How a liquidity crunch in the short-term lending markets sent interest rates soaring. Why this is a huge blunder on the part of the Federal Reserve, and what it means for us as individual investors.
In this episode you’ll learn:
- What are repurchase agreements and how are they used to finance U.S Treasuries.
- How outflows from money market funds and hoarding by banks led to a liquidity crunch that caused repo rates to spike to 10%.
- Why banks are hoarding reserves held at the central bank even though there are over $1.4 trillion of them, up from $20 billion in 2007.
- How quantitive easing increases reserves and quantitative tightening reduces reserves.
- How the Federal Reserve was able to stop the disruption in the repo market, even though the central bank was caught off guard and could have prevented it.
- How individual investors can protect themselves from unintended consequences arising from the unconventional policies and experiments being conducted by the Federal Reserve and other central banks.
Show Notes
New York Fed injects $66bn into short-term lending markets by Joe Rennison—Financial Times
Repo and Reverse Repo Agreements—Federal Reserve Bank of New York
Repo: What just happened? by Alex Roever, Teresa C Ho, Ryan J Lessing, Colin W Paiva—J.P. Morgan
Primary Dealers—Federal Reserve Bank of New York
Excess Reserves of Depository Institutions—Federal Reserve Bank of St. Louis
Three Market Shocks and Investors Say ‘No Problem’ by James Mackintosh—The Wall Street Journal
Bank Capital Requirements: A Primer by Thomas Wade—American Action Forum
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Episode Summary
The Federal Reserve recently lost control of its policy rate due to a complicated spike in repurchase agreement (repo) interest rates. Repo rates are, “The cost of borrowing cash overnight in exchange for U.S. treasuries.” When the interest rate on this transaction soared to 10%, it caused a loss of control over the Fed’s policy rate and panic among some on what to do with their investments. In this episode, David explores why the repo rate spiked, the role of bank reserves in the matter, and what we can do to avoid the negative consequences of the recent jump in repo rates.
A need for cash drives repo rates skyward
In exchange for cash overnight, one entity can sell government securities to another entity and purchase those securities back the following day at a higher price than what they sold them for. The difference between the sell-price and the buy-back-price constitutes the interest rate. Given the ultra-short term nature of repos and the hiqh quality collateral, repo interest rates are generally in line with the Fed funds rate target set by the Federal Reserve.
Repurchase agreements facilitate the financing of new U.S. Treasury securities issuance by primary dealers. These primary dealers are financial institutions who are required to bid on all new Treasury bond and note auctions, These primary dealers enter into repo agreements with money market funds, commercial banks and with the Federal Reserve itself to exchange Treasury securities for cash.
When these primary dealers enter into repurchase agreements with the Federal Reserve, it leads to an increase in reserves on deposit at the central bank as the cash held by primary dealers at the Federal Reserve increases.
In late September 2019, the jump in the repo rate meant that there weren’t enough entities willing to enter into repo transactions as banks and money market funds wanted to conserve their cash.
Why was there a shortage of cash? Money market funds play a large role in repo transactions. These funds, which invest in short-term debt securities, had approximately $35 billion in outflow over the last couple of weeks because investors in the money market funds needed cash in order to pay their September 15th taxes and to settle payments from the recent auction of treasury securities. Consequently, money market funds were less willing to enter into repo transactions due to these cash outflows.
The role that banks play in controlling the repo rate
Commercial banks are also generally willing to participate in repos because they earn a higher yield from repo agreements than they can on the reserves they keep at the central bank, the Federal Reserve. Yet, recently banks have been less willing to participate in repos because the level of reserves has been dropping as part of the Federal Reserve’s actions to reduce the size of its balance sheet.
With less reserves on deposit at the central bank, many commercial banks find they need to conserve their existing reserves in order to have sufficient liquidity to pass quarterly stress tests required as part of banking regulations. Consequently, commercial banks are less willing to lend cash for the repo transactions, which puts stress on the repo market, driving up the interest rate.
