Recent volatility in overnight funding markets has resulted in unprecedented levels of interest rates on repurchase agreements — so-called “repo rates.” The unexpected turbulence has prompted the Federal Reserve (Fed) to inject billions of dollars of liquidity into the system through open market operations used to control short-term interest rates. But while several factors appear to be pressuring money markets (more about that below), it is important to point out that systemic credit market distress is not one of them.
A supply/demand imbalance drove repo volatility
Invesco Fixed Income’s view is that a simple supply/demand imbalance has been building between the amount of collateral (Treasury securities) in the money market and the amount of cash available to purchase it. On Sept. 17, this dynamic intensified as a large settlement of Treasury securities, a spike in the issuance of Treasury bills, constraints on the volume of securities that primary dealers could absorb, and quarterly corporate tax payments combined to generate an outsize surplus of collateral relative to the amount of available cash.
Cash, in this instance, is bank reserves. The bulk of bank reserves is owned by the four largest banks in the US, which account for about half of all reserves.1 This high concentration of reserves (mostly required to fulfill bank regulatory rules), has created a scarcity of cash available to lend (buy securities overnight) in the repo market.
The Fed’s temporary actions stabilized the market
In recent weeks, the Fed has stepped in to provide the needed cash by purchasing government securities, removing excess collateral from the system, and expanding its own balance sheet (i.e., the amount of securities it owns).
All eyes were on market conditions as of Sept. 30 (the end of the third quarter), to see if these actions by the Fed had stabilized the repo market successfully. Overnight repo rates opened slightly elevated at 2.70%/2.50% bid-offer but reflected an ordinary trading pattern relative to normal quarter-end pressures. 2 The overnight Fed repo operation was well undersubscribed at $63 billion of the $100 billion available. 2 These two facts tell us that the Fed’s temporary repo operations have stabilized funding markets and have helped equilibrate the previous supply/demand imbalance.
Although these operations have been successful in stabilizing the repo market and lowering repo rates, they are temporary and limited — overnight repo operations are limited to $100 billion and are set to occur each day until Oct. 10.2 Three longer-term repo operations totaling $150 billion will mature between Oct. 8-11.2
We expect the Fed to enact a longer-term solution
In the near term, we expect the Fed to continue to maintain stability with temporary overnight and term repo operations. As the end of 2019 approaches, we anticipate that, beginning in mid-December, the Fed will conduct overnight and term repo operations that mature in 2020 to help alleviate seasonal funding pressures that typically arise with year-end reporting periods.
In the longer term, we believe the Fed will enact a more permanent solution to maintain stability, including the expansion of its balance sheet through purchases of Treasury securities. This would generate growth of the Fed’s balance sheet for the first time since quantitative easing ended in October 2014. We believe the Fed is also likely to create a new standing repo facility. The standing repo facility would provide primary dealers and government-sponsored enterprises with daily access to liquidity and address the build-up of excessive collateral in funding markets. This would be very similar to the temporary overnight repo operations already implemented in September.
We believe these tools will enable the Fed to contain interest rate volatility going forward and promote the continued smooth functioning of money markets.
1 Source: US Federal Reserve, as of March 31, 2019
2 Source: Federal Reserve Bank of New York, “Repurchase agreement operational details”
Blog header image: Christophe Hautier / UnSplash
The repo (or repurchase) rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds. The repo rate can be used by monetary authorities to control inflation.
Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.