Two weeks ago, something weird happened in the lending markets that businesses and banks use to shuffle their spending money around. A sharp increase in repo rates resulted in the Federal Reserve conducting its first major intervention in short term lending markets since the 2008 credit crisis.
So what happened? Reuters had a good explainer at the time which I’ll excerpt below:
Cash available to banks for their short-term funding needs all but dried up earlier this week, and interest rates in U.S. money markets shot up to as high as 10% for some overnight loans, more than four times the Fed’s rate.
That forced the Fed to make an emergency injection of more than $125 billion over the past two days, its first major market intervention since the financial crisis more than a decade ago, to prevent borrowing costs from spiraling even higher. While the effort restored a measure of order to the short-term bank funding market, it was not enough to stop the Fed’s benchmark lending rate from rising on Tuesday above its targeted range of 2.00% to 2.25%.
The exact cause of the squeeze is a matter of some debate, but most market participants agree that two coincidental events on Monday were at least partly to blame. First, corporations had to withdraw funds from money market accounts to pay for quarterly tax bills, and on the same day the banks and investors who bought the $78 billion of U.S. Treasury notes and bonds sold by Uncle Sam last week had to settle up.
On top of that, the reserves that banks park with the Fed and are often made available to other banks on an overnight basis are at their lowest since 2011 thanks to the central bank’s culling of its vast portfolio of bonds over the past few years.
Added together, these factors are testing the limits of the $2.2 trillion repurchase agreement – or repo – market, a gray but essential component of the U.S. financial system.
Reuters: The Fed has a repo problem. What’s that?
What is a repo rate? What’s a money market?
It’s helpful at this point to think about what exactly we mean when we say “money market”. Many people know that a money market fund is kind of a low risk, interest bearing account that you might have some of your savings invested in. But what is a money market fund actually investing your money in?
The most important thing to know about “money markets”, is that big companies don’t have checking or savings accounts. Walmart can’t just walk into Wells Fargo and open up a checkbook with the billion dollars they need to pay bills.
Companies need to get and put money somewhere
So companies need to borrow and lend (invest) money in short-term lending instruments to balance everything out. For example, overnight lending is where you park your daily cash inflows with another company that needs overnight cash to settle their payables due that day. Another way to describe this “parking” operation is to say the first company lent money overnight to the second.
Without getting in the weeds, there are a lot of different ways for these types of overnight borrowing and lending operations to occur between corporations. Short term, secured borrowing, known as repo financing, is one of these ways. These operations are subject to forces of supply and demand balancing just like any other market. So if too many people NEED cash overnight, the overnight interest rate available in the market will increase and it will become more expensive to borrow money.
The Fed tries to keep this market smooth and stable
On top of that, the Federal Reserve tries to stabilize these money markets so that the market interest rate is close to their published target overnight interest rate. If there are a lot more overnight cash borrowers than overnight cash lenders, the Fed might have to inject a large amount of money into the system.
That happened two weeks ago when overnight rates went up to 10% (the Fed’s target was 2.0 – 2.25%) and the Fed had to inject $125 billion in to get rates back down to target. So how big of a deal is that? Depends on who you ask.
New York Fed President John Williams believes it’s mostly OK. He focused on how successful the Fed’s intervention was, and how they were well prepared to intervene to restore liquidity.
But here’s the thing– the combination of quarter-end settling up with the IRS, and settling up a treasury auction with Treasury, happens sometimes. Not all the time, but sometimes. The fact that this time was so disruptive is unusual and therefore concerning. Williams’ comments focused on how well the intervention worked to restore order to the market, but that doesn’t really solve the issue of why the disruption happened to begin with.
And as it happens, the same thing happened again later when there were no quarter-end pressures. Jon Hill, rates strategist at BMO Capital Markets stated in a Bloomberg piece,
“Secured funding markets are clearly not functioning well. Monday’s jump in overnight repo rates, especially since it’s not happening at the end of a quarter, is “bordering on chaos”.
CNBC: The Fed’s fix of the crucial repo lending market for banks will be put to the test on Monday
What’s the right investing move now?
So what should we do? I think the trouble in repo markets, combined with the inverted yield curve for longer maturities, are signs of credit market stress. That’s not good for the economy. I think that we have a higher probability of a recession today than we would in an imaginary universe where everything was exactly the same except money markets were working fine and the yield curve was sloped in the proper direction. But I still don’t think you should change anything in your portfolio.
Stay put, and focus on your long-term future!
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