Why is the US Repo crisis ongoing?

The US Repo crisis is something that seems to turn up every day, or if you prefer as often as we are told there is a solution to trade war between the US and China. On Friday the New York Federal Reserve or Fed provided another US $72.8 billion of overnight liquidity in return for Treasury Bonds ( US $56.1 billion) and Mortgage-Backed Securities ( US $16.7 billion). So something is still going on in spite of the fact that we have two monthly plus Repos ( 42 days) for US $25 billion each in play and 3 fortnightly ones totalling around US $59 billion. So quite a bit of liquidity continues to be deployed and this is before we get to the Treasury Bill purchases.

In accordance with this directive, the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.

As an example Friday saw some US $7.525 billion of these bought. So the sums are getting larger.

How did this start?

The Bank for International Settlements or BIS which is the central bankers central bank puts it like this.

On 17 September, the secured overnight funding rate (SOFR) – the new, repo market-based, US dollar overnight reference rate – more than doubled, and the intraday range jumped to about 700 basis points. Intraday volatility in the federal funds rate was also unusually high. The reasons for this dislocation have been extensively debated; explanations include a due date for US corporate taxes and a large settlement of US Treasury securities. Yet none of these temporary factors can fully explain the exceptional jump in repo rates.

Indeed, as for a start the issue has proved to be anything but temporary.

Where the BIS view gets more interesting is via the role of the banks or rather a small group of them.

US repo markets currently rely heavily on four banks as marginal lenders. As the composition of their liquid assets became more skewed towards US Treasuries, their ability to supply funding at short notice in repo markets was diminished.

As the supply of reserves fell in the QT or Quantitative Tightening era they stepped up to the plate on a grand scale.

As repo rates started to increase above the IOER from mid-2018 owing to the large issuance of Treasuries, a remarkable shift took place: the US banking system as a whole, hitherto a net provider of collateral, became a net provider of funds to repo markets. The four largest US banks specifically turned into key players: their net lending position (reverse repo assets minus repo liabilities) increased quickly, reaching about $300 billion at end-June 2019 . At the same time, the next largest 25 banks reduced their demand for repo funding, turning the net repo position of the banking sector positive (centre panel, dashed line).

So things became more vulnerable as we note this.

At the same time, the four largest banks held only about 25% of reserves (ie funding that they could supply at short notice in repo markets).

Then demand for Repo funding was affected by the US Treasury.

After the debt ceiling was suspended in early August 2019, the US Treasury quickly set out to rebuild its dwindling cash balances, draining more than $120 billion of reserves in the 30 days between 14 August and 17 September alone, and half of this amount in the last week of that period. By comparison, while the Federal Reserve runoff removed about five times this amount, it did so over almost two years

As you can see the drain from QT was added to in spite of the fact that the market had become more vulnerable due to the lack of players. There was a clear lack of joined up thinking at play and perhaps a lack of any thinking at all. A factor here was something the BIS identifies for the banks.

For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes

After a decade the experienced hands had in general moved on.

But it was not enough to collapse the house of cards. There were other nudges as well on the horizon.

Market commentary suggests that, in preceding quarters, leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives. Since 2017, MMFs have been lending to a broader range of repo counterparties, including hedge funds, potentially obtaining higher returns.

So hedge funds were playing in the market but as it happened were not an issue for a while as the US Money Market Funds (MMF) turned up. But then they didn’t.

 During September, however, quantities dropped and rates rose, suggesting a reluctance, also on the part of MMFs, to lend into these markets. Market intelligence suggests MMFs were concerned by potential large redemptions given strong prior inflows. Counterparty exposure limits may have contributed to the drop in quantities, as these repos now account for almost 20% of the total provided by MMFs.

So there is a hint that maybe a hedge fund or two became such large players that they hit counterparty limits. Also redemptions from MMFs would hardly be a surprise as we note the interest-rate cuts we have seen in 2019.

Why should we care?

There is this.

 Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly.

So they oil the wheels of financial markets and when they don’t? Well that is one of the causes of the credit crunch.

The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).

In case you did not know what they are.

A repo transaction is a short-term (usually overnight) collateralised loan, in which the borrower (of cash) sells a security (typically government bonds as collateral) to the lender, with a commitment to buy it back later at the same price plus interest.

Also it is one of those things which get little publicity ( mostly ironically because they usually work smoothly) but there is a lot of action.

 Thus, any sustained disruption in this market, with daily turnover in the US market of about $1 trillion, could quickly ripple through the financial system.

Comment

Some of the factors in the Repo crisis were unpredictable. But it is also true that the US Fed was at best rather flat-footed. There had been a long-running discussion over the use of Interest On Excess Reserves or IOER to banks on such a scale which was not resolved. Then there was the way that so few banks (4) were able to become such large players creating an obvious risk. Then the role of the MMFs as by their very nature they flow into and out of markets and are likely to flow out when interest-rates are declining.

The BIS analysis adds to what we know but changes in stocks give us broad trends rather than telling what flowed where or rather did not flow on September 17th or since. As David Bowie put it.

Ch-ch-ch-ch-changes
Turn and face the strange
Ch-ch-changes
Don’t want to be a richer man
Ch-ch-ch-ch-changes
Turn and face the strange
Ch-ch-changes
There’s gonna have to be a different man
Time may change me
But I can’t trace time

Number Crunching

The BIS has been looking into some other areas.

