks to hoard reserves.
- The Treasury issuance has increased meaningfully. And at various times when taxes need to be paid or bond markets sell off, the dealers end up with much larger levels of inventories that need to be financed.
Therefore, even during an era where you have outstanding reserves at almost 50 times the pre-crisis levels, and all these issues coming together in one go, it was no surprise that the squeeze for reserves showed through very acutely this week.
The problem, at the end of the day, is that in an era of QE and new regulations, reserves, which are really a monetary policy tool, are being used for regulatory objectives.
There are plenty of solutions available to deal with this core issue;
- The Fed could intervene in the market to provide liquidity with a one-off repo facility, as it has done over the past few days. It is something they did frequently pre-crisis.
While this is viable solution, it is a very unstructured and unsustainable solution for an era when Treasury issuance and financing needs are only going up.
- They could start another QE program to create more reserves.
But that is really conflating monetary policy-setting with the technicalities of regulation and money market operations. It is like using a shotgun to kill a mosquito – doable but overkill.
- They could make a full allotment repo facility available to primary dealers at an appropriate interest rate.
This, in my mind, is the easiest and best long-term solution. It is a structured and evergreen facility that reduces the incentive for banks to hold or hoard reserves while providing the Fed full flexibility to set monetary policy. Effectively, such a standing facility will convert other high-quality collateral like Treasuries into reserves quickly and there will be no reason to hoard reserves.
The bottom line is that the repo rate machinations are easy to explain, and not a systemic issue yet, and likely to be solved by the Fed in quick order.
*A repo is when one party lends out cash in exchange for a roughly equivalent value of securities, often Treasury notes. This market exists to allow companies that own lots of securities but are short on cash to cheaply borrow money.
Blog header image: Mint Images / Offset
The opinions expressed are those of the author as of September 19, 2019, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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