The demand for reserves is directly linked to liquidity regulations
There are numerous regulations regarding liquidity needs in banks. Essentially, banks need sufficient high-quality liquid assets to survive stress in the market. Liquidity ratios require commercial banks to have sufficient liquid assets to cover 30 days worth of cash outflows. Systematically important commercial banks also need to have enough liquidity to ensure that the bank could dissolve without chaos. 68% of banks say that liquidity requirements are the driving force behind the demand for reserves.
The high demand for reserves is made difficult because there appears to be a shortage of them. Bank reserves exploded from $20 billion in 2007 to over $2 trillion at their peak in 2014 as part of the Federal Reserves’ quantitative easing program. When the Federal Reserve buys U.S. Treasury securities, it creates a liability by crediting commercial banks’ reserves on deposit at the central bank. Meanwhile, new Treasury issuance drains commercial bank reserves because households and businesses who purchase the new Treasuries reduce their bank deposits in order to invest in the newly issued Treasuries. Total reserves now equal $1.4 trillion—a number banks are desperately trying to hold onto.
While the demand for cash would normally be met by banks being willing enter into repos, the new liquidity regulations are causing the banks to hold onto their reserves to meet liquidity requirements.
Taking steps towards a more controlled repo rate
To solve the cash-demand dilemma in the wake of rising repo rates, the Federal Reserve has been participating in repurchase agreements in order to assist primary dealers and increase the level of bank reserves.
David explains that there are several options available for solving the crisis. The Federal Reserve could expand its balance sheet through additional quantitative easing, or it could define an easier way for banks to trade treasuries for cash reserves. Many believe that the reserve shortage is an entirely solvable issue. David reminds listeners that the Federal Reserve isn’t perfect. It messes up, as it did with the failure to keep the repo rate steady. We should not be alarmed when such an event happens, however. The problem was solved by the Federal Reserve stepping in and providing liquidity. The goal, however, should be to create safety buffers in our finances for times when things get rocky. Assets outside of the financial system may prove invaluable should another mishap occur. Be prepared. There’s no reason to be detrimentally caught off guard.
Episode Chronology
- [0:20] The Fed loses control over policy rates, and repo interest rates soar.
- [2:19] What is a repurchase agreement (repo)?
- [5:02] Why the big players in repos pulled back on Sept. 16th.
- [8:38] Banks need more liquidity because of regulations.
- [12:53] Why reserves have fallen so low.
- [17:43] How does the reserve balance get reduced?
- [19:23] The Fed may have shrunk its balance too far.
- [21:36] What can be done about the reserve shortage?
- [24:17] What can we learn from the repo rate raise?
Related Episodes
Federal Reserve Insolvency and Monetizing the National Debt
388: Will Quantitative Tightening Lead To Even Greater Financial Losses?
428: How the Coming Credit Crunch Could Harm the Economy and Real Estate Prices
Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 270. It’s titled, “Repo Rates Soared—Here’s Why It Matters.”
Esoteric financial news
Last week I got a call from a retired family member who heard from a friend that there was some disruption related to interest rates and banks that was very similar to what happened during the Great Financial Crisis of 2008. He wanted to know, should he move his assets to cash.
This is remarkable. How quickly an esoteric financial news event that we’re going to talk about in today’s episode, spread among some people in the U.S. And they were worried about it, even if they didn’t really understand it. And it’s not easy to understand. Believe me, it’s taken me a number of hours of going through, trying to understand what happened, why it happened, and why it matters.
What happened with the banks?
Here’s a sense of what happened per the Financial Times. “The cost of borrowing cash overnight in exchange for U.S. treasuries, known as a repurchase agreement, or repo, soared early last week, pushing the main interest rate targeted by the Federal Reserve out of its target range. That prompted the New York Fed to intervene in the market for the first time in a decade on Tuesday. It subsequently continued daily $75 billion cash injections throughout the week.”
Now that’s the crux of it. There’s these financial transactions, or securities, called repurchase agreements, which we’ll look at. But more importantly, the interest rate on them got out of control, up to 10%, at one point. Which means the Fed lost control of its policy rate, for a short amount of time, which gives a hint at what we can learn from this. The Fed doesn’t have complete control over what is going on.
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