Fed Still Running Repo Operations; Will They Ever End?
Sometimes it’s a lot easier to sit down at the table than it is to fold your hand and leave.
Nearly four months after it started, the Federal Reserve continues to run overnight repo operations and it’s unclear when the central bank will actually end these “emergency” measures.
The Fed stepped into the repo markets last September to “unplug” the financial system’s “plumbing” with an injection of cash. It was the first such move since the financial crisis a decade ago. The move stabilized the markets, but months later, it doesn’t appear the Fed has a viable exit strategy.
Repurchase operations are an important aspect of the banking system. The repo market enables banks to borrow cash in order to maintain liquidity and meet daily needs. In a repo trade, banks and other firms use Treasurys and other “high quality” securities as collateral for short-term loans. The bank then repurchases the bonds paying a nominal rate of interest – usually within 24 hours.
Interest rates on repo deals typically hover in the same ballpark as the Federal Reserve’s benchmark rate. But when investors become wary of lending for whatever reason, or if cash reserves fall, that interest rate can skyrocket. This is what happened in September. Available cash essentially evaporated and repo rates surged to over 10%. This prompted the Fed to step in and conduct repo operations in order to inject cash into the system.
Peter Schiff succinctly explained what happened in a pair of tweets.
The financial media and Wall Street are downplaying the significance of the NY Fed’s emergency injection of 53B into the banking system to prevent interest rates from rising. The Fed can’t suppress rates forever, and the longer it does, the greater the crisis when it gives up! … Market forces were pushing interest rates up to attract funds. The Fed intervened by creating money out of thin air to artificially suppress them.”
There were two coincidental events analysts blamed for the repo market meltdown at the time. Corporations had just withdrawn funds from their bank accounts to pay quarterly tax bills, and on the same day, investors who had bought some $78 billion in US Treasury bonds at a recent auction had to settle up, requiring more big cash withdrawals.
But if the problem in the repo market was simply a function of a short-term cash shortage for banks, why is the Fed still running repo operations today?
Because the repo fiasco in September was a sign of underlying systemic problems in the financial markets.
In a nutshell, cash reserves that banks park with the Fed and are often made available to other banks on an overnight basis hit their lowest since 2011. This was the result of the Fed’s balance sheet reduction. In other words, the problems in the repo markets last September were tremors caused by the Federal Reserve’s quantitative tightening.
In the wake of the 2008 crash, the Fed bought more than $3.5 trillion in bonds and banks built up massive cash reserves at the Fed. That level peaked at around $2.8 trillion and began to drop in 2015 when the Fed started raising interest rates. The decline in reserves accelerated when the central bank began its balance sheet reduction operation. According to Reuters at the time of the repo market meltdown, “bank reserves at the Fed last stood at $1.47 trillion, the lowest level since 2011 and nearly 50% below their peak from five years ago.”
Repo operations can’t fix a central bank reserve shortage. That requires quantitative easing. At the time, Jeffrey Gundlach said the repo operations could be a prelude to the next round of quantitative easing. Sure enough, it was. Less than a month after the repo fiasco, the Fed announced a massive bond-buying program. It refuses to call it quantitative easing, but that’s exactly what it is.
The central bank is still running repo-operations and it doesn’t seem to have any kind of workable exit strategy. In just three months, the Fed has become a dominant player in the repo market. It can’t simply just get up and walk away from the table. The Fed’s intervention altered market dynamics. As Reuters noted, “allowing dealers to borrow cash at a cheaper rate than is available from other market participants, which discourages firms from borrowing in the private market they used before the Fed began to intervene.
As an interest rate strategist at TD Securities told Reuters, “The repo operations are a band-aid, but the wound isn’t healed fully.”
According to the Reuters report, the Fed will continue injecting tens of billions a day into the repo market through at least the end of January. Head of US rates strategy at Bank of America Merrill Lynch Mark Cabana said, “It seems implausible to me that the Fed will be able to stop their repo operations by the end of January.”
Minutes from the December Federal Open Market Committee indicate that the central bank would like to begin tapering its repo operations in mid-January, but said it may have to stay in the repo game until at least April.
If I were a betting man, I would put money on the Fed still running repo operations in May. Like so many “emergency measures,” Fed repo operations could become permanent. I’m not alone in thinking so. According to Reuters:
Some financial firms are urging the Fed to stay involved permanently through a standing repo facility, which would allow firms to trade Treasury holdings for cash. But Fed officials are still working out the details and plan to keep discussing the issue at future meetings, the minutes from Friday showed.”
As Milton Friedman said, there is nothing as permanent as a temporary government program. The same can be said of central bank programs.