Concerns remain as latest repo operation brings in $50B
New questions about the short-term market arose as the latest repurchase agreement operation (repo) from the Federal Reserve Bank of New York intervened in the market Wednesday, accepting $49.854 billion in bids from primary dealers.
The Fed has been trying to rein in volatility in the market and keep the fed funds rate within its target range. This intervention was larger than the $35 billion one on Tuesday.
The troubles in the market began in September, with the rate on overnight repurchase agreements soaring to around 10% from 2%. The Fed responded by injecting liquidity into the markets and later started buying Treasury bills to increase the reserves in the system.
“The Fed has been proactive executing massive repos both on an overnight and term basis,” said Peter Nowicki, senior vice president futures sales at Wedbush Securities. “The repo stop out levels (lowest lending rate) have been around 1.80% (equal to IOER) and repo has been sub 2% recently. With month end approaching, there is some concern that rates could spike somewhat but I expect the Fed to be as aggressive as they can, given the markets, press and now politicians paying attention to this issue.”
Sen. Elizabeth Warren, in a letter Friday to Treasury Secretary Steven Mnuchin, expressed concern “that big banks are using short-term lending market volatility to pressure regulators to weaken” financial rules, and asked him to explain why intervention in the market was needed.
JPMorgan researchers have identified “structural issues ... that continue to be potential for concern," Nowicki said, "but I expect the Fed to address them with massive liquidity.”
Michael DePalma, portfolio manager of the High Yield ETF, said in a Bond Buyer podcast last week that he expects the trouble to linger, although he saw some stabilization. He suggested the Fed might have known the issues in advance, but “prepared poorly” and “dropped the ball.”
While the Fed has moved to stabilize the market, “the fact that the Fed was initially blindsided by the liquidity breakdown is still concerning,” said Dec Mullarkey, managing director, investment strategy at SLC Management. “What appears to have been overlooked is that while the aggregate reserves in the system seemed fine, the distribution across banks was not uniform.”
Capital rules imposed after the financial crisis have made big banks “stingy” about parting with liquidity. “It appears the Fed didn’t calibrated this shift correctly. However, they did act swiftly when markets misfired as traditional buyers and sellers weren’t restoring order,” Mullarkey said.
“The key takeaway is that the Fed will need to be very alert to potential market disconnects,” Mullarkey said. “Their involvement over the last decade has been a major driver of markets. As it normalizes its role there is a lot of room for unintended consequences as it is such a dominant market agent right now.”
“The Fed is still supplying an incredible $200 billion of short term financing to repo markets,” said Bryce Doty, senior portfolio manager at Sit Fixed Income Advisors LLC. “The Fed plans on printing money in order to buy nearly $50 billion in T-Bills a month in a misguided attempt to end the emergency injections of cash.”
Since the Fed pays 1.8% on excess reserves, more than T-bills yield and nearly as much as what is earned on a 10-year Treasury, “banks have little reason to use this cash to take a potential risk of default in the repo market when they are getting such a sweet deal from the Fed,” Doty said.
And as the Fed buys more T-bills, yields will slide, making the 1.8% rate “look just that much better,” he said.
“The Fed simply needs to stop paying such an attractive rate on 100% of banks’ excess reserves,” Doty said. “Limiting the amount of excess reserves that can receive interest instantly unleashes liquidity currently locked up at the Fed as banks seek to earn something on the portion of their cash no longer earning 1.8%.”
While a “Band-Aid solution of conducting repo operations will keep rates where the Fed wants them to be,” Edward Moya, senior market analyst, New York at OANDA, said he expects the Fed to “offer a more permanent solution in the coming meetings.
“Expectations are growing for the Fed to create a standing repo facility, which ultimately would provide a ceiling on rates and deliver certainty that cash is available," Moya said. "The Fed needs to act soon as the temporary solutions will eventually provide further strain on the system and we could see funding issue fears return. With year end upon us, corporate tax payments will likely see this corner of the market tested again.”