The Fed’s Repo ‘Hiccup’ and Other Reasons Not to Panic
The Federal Reserve, as expected, cut interest rates by another quarter of a percentage point last month. But the bigger news was a surge in repo rates due to an unexpected shortage of reserves. Interest rates in the short-term funding market for overnight repurchase agreements spiked as high as 10% from around 2.25% last month, a phenomenon not seen since the worst days of the 2008 financial crisis.
The New York Fed responded with some of its first open-market operations since 2008, injecting money into the repo market to push down the spiking short-term rates. So far, that intervention has been effective and the Fed has committed to further intervention to keep repo rates from spiking.
This event, anomalous as it may be, shows that there are still kinks and risks in the Fed’s agenda of maintaining a multitrillion-dollar balance sheet more than a decade after the 2008 global financial crisis.
Before the surge in repo-market rates, the Federal Reserve’s framework for managing its balance sheet (which is done by the New York Fed’s markets group) was thought to be sound. But as the Fed sought to tighten monetary policy, the Fed’s post-crisis balance sheet required reverse repos and paying interest on excess reverses to manage the increase in short-term rates (similar to traditional price controls but for the money market). Meanwhile, traditional Fed repos were thought to be of relatively little use in managing interest rates.
But, as is often the case, a series of unforeseen events shattered conventional wisdom. These included a sizable amount of corporate tax payments due (requiring companies to issue debt) and the growing size of Treasury debt being increasingly issued in short-term Treasury bills, which have caused a massive supply and demand imbalance in short-term funding markets.
The old Fed repo facility offering short-term funding was unexpectedly oversubscribed, forcing some financial market participants to look elsewhere in a scramble to quickly find overnight funding. This caught many off-guard and allowed private market lenders to charge much higher overnight interest rates. The Fed has now realized that it can no longer be on autopilot with its current balance-sheet framework and will have to do some tinkering.
One of the worst events of the recent repo crisis was a spike from 2% to 5.25% in the secured overnight funding rate (SOFR), the Fed’s prized new benchmark short-term interest rate meant to replace the London Interbank Offered Rate, or LIBOR, a survey-based rate that trillions of loans around the world are linked to and was manipulated for a long time by many Wall Street banks to disguise their true borrowing costs.
Meanwhile, the Fed is winding down its balance sheet from its peak of $4.2 trillion with its “quantitative tightening” that began in October 2017 and was set to end in September 2019 leaving the Fed’s balance-sheet size at $3.8 trillion.
This means that a large Fed balance sheet will continue to be a permanent fixture for the foreseeable future and that short-term hiccups like those seen in repo markets could occur more regularly unless the Fed were to expand some parts of its balance sheet to replenish the system with new reserves. The Fed now plans to backtrack and expand its balance sheet slightly by buying Treasury bills in a move that will also increase the reserves in the system (a liability of the Federal Reserve used to pay for the Treasury bill purchases).
While the Fed will have to rethink its balance-sheet management tools to avoid events like this, the good news is that our financial system is much safer now than in the pre-crisis world. Mutual-fund reforms implemented in 2016 requiring prime money-market funds to post “variable net asset values” rather than “constant net asset values,” allows investors to see the true value of their investments.
This is an important reform that often goes overlooked. The concept of “breaking the buck,” that is when a fund’s net asset value falls below zero, used to cause widespread panic in financial markets and triggered a run on money-market mutual funds in 2008. Unfortunately some mutual fund companies have recently tried to repeal such reform and are still trying to disguise their prime money funds (which include defaultable commercial paper) as “risk free.”
“Breaking the buck” is one concern investors have less to fear as the yields of commercial paper (short-term bonds) of companies like Evergy Inc., a holding company for several utilities in Kansas and Missouri, doubled in the past few weeks during the repo crisis not unlike Lehman short-term interest rates in 2008. Fluctuations in prime money-market mutual fund NAVs did not cause investors to redeem in mass in part because of money market mutual fund reform.
In addition, banks are much more adequately capitalized, meaning they take on much less leverage than in 2008 in part thanks to Basel III capital requirements. While Dodd-Frank was very poorly written with many unnecessary features—including the Volcker rule, which acts to reduce market liquidity—capital requirements were a good step forward when it comes to promoting financial stability. Thanks to these post-2008 reforms, we can be confident that a small-blip in overnight funding markets will not become a full-blown panic and that the Fed will act prudently to add more reserves in the system to meet demand.
Jon Hartley is a Master's in Public Policy candidate at the Harvard Kennedy School.
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