If it's so boring, why has everyone got so agitated about it ?

ref :- "Repo Market's Liquidity Crisis Has Been a Decade in the Making" , Bloomberg Markets, 22/9/19

We've highlighted this Bloomberg article, but frankly, we might have settled on any one of countless pieces in the financial media this weekend on the same theme. It's not as though there was any shortage of issues to focus on after a week that saw attacks on Saudi oil installations and their hugely worrying geopolitical and economic implications, and another 25 basis point cut in the Fed Funds rate which even at the Federal Reserve had dissenters on either side of the argument. Some saw the move as unnecessary and others felt it was not decisive enough. President Trump predictably voiced (well, tweeted) his thoughts on the matter , pouring vitriol on Chairman Powell and the Fed for their supposed timidity and suggesting that a full 1% cut was what the country needed (not to mention his own 2020 presidential campaign).

So why then has the market in Repurchase Agreements -- or Repos -- demanded so much attention ? It's probably worth a definition or two (with a nod of thanks to Investopedia) :

A repurchase agreement (REPO) is a form of short-term borrowing for dealers most commonly in government securities, though they can be used for other markets. A dealer sells government securities to another with an agreement to buy them back at a later date (usually the following day) at a higher price. The difference in price reflects the implied rate of interest. Thus, a repurchase agreement is effectively a collateralised loan. Those who lend securities and receive cash might typically include hedge funds and dealer-brokers who own Treasuries say, but need cash for day-to-day operations. Those lending cash in return might be money-market managers and other asset managers looking for solid but safe returns on their cash.

As opposed to Fed Funds :

The Fed Funds Rate refers to the interest rate that banks charge one another for lending money overnight from their balances at the Federal Reserve. Banks are obliged to maintain a reserve equal to a percentage of their deposits held in the Fed system. Any excess is available to lend to other banks who may have a shortfall on that day.

The repo market plays a key role in providing the liquidity necessary for the smooth functioning of capital markets. Crucial though it is , however, few would describe repos as an exciting corner of the market-place. Normally, when things are running smoothly that is, repo rates only budge a few basis points during the day and in truth most of the action is concluded by about 9.00am NYT with dealers eager to satisfy their daily requirements as soon as possible. As a rule, rates don't vary too far from those of fed funds ..... but not last week.

In the week that saw Wednesday's 25bp rate of fed funds cut , a sudden and severe shortage of lenders saw overnight repo rates spike to above 10% at one point on Tuesday. They even dragged fed funds above the Fed's (then) target range of 2.0 - 2.25%. That's not good for the Fed's credibility, and in particular the Federal Reserve Bank of New York (which handles the Fed's money-market operations) has copped a lot of flak for not spotting the problem quickly enough, for acting too slowly to remedy it by making cheap cash available, and for bringing the credibility of their own new personnel into question by bungling the first attempt to sort out the problem .

They did eventually (in market terms) get it sorted out .... by the use of overnight repos the NY Fed injected $52 bn on Tuesday, and $75 on the final three days of the week. Repo rates fell back to 1.9% and the Fed has committed to more operations over the next three weeks to keep things calm. But this is touchy subject matter -- liquidity drains and spikes in repo rates characterised the period that led to the financial crisis.

Now, there were particular factors that led to last week's cash shortage (and that the NY Fed, one might argue, should have seen coming) : a payment date for corporate taxes, a settlement date for those who had bought up a particularly heavy tranche of new Treasury T-Bill issues, end of quarter manoeuvering by financial institutions. But there are some more fundamental, far-reaching issues causing concern. The unwinding of the Fed's QE programme that bought trillions of dollars of bonds to pump money into the system, by definition drains money out of it again. To quote Bloomberg :

"The problem is that, in reducing the asset side of its ledger, the Fed also has to shrink its liabilities to balance its balance sheet. Those liabilities consist of currency in circulation, which naturally has increased with the economy, and bank reserves, which have fallen".

In itself, that's not necessarily a reason that might cause a lack of cash in the banking system. But since the financial crisis, new regulations (Dodd-Frank, Basel 3) compel banks to set aside much of previously useable reserves to satisfy more stringent requirements. The same legislation also introduced capital constraints that make position-taking in money-markets too costly to be viable. JPMorgan boss Jamie Dimon puts it thus : "Banks (still) have a tremendous amount of liquidity, but also have a tremendous amount of restraints on how they can use that liquidity".

Short-term operations will doubtless keep a lid on things .... in the short-term. Looking further ahead, some see the cure for liquidity drains as a resumption of QE .... the Fed should re-expand its balance sheet to add liquidity permanently back into the system.

Restart QE ? How things change .... and how quickly. But lack of liquidity is like a sword of Damocles hanging over markets, and ultimately therefore over economies. The Fed (amongst others) will have to consider some bold action to avert crises in the future .... and whilst they're at it, they ought to be considering how to act in the present if they want to appear a bit more "market-savvy".

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