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.
“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.
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.
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:
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.
Jun 28, 2018
Jul 25, 2018
Oct 24, 2018
Nov 1, 2018
Jan 15, 2018
You are leaving the Mercer Global Advisors website and will be redirected to the Science of Economic Freedom (SOEF) website. SOEF is brought to you by Mercer Advisors Inc., the parent company of Mercer Global Advisors Inc., and is not involved with investment services. Mercer Global Advisors Inc. is an SEC-registered investment adviser headquartered in Denver, CO.
The Science of Economic Freedom website should not be construed by any consumer and/or prospective client as Mercer Advisors’ solicitation to effect, or attempt to effect, transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet. Furthermore, information on the SOEF website should not be construed, in any manner whatsoever, as the receipt of, or a substitute for, personalized individual advice from Mercer Advisors.