(Bloomberg Opinion) — The repo market madness lives on for a ninth day.
The Federal Reserve Bank of New York announced Wednesday that it would increase the size of its next overnight system repurchase agreement operation to a $100 billion maximum, from $75 billion previously, and also raise the limit on its 14-day term repo operation to $60 billion from $30 billion. Simply put, the bank wants to flood the funding market with enough cash to soak up all the securities that dealers submit(1)and leave no doubt that the critical financial-system plumbing is in fine working order ahead of the end of the quarter.
By now, just about everyone has heard the explanations for this persistent liquidity squeeze, which has lasted long enough to refute the earlier notion that it was merely a one-day confluence of unfortunate events. To some, the main structural issue is that banking regulations are disrupting the financial system’s inner workings. Others say the Fed has simply found the lower bound for reserves necessary to control short-term rates and can move forward accordingly.
In addition to those two assessments, I’d offer another angle that’s largely flown under the radar: The chaos in repo markets was a long time coming given the widening U.S. budget deficits and the lenders that are financing that shortfall.
Deficits, while nothing new, add up over time. And while they declined each year from 2011 through 2015, both overall and as a percentage of gross domestic product, the gap has widened again under President Donald Trump. Put it all together, and the amount of U.S. Treasury securities outstanding has roughly tripled since the financial crisis:
This growth was mostly under control in the years after the financial crisis because the Fed had been buying up large chunks of the Treasury market through its quantitative easing programs. But it was gradually reducing the size of its balance sheet from late 2017 until July, precisely at the same time that the Treasury Department was increasing the size of its monthly auctions to finance the bigger budget shortfalls. All told, the Fed now holds about $2.1 trillion of Treasuries, down from almost $2.5 trillion previously:
(Bloomberg Opinion) — The recent unrest in money markets, which briefly caused short-term interest rates to get out of the Federal Reserve’s control, won’t undermine the central bank’s ability to achieve its longer-term economic goals. That said, it does signal that something’s very wrong with the financial system.
To understand what’s going on, let’s return to a simple model. Suppose there’s only one big bank. It has a choice of what to do with most of its assets: It can keep them on deposit at the Fed, earning the interest rate that the central bank pays on excess reserves; or it can take more risk and earn more return by investing in securities or loans. In this world, all the assets earn the same “risk-adjusted” return, which the Fed effectively determines by setting the interest rates on excess reserves.
Now let’s take a step closer to reality. There are two groups of banks, “tight” ones that hold few excess reserves, and “flush” ones that hold a lot. Flush banks can lend reserves to tight banks in the federal funds market, a focal point of the Fed’s monetary policy. As long as this lending happens freely, all assets will still have the same risk-adjusted return, and the one-bank model will still be a good indicator of how the many-bank world will respond to the Fed’s policies and to various shocks.
In recent days, though, that crucial free-lending condition hasn’t held. On the contrary, a convergence of events — a deadline on corporate-tax payments and the settlement of a big Treasury auction — created a sudden and severe shortage of reserves. As a result, interest rates diverged sharply in markets where they should be the same. In the repo market, where participants borrow and lend against the collateral of Treasuries and other securities, they shot up above 5%. And in the federal funds market, they breached the upper bound of the Fed’s 2%-to-2.25% target range.
The deeper issue is that, since the 2008 crisis, regulatory reforms — such as requirements that banks hold a certain amount of liquid assets, and maintain a minimum leverage ratio (equity capital as a percent of total assets) — have constrained the ability of flush banks to lend, and of tight banks to borrow. Such constraints interact in complicated ways with financial market conditions. For example, European banks must report their leverage ratios as of the last day of each quarter, so they reduce their repo activity to make those ratios look better. As a result, even when excess reserves seem abundant, funding costs for banks may exceed the interest rate that the Fed controls.
This isn’t necessarily a problem for the Fed’s monetary policy, because the central bank can inject cash into various markets to bring interest rates into line. That’s precisely what the Fed has been doing in the repo market. And it can make the fix more permanent by creating what’s called a standing repo facility, which means the Fed will inject sufficient funds every day, as needed, to ensure that the federal funds rate stays in what it deems the appropriate range.
The trouble in the financial system’s plumbing might be due to trouble in the shadow banking sector, says economist Joe LaVorgna.
The Federal Reserve Bank of New York added $110 billion of cash to the financial system Thursday, the eighth consecutive business day of Fed support for the market for overnight repurchase agreements, or repos.
The N.Y. Fed added $50.1 billion of overnight cash, swapping dollars for $34.55 billion of Treasuries and $15.55 billion of mortgage-backed securities. That was half of the $100 billion of securities the Fed said it would accept.
The Fed also offered two-week repos on Thursday. In these operations, the Fed provides cash in exchange for securities and holds them for two-weeks. The Fed said it accepted $37.55 billion of Treasuries but received requests to take $43 billion. It took $24.25 billion of mortgage-backed securities with bids for $29.25 billion.
The Fed’s repo operations are highly unusual. The Fed launched them after short-term repo rates spiked to nearly 10 percent last week as financial firms sought short-term funding. Stress–and Fed intervention–is expected to continue through the end of the year although the current Fed program officially expires on October 10.