The interest rate charged for repurchase agreements, or “repos”, spiked briefly on Monday, surging to as high as 8.5% by some measures. As one of the most significant U.S. borrowing mechanisms (whereby short-term liquidity needs are met by debt securities lending) and a particular pain point during the Global Financial Crisis, this sharp increase has forced investors to consider two issues: first, if a rapidly rising repo rate portends things to come; and second, if the Federal Reserve has lost control of short-term interest rates.
This particular spike in the repo rate seems to be tied to three distinct coincidental events:
- Roughly $300 billion in gross Treasury supply was auctioned across the curve last week and settled recently.
- Corporations have withdrawn cash from banks and money-market funds to make quarterly tax payments over the weekend.
- Banks are targeting higher capital levels in the lead up to quarter-end to satisfy reporting requirements.
Beyond this, structural forces have encouraged the repo rate to spike – indeed, numerous times since the financial crisis. Most notably, concentrated ownership of reserve capital among the country’s largest commercial banks has created an illusion of liquidity. In some instances, therefore, large short-term liquidity needs from small or mid-sized banks can have outsized effects on the borrowing rate. It is possible that this factor contributed to Monday’s spike, as well. In short, the trauma may not be as acute as initially thought.
This most recent spike in the repo rate has almost certainly impaired the Fed’s credibility – the spread between the federal funds rate (FFR) and the repo rate should never have ballooned to such an extent, the argument goes. But despite a potentially besmirched reputation, the worries around Fed control of interest rates are likely overblown.
Controlling the repo rate is, at least in theory, well within the Fed’s ability. The Interest on Excess Reserves (IOER) rate, which is the interest rate paid on balances that exceed reserve requirements, can influence liquidity levels by encouraging, or discouraging, lending activity. In an effort to force the IOER rate lower, the Fed started targeting it separately from the FFR earlier this year. Any future cuts to the FFR will therefore likely be accompanied by greater cuts to the IOER rate, which evidently is too high.
In addition, sustained open market operations are likely to resume. On Tuesday, the New York Fed (the bank responsible for conduction open market operations) completed a 15 minute, $53 billion reverse repurchase operation of outstanding Treasuries, simultaneously injecting financial markets with emergency liquidity and removing extra collateral. By this measure, it seems increasingly likely that the Fed will restart quantitative easing in some form to continue to provide markets with liquidity.
As it stands, Monday’s spike in the repo rate, while shocking, is not extraordinarily worrisome, given both the context surrounding its timing and the availability of potential remedies. Should wide spreads be sustained, it may be time to start worrying; but for now, don’t fear the repo.
Daily change in the Secured Overnight Financing Rate (SOFR)*
Change in 99th percentile level of daily trading range, 12/31/2018 - 9/16/19, %
Source: New York Fed, J.P. Morgan Asset Management.
*SOFR provides a broad measure of the general cost of financing Treasury securities overnight, and is calculated based on Treasury GC repo transactions, plus transactions cleared through the Fixed Income Clearing Corporation's (FICC) Delivery-versus-Payment (DVP) repo service. Data are as of September 16, 2019.