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Before the U.S. repo market went haywire in mid-September, there were persistent signals for about a year that something was off.
Rates had developed the troublesome habit of jumping at the end of months and quarters — most notably in December 2018 when overnight rates surged above 6% — as banks withdrew cash to meet regulatory requirements while new Treasury securities flooded the market, knocking supply and demand out of balance.
Federal Reserve officials had been downplaying the possibility that these irregularities were foreshadowing a significant liquidity crunch. After all, none of these episodes were as violent as what happened the week of Sept. 16, when the rate on overnight repurchase agreements jumped to 10% from around 2%. Still, they were frequent enough that some experts worried about an eventual blow-up.
There are lingering questions about how quickly central bank policy makers, who meet later this month, will enact new fixes — and what these could be. But Chairman Jerome Powell acknowledged Tuesday that reserves in the banking system got too scarce.
“Was the event of Sept. 16th easy to predict? No,” said Jim Bianco, president of Bianco Research LLC. “But was the market getting less and less liquid, making it more susceptible to events like the 16th? Yes. It’s like using a hammer to hit a pot of boiling water with a lid. Do you know which whack will make it blow up? No, but you know that it will blow up.”
Fed policy makers last met the week of the repo tumult. Minutes from that gathering will come out on Wednesday, and though investors will parse that to see what policy makers thought about the turmoil and the steps the Fed intends to take, Powell probably superseded that Tuesday.
During a speech in Denver, the chairman said the central bank will buy Treasuries to increase reserves, aiming to avoid a repeat of last month’s turmoil. “My colleagues and I will soon announce measures to add to the supply of reserves over time,” he said.
The remarks — coupled with comments last week from John Williams, who runs the New York branch of the central bank that deals closely with markets — show Fed officials may finally be awakening to market participants’ concerns about dwindling liquidity in the banking system.
After rates soared in December, Fed staff concluded their techniques for keeping rates under control were still effective, according to minutes from the January Federal Open Market Committee meeting. A Fed survey of banks published in February suggested there was still a long way to go until reserves reached institutions’ lowest comfortable level, which suggested a sudden drying up of liquidity would not be a significant risk.
By early April, reserves had fallen below $1.5 trillion. Lorie Logan, who currently oversees market operations at the New York Fed, said in a mid-April speech that her team’s “current view is that reserves remain ample and well above the level” the banking system needed, while adding a number of caveats, including one she raised at the FOMC meeting two weeks later.
That’s not to say that the Fed completely ignored the signals. Even before the latest turmoil, the central bank had been forced to make adjustments to its interest on excess reserves rate to maintain control of its benchmark rate — a step it also took in September. By the May 1 FOMC decision, Logan was warning that some banks were operating with reserve balances closer to their lowest comfortable levels. She told policy makers in July that the level of reserves was expected to “decline appreciably” over the coming months.
It has come down, slumping to $1.26 trillion in late September from $1.39 trillion on July 31.
A New York Fed spokesman declined to comment.
But market observers said that the problems started long before then.
In hindsight, “there is increasing confidence that it started late last year,” said Priya Misra, head of rates strategy at TD Securities. “It’s only evident where there’s a repo market dislocation and outsized moves. The Fed was not in this camp.”
For much of the year, Fed officials were in the process of unwinding the asset-buying spree they embarked upon to prop up the economy following the 2008 financial crisis. But shrinking the Fed’s balance sheet, just as other liabilities grew, sucked reserves out of the banking system. That led to cash scarcity just when funding markets needed it the most, heightening the risk that motivated buyers might have to pay up.
The Fed has succeeded in calming down the repo market, using a series of overnight and 14-day term operations — lending cash to primary dealers against Treasuries or other collateral for the first time in a decade — every day since Sept. 17. It will continue the operations through October.
But these actions look like a temporary fix. Wall Street analysts and other experts want long-term solutions from the Fed, like rebuilding reserves through buying hundreds of billions of Treasuries or creating a standing repo facility — a tool that would allow eligible banks to convert Treasuries into reserves on demand at an administered rate.
The Fed will discuss the balance sheet at the Oct. 29-30 meeting, Vice Chairman Richard Clarida said at a forum last week, including the prospect of building a buffer of reserves. But he said that they still needed to decide what “an appropriate buffer” would be. Powell suggested Tuesday that the Fed will purchase Treasury bills, though he didn’t specify how many.
Ahead of mid-September’s turmoil, policy makers didn’t regard periodic spikes in the repo rate since last year as unusual and thought the market was resilient enough to handle those moves, according to a person familiar with their thinking. Even after the tumult, officials thought they had enough tools in place to handle the situation and saw the system of ad-hoc injections as working, said the person, who is not authorized to talk publicly.
Policy makers have avoided creating a standing repo facility because they wanted to engage in as little intervention as possible in the market, the person said.
A standing repo facility isn’t a new idea. In 2014, Brian Sack, former head of the New York Fed’s markets group, and Joseph Gagnon, another ex-Fed official, warned that the central bank needed to immediately switch to a new operational approach, including a standing repo facility.
“A standing repo facility open to banks, broker-dealers and perhaps other financial institutions who hold Treasury collateral would have prevented the mid-September spike in repo rates,” Gagnon said in an email Thursday. That’s because they “could have borrowed from the Fed at only a small premium over the target fed funds rate. They would not pay 5% or more when they could borrow at the facility much closer to 2%.”
Morgan Stanley strategist Matthew Hornbach said the Fed buying billions of dollars of Treasuries is the only solution to permanently alleviate funding stress. That’s because relying on repo operations doesn’t address the issue of declining reserves as the Treasury rebuilds its cash balance.
“Get to the heart of the problem: increase reserves,” TD’s Misra said. “If they were close to having the perfect facility set up, Powell would’ve discussed it. The debate is do they need to build a buffer.”
— With assistance by Matthew Boesler
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