What the lack of yearend volatility in short-term credit markets tells you about recent repo fears.
In markets, widely watched and well-known events routinely underwhelm. On this final day of 2019, the repurchase agreement (repo) market taught this lesson once again … by doing next to nothing noteworthy. That likely comes as a surprise to many pundits who have been obsessing over short-term interest rates for months. But to us, it is the highly predictable outcome of the Fed returning to what it routinely did for decades before its wrongheaded quantitative easing (QE).
This story starts back in September, when repo rates—which typically hover right around the middle of the fed-funds target range—surged. The repo market is where banks lend excess reserves to one another against high-quality collateral, like short-term Treasurys. As we wrote in our September ‘splainer, banks’ reserves occasionally dip below regulatory minimums for short periods of time. (This is normal!) When they do so, banks typically seek to borrow from one another or big investors, like money market funds.
A spike in repo rates indicates either tight supply of reserves on offer, high demand for reserves or both. It could be an indicator all isn’t well in the banking system—banks may not want to lend reserves for fear of a crisis or that the counterparty won’t be able to repay. But could doesn’t mean is. It could also be the confluence of several benign factors, which we argued was the case in September. It seemed to us the combination of the lasting impact of regulation requiring big banks to carry more liquidity combined with a Japanese holiday, US corporate tax payments and a big US Treasury bond auction to suck excess reserves out of the repo market temporarily. The rate spike reversed fast after the Fed stepped in to serve as counterparty and offer more reserves.
The Fed’s move started its own narrative flow, of course, with many pundits presuming it showed the market needed unusual and extraordinary help. Pundits tally the scope of Fed interventions daily; others wonder what the “lasting solution” is. This narrative overlooks the fact the Fed routinely intervened in the repo market before 2008. It didn’t need a lasting solution. It was the lasting solution. It stopped doing so thereafter, as the Fed’s creation of reserves to buy long-term bonds under QE flooded markets with excess reserves. Intervention wasn’t necessary as a result. Fed head Jerome Powell said this meant the central bank could take a more passive approach to repo intervention.
But as the banking system grew in recent years—and the Fed began gradually unwinding QE—the flood of reserves receded. Hence, the Fed was forced to return to its pre-crisis norm, intervening in the repo market even though it said it didn’t want to.
Anyway, the Fed’s interventions since September had many fretting whether it would be sufficient to hold down repo rate volatility at yearend. Historically, quarter end has often seen repo rates lurch some, as corporations and banks close their books. That, plus the holiday season, had many fearing a September redux the Fed couldn’t control. But in the end, here is what happened:
While the rate on overnight general collateral repo first traded at 1.88%/1.85% on the final day of 2019, it subsequently slipped back to 1.65%/1.45%, based on ICAP pricing. That’s within the target range of 1.50% to 1.75% that the Federal Reserve has in place for the effective fed funds rate, the policy target benchmark. The final overnight operation of 2019, meanwhile, was undersubscribed.[i]
See? A snoozefest. Now lots of folks are pushing out the goalposts, presuming it is actually January or March or whatever future month you want to pick that poses problems. But the reality is that the Fed can intervene indefinitely if it wants to. Or it could create a permanent facility to do so going forward, which really wouldn’t be that novel, because again, they did this for eons before 2008.
September’s spike happened because the Fed was late—caught flat-footed. This time, with pundits widely expecting and publicly discussing yearend turmoil, it wasn’t. That shows you the issue this fall was the Fed was out of practice—not that the repo market was out of options.
[i] “Fed Wins Year-End Repo Battle, But War to Control Rates Drags On,” Alexandra Harris, Bloomberg, 12/31/2019. https://www.bloomberg.com/news/articles/2019-12-30/fed-wins-year-end-repo-battle-but-war-to-control-rates-drags-on
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