The Repo Market: Do Americans Actually Understand How It Works?
The Repo market is back in the headlines… but did anyone notice on Monday?
This morning, while doing my best to follow the news around Iran and the United States, I had to gloss over MSNBC and CNBC to discover something far more important.
I turned on Bloomberg News, which gave me hot flashbacks to intense finance courses in graduate school. There is a level of discussion on Bloomberg that is almost too difficult to understand at 8 in the morning when you have a toddler.
But the discussion turned to Repo markets.
While Bloomberg analysts and guests didn’t seem too alarmed around recent developments, I became alarmed because ordinary people once again have no idea what is going on in the most important lending markets in our economy.
It’s the element of information inequality that continues to plague societies. Bloomberg analysts were talking about the repo markets like two people in a bar might talk about a baseball game.
The only difference is that everyone in the bar actually understands the rules of baseball.
Repo markets might as well be the moon to the barflies.
And perhaps to a lot of colleagues in the media.
The Fed’s Decision
In a little while, we’re going to receive some insight from the Federal Reserve on interest rates.
It’s not so much the cuts that I’m very concerned about. It’s the statement of Jerome Powell… and Repo markets.
The Federal Reserve cannot be indecisive about the future. The market wants accommodation.
While all the chatter is about the Fed’s benchmark rate, we’ve seen a brand-new curveball on rate decision day.
Over the last two days, the Federal Reserve Bank of New York has stepped in to offer emergency cash injections into the financial system. The reason: Cash that is available to Fed member banks completely dried up on Monday and Tuesday.
It pushed up interest rates for money markets by double-digits in some cases.
This morning, that critical lending rate actually traded above the Fed’s target rate of 2.00% to 2.25%.
The fact that we’re seeing banks experiencing a cash crunch is alarming.
We can blame the fact that companies withdrew money to pay quarterly taxes.
And we can say that last week’s $78 billion bond sale by the U.S. Treasury required the banks to pay.
But we can’t excuse away the fact that the repo market is flashing a big red sign about banking reserves.
The repo market is like water
Repo trades are the repurchasing of bonds by Wall Street companies and banks who have used these securities as collateral to raise cash for lending activities.
These borrowers then buy back the bonds the next day at a nominal interest rate.
Fear – the ultimate tool of market behavior – can fuel spikes in those repo rates if people are afraid of lending.
And when that happens, it sends a whipsaw up the credit cycle of the U.S. economy and can paralyze money flows.
For all the talk about stress tests and liquid reserves, we know that banking reserves aren’t truly reserves at all.
Back when the Fed started raising interest rates in 2015, bank reserves sat at about $2.8 trillion.
When the Fed started cutting down on its balance sheet and raising rates, bank reserves started falling rapidly.
The Fed seems to have recognized a pattern.
So, it’s been holding bonds on its balance sheet and cutting rates again.
It’s not so much about giving the economy a boost with a rate cut – like President Trump seems to imply.
It’s about providing enough accommodation to ensure that reserves remain healthy and that the benchmark rate remains in the target range.
Those reserves are the primary source of funding the repo markets and key credit operations.
If the Fed is unable to control this rate and people are too afraid to lend money again – we have a serious problem on our hands. Only this time, there’s not much that the Fed can do in terms of further cuts or adding assets.
Maybe the real lesson for me today is that I’m alarmed that Bloomberg wasn’t alarmed.
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