Invesco Fixed Income believes the Federal Reserve (Fed) will add sufficient liquidity to the banking system to alleviate rate pressure in the funding/repo markets that typically arises at year-end, and avoid the severe volatility experienced in September. In the press conference that followed the Fed’s December meeting, Chairman Jerome Powell was clear that the Fed will do what is needed to keep the federal funds rate in its target range and repo rates under control. Soon after, the Fed also provided an update on its year-end operations:1
- The Fed will provide up to $490 billion in liquidity available through term and overnight repos through year-end. The Fed has been conducting daily overnight repo operations and offering periodic term repo since the first signs of repo market pressure emerged in September. (See our blog “Temporary measures have stabilized repo markets.”)
- T-bill purchases are expected to reach $150 billion by year-end. The Fed has been purchasing US Treasury bills in the secondary market to inject liquidity into the banking system.
Therefore, by year-end, it is anticipated that the Fed will provide up to $640 billion in total liquidity, including $490 billion via open market operations (OMO) repo and another $150 billion in outright T-bill purchases.1
Figure 1: General collateral Treasury overnight repo rates have normalized since September
Will these measures be sufficient to smooth expected year-end pressures?
The challenge the Fed faces is that, although we believe it has offered sufficient liquidity to primary dealers to fund themselves over year-end, it cannot extend this liquidity directly to non-primary dealers and other market participants who are not eligible counterparties to the Fed. The uncertain liquidity needs of non-primary dealers could cause some repo volatility at year-end, but we believe the Fed has the tools in place to avoid a spike in rates similar to what we experienced in mid-September.
Is a permanent solution possible?
The Fed has also discussed the possibility of implementing a standing repo facility (in which it supplies banks with reserves in exchange for Treasury securities). This facility could provide a long-term solution to alleviate funding pressures in the markets by establishing a ceiling on repo rates, however, Powell has noted that this facility is not currently a priority.
We believe the Fed is monitoring the year-end situation closely and will likely make adjustments, if necessary, to ensure sufficient liquidity. We believe such flexibility reduces the risk of extreme volatility in the federal funds rate and repo rates at year-end.
1 Source: Federal Reserve Bank of New York, Dec. 12, 2019
Blog header image: Nick Fewings / Unsplash
The federal funds rate is the rate at which banks lend balances to each other overnight.
The repo (or repurchase) rate is a form of short-term borrowing at a designated rate, whereby a financial institution lends money to a commercial bank. The repo rate can be used by monetary authorities to control inflation.
The opinions referenced above are those of the author as of Dec. 18, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.