- The Fed will extend repo operations to relieve funding pressure.
- The Fed plans to buy Treasury bills through at least the second quarter of 2020.
- We believe the repo market will continue to stabilize.
In recent weeks, the Federal Reserve has provided billions of dollars of liquidity for participants in the market for repurchase agreements, or repos, to stabilize interest rates following a spike in mid-September. We believe pressures in this market materialized due to a significant supply and demand imbalance in bank reserves. Our view is the Fed’s intervention will help bring more stability to the overnight funding markets over the long term.
Here is a look at what happened on Wall Street and its implications for investors.
“Our view is the Fed’s intervention will help bring more stability to the overnight funding markets over the long term.”
An overview of recent events
A repo is a short-term loan that is collateralized by high-quality securities such as Treasuries and agency bonds. The maturity of the loans is typically overnight. The primary participants in the short-term funding markets include banks, money-market mutual funds, and hedge funds. The basic mechanics of an overnight repo transaction are as follows:
- The borrower receives cash and pledges collateral (Treasuries or agency securities) in exchange for the cash.
- At maturity, the lender receives interest and returns the pledged collateral to the borrower.
In mid-September, there was an unexpected shortage of cash in the financial system, and with so much demand for cash, overnight borrowing rates in the repo market surged to as high as 10% from an average of about 2.2%. Repo rates are normally aligned closely to the Fed’s policy rate, which is currently between 1.75% to 2.00%.
The spike in the repo rate was partly due to a larger supply of Treasuries. The U.S. Treasury Department renewed its issuance of notes and bonds at record levels following a decision by Congress to suspend the debt ceiling until 2021. Primary dealers, including many large banks, are required to participate in Treasury bond and bill auctions, and typically use the repo market to finance their purchases.
In mid-September, large Treasury issuance coincided with corporate tax payments, with both acting as a drain on bank reserves. In other words, Treasury issuance and corporate tax payments removed cash from the system that would otherwise have been a source of lending in the overnight repo markets. Corporate tax payments also drove outflows from money market funds, which act as lenders of cash in the repo markets. As a result, those who were looking to finance their Treasury purchases using repos (particularly primary dealers) had to pay significantly higher rates than normal due to a lack of market demand (lower reserves/less cash in the system) for repos.
Fed intervenes to provide liquidity
The Fed — mostly through the Federal Reserve Bank of New York (aka the N.Y. Fed) — began conducting “open market operations” in mid-September following the disruption in the availability of cash in the financial system. In exchange for the cash, borrowers offer collateral that includes Treasuries, agency debt, and agency mortgage-backed securities. Since then, the Fed has continued to intervene by using open market operations on both an overnight and term basis to provide liquidity and stability to the repo market. Fed chair Jerome Powell said the central bank is committed to keeping financial markets functioning normally.
In early October, the N.Y. Fed said it will continue to offer overnight open market operations (OMOs) for an aggregate amount of at least $75 billion each day through November 4. The central bank also extended their repo facility with a two-week maturity, offering at least $35–$45 billion through November 12.
Then, on October 11, the Fed said it will continue its overnight funding operations at least through January 2020. The Fed also announced it will purchase Treasury bills at an “initial” pace of about $60 billion from mid-October to mid-November. These purchases will continue until at least the second quarter of 2020 to “mitigate the risk of money market pressures that could adversely affect policy implementation.”
Although the move will expand the Fed’s balance sheet, the central bank does not view it as monetary stimulus or akin to its quantitative easing (QE) program. One key difference, for example, is that buying short-term debt provides less economic stimulus than purchases of long-term debt under the QE program several years ago.
Overall, more proactive moves from the Fed highlight the central bank’s willingness to stabilize the overnight lending markets. As result of these interventions, repo rates have stabilized to more normal levels.
What comes next?
Shortly after the spike in repo rates, our initial view was that the events may be a catalyst for one of the following:
- A continuation of the Fed’s open market operations over the short term.
- A standing Fed repo facility that allows banks to access cash when there is less liquidity.
- A “soft” QE program. The Fed will purchase Treasuries, in turn raising reserves, to relieve potential stresses in the short-term funding markets. But Powell has said the Treasury bill purchases — though aimed at expanding the Fed’s balance sheet and bank reserves — should not be confused with the QE during and after the global financial crisis.
As mentioned above, the Fed has acted on both the first and third options by extending open market operations and purchasing Treasury bills. However, we have yet to see any material progress by the Fed in terms of a plan for a standing repo facility. We will be looking toward the upcoming October FOMC meeting for more guidance on this option.
We are also mindful that other seasonal and structural factors can create imbalances in the short-term markets. For example, the weeks leading up to bank regulatory reporting dates, particularly at year-end, typically coincide with decreased liquidity and funding pressures. While we expect the Fed to remain proactive in its efforts to promote stability, we believe it’s prudent to actively position portfolios ahead of these pressure points.
Implications for other markets
Finally, we believe that volatility in the repo market was predominantly isolated to overnight repos and to very short-dated commercial paper (with maturities of up to one week). It did not spill over to other markets that are widely used in ultra-short bond portfolios. These markets include longer-dated commercial paper, investment-grade corporate bonds, and high-quality mortgage-backed and asset-backed securities.
About the authors
Members of Putnam’s Short-Term Liquid Markets Team and Global Investment Strategies Group contributed to this article:
Joanne Driscoll, CFA, Portfolio Manager
Michael J. Lima, CFA, Portfolio Manager
Timothy Lyons, Trader
Kevin Calabro, Investment Director