What’s Going on with the Repo Market?
Repurchase agreements (“repos”) provide critical short-term financing for large institutions to pay taxes, make payroll, fund operations, etc. The repo market is perhaps the most critical part of the plumbing that makes the global financial system work. Last week the market saw cash flow out of the repo market. In response, the Fed pumped cash back in.
What is the “repo market”?
“Repo” is short for repurchase agreements, which are basically short-term overnight loans. It’s where big piles of cash meet large pools of securities. The equilibrium between the two is the overnight interest rate (quoted on an annualized basis). Repos allow large investors, such as mutual funds, hedge funds, and other large institutions, to get the financing they need to run their businesses. In exchange, they pledge securities they own as collateral. These markets typically operate quite smoothly and overnight rates are typically in line with the Fed Funds rate (which was in 2% – 2.25% target range on September 16). The repo market is a critical resource for large businesses to get the overnight financing they need to pay taxes, make payroll, fund operations, etc.
What happened last week?
A significant amount of cash (supply) flowed out of the repo market just as more securities (demand) were flowing in. Said differently, the supply of money went down as demand soared. That pushed up the overnight rate to an annualized rate of over 10% on Tuesday, September 19. Volatility in the repo market also skyrocketed. Of major concern to the Fed was that volatility had pushed the effective fed funds rate above its target range at a time when the Fed was actually preparing to drop the ceiling from 2.25% to 2%. This effectively neutralized, albeit temporarily, the transmission of the Fed’s monetary policy throughout the economy. In response, the Fed injected cash into the system to stabilize rates, the first time they’ve done so since 2008.
Why did this happen?
In 2008, the repo market froze because financial institutions were failing. Bear Stearns, Lehman, AIG, Merrill Lynch, and many others were holding large volumes of real estate- and debt-related securities that were of questionable value. Lenders stopped accepting such securities as collateral, effectively starving these firms, and the broader economy, of much needed cash. That’s not the case this time. This time the issue was that there simply wasn’t enough cash in the system, not that lenders were questioning the value of borrower’s collateral.
It appears the price for cash skyrocketed early last week for three basic reasons:
- Soaring federal debt: Over the four weeks leading up to September 16, the US Treasury borrowing about $336 billion to finance our debt. Said differently, the US Treasury effectively removed $336 billion in cash from the financial system just prior to 9/16. The US federal government is estimated to run a 2019 deficit of nearly $1 trillion.
- Reduction in the Fed’s balance sheet: The Fed continued to shrink its balance sheet up until mid-September. It began the year with a balance sheet of slightly more than $4 trillion. By the week of September 11, the Fed’s balance sheet had shrunk to about $3.76 billion, meaning that the Fed effectively removed about $250 billion in cash from the financial system over the past 8 ½ months. The Fed shrinks it’s balance sheet when it decides not to replace maturing bonds. As bonds mature (and doesn’t buy new ones), the Fed removes cash from the financial system. The Fed stopped shrinking its balance sheet when it decided to inject cash into the market last week.
- Corporate taxes were due: Corporate taxes were due on Monday, September 16, leading to a large increase in cash to pay the US Treasury. It’s unclear what the exact demand was for cash on September 16, but I would note that corporate taxes make up about $109 billion of all Federal revenues. While that makes up only about 3.3% of all Federal revenues, it’s still a big number, especially when the financial system is running low on cash.
What should you do about it?
Remember that the media has a tendency to sensationalize the news. Resist buying into sensationalized accounts of what happened last week. Focus on the facts. And the facts are that broad asset class diversification, a suitable emergency reserve, and ongoing financial planning are the best defense against future economic challenges.
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1 Bloomberg, September 23, 2019
2 Congressional Budget Office
3 FRED, Federal Reserve Bank of St. Louis
4 Center on Budget and Policy Priorities
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