An analysis of the #TriennialSurvey finds that global notional for #OTCderivatives rose to $640 trn in 2019, dominated by #InterestRateDerivatives

Average daily turnover of OTC interest rate derivatives more than doubled over 2016-19 to $6.5 trillion, taking OTC markets’ share to almost half total trading

30 years, 53 countries, 1,300 reporting dealers, and $6.6 trillion daily FX trades,

Weekly Podcast

 

A new era of US QE starts with it being renamed Reserve Management

Last night saw something of an epoch making event as all eyes turned to Denver Colorado. This time it was not for the famous “hurry up offence” of John Elway in the NFL but instead there was a speech by Jerome Powell the Chair of the US Federal Reserve. In it he confirmed something I have been writing about on here for some time and the emphasis is mine.

Reserve balances are one among several items on the liability side of the Federal Reserve’s balance sheet, and demand for these liabilities—notably, currency in circulation—grows over time. Hence, increasing the supply of reserves or even maintaining a given level over time requires us to increase the size of our balance sheet. As we indicated in our March statement on balance sheet normalization, at some point, we will begin increasing our securities holdings to maintain an appropriate level of reserves. That time is now upon us.

This of course raises my QE ( Quantitative Easing) to infinity theme. I also note Chair Powell raises the issue of the balance sheet so let us look at that. It peaked at around US $4.5 trillion as we moved into 2015 and stayed there until October 2017 when the era of QT ( Quantitative Tightening) or reverse QE began and it began to shrink. Over the last year it shrank from US $4.17 trillion to US $3.76 trillion before the repo crisis struck.

In mid-September, an important channel in the transmission process—wholesale funding markets—exhibited unexpectedly intense volatility. Payments to meet corporate tax obligations and to purchase Treasury securities triggered notable liquidity pressures in money markets. Overnight interest rates spiked, and the effective federal funds rate briefly moved above the FOMC’s target range. To counter these pressures, we began conducting temporary open market operations. These operations have kept the federal funds rate in the target range and alleviated money market strains more generally.

What this misses out is that US Dollar liquidity has been singing along with Queen for some time.

Pressure: pushing down on me,
Pressing down on you, no man ask for.
Under pressure that burns a building down,
Splits a family in two,
Puts people on streets.

Here I am from the 25th of September last year.

The question to my mind going forwards is will we see a reversal in the QT or Quantitative Tightening era? The supply of US Dollars is now being reduced by it and we wait to see what the consequences are.

As you can see the phrase “unexpectedly intense volatility” is not true of anyone who is a follower of my work. One way of looking at this is that forwards pricing of the US Dollar has been in the wrong place for theory. This is one of the reasons why German bond yields have gone so negative ( as I type this the benchmark ten-year yield is -0.58%) because if you try to switch to US Treasury Bonds to gain the 1.54% or 2% higher yield you find that exchange rates take away the gain. To get a higher yield you have to take an exchange rate risk. Returning to the Chair Powell statement we see that it is more realistic to say we were hovering near an edge and then slipped over it.

If we return to the balance sheet we see that it has risen to US $3.95 trillion for a rise of the order of 190 billion in response to the repo crisis. The exact amount varies daily with the individual repo operations and also fortnightly as we now have those too. Just as an example the difference between the operations on Monday and yesterday was some US $9.55 billion lower. I point this out as some places have been claiming you add the repo operations up which is really rather odd when most so far only have the lifespan of a Mayfly.

Those who analyse events via the prism of bank reserves should be happy with this bit.

Indeed, my colleagues and I will soon announce measures to add to the supply of reserves over time. Consistent with a decision we made in January, our goal is to provide an ample supply of reserves to ensure that control of the federal funds rate and other short-term interest rates is exercised primarily by setting our administered rates and not through frequent market interventions.

An official denial

By now you should all know how to treat this.

I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.

Indeed the next part is simply untrue or if you are less kind a lie.

Neither the recent technical issues nor the purchases of Treasury bills we are contemplating to resolve them should materially affect the stance of monetary policy, to which I now turn.

One of the roles of a central bank is setting interest-rates as part of monetary policy. Those who follow my podcasts will know I defined it as there second role after the existence and provision of a currency, in this case the US Dollar. Briefly monetary policy was affected as overnight interest-rates went outside the official range as described below by the Financial Times.

the pressures that bubbled up in September and sent the cost of borrowing cash overnight via repurchase, or repo, agreements as high as 10 per cent.

That is not as large as you might think as the impact is only for each day but it was way outside the official range. Also there were times when the role of a central bank was in setting the interest-rate for overnight money in terms of its monetary policy. The credit crunch moved events along as that did not have the hoped for impact on the real economy ( and hence we got QE) but the underlying principle remains.

Comment

So we find that the new version of Quantitative Easing or what will no doubt be called QE4 had the champagne bottle smashed on it last night by Jerome Powell as it got ready to go down to the slipway. It remains for it to be fully fitted out as I do not believe it will stop here.

making the case instead for the Fed to buy anywhere from $200bn to more than $300bn of shorter-dated Treasury bills over the next six months. ( Financial Times)

As you can see the lower estimate pretty much coincides with the change in the balance sheet do far with the repo operations. The larger amount perhaps aims for some sort of margin.

The difference between this and the QE we have seen so far is the term of the assets purchased. Treasury Bills last for up to a year whereas Treasury Bonds are for longer periods of time with what is called the long bond being for thirty-years. Also bills do not pay interest as you pay less for them to allow for that.

So there are minor differences with past QE efforts but the direction of travel is the same. Let me put it another way with this from the US Federal Reserve,

Total assets of the Federal Reserve have increased significantly from $870 billion on August 8th, 2007

They have indeed as we wonder how long it will be before we get back to the previous peak of US $4.5 trillion and presumably beyond.

If QE really worked it would not need so many new names would it? Japan now calls it QQE and now the US calls it reserve management. Perhaps Governor Carney will call it climate-related QE.