It is rarely a good sign when a boring market suddenly becomes interesting and the US repo market is usually among the duller ones. From the number of headlines it has generated in recent months, that is set to change.
Repos are contracts to sell high quality assets (usually Treasuries) at one price, and then buy them back a short time later at a higher one. As such, the difference between the sale and purchase prices represents the cost of short-term, secured borrowing in USD. The repo market is an important source of liquidity for corporates, and hedge funds also make heavy use of it to provide leverage and boost returns. But with the impending discontinuation of Libor, repo rates now have a third role. They are the basis for the calculation of SOFR, the supposedly “risk-free” rate that is set to replace Libor in trillions of dollars’ worth of debt and derivative contracts.
Soaring repo rates
This renewed importance makes it all the more troubling that the repo market is currently showing signs of stress which recall the early days of the last financial crisis. An unexpected liquidity squeeze in September sent overnight rates soaring to more than four times the upper bound of the Federal Reserve’s policy rate. Fears are now growing that a similar – or worse – spike will be seen at the end of the year.
These concerns are valid for a variety of reasons. To start with, 2018 gave us a precedent for a year-end funding squeeze. Repo borrowing is usually in high demand at calendar quarter ends, as banks and corporates hoard cash in order to tidy up their balance sheets for reporting purposes. Last year, this coincided with an unexpectedly high issuance of Treasuries, which sucked cash out of the market and made dealers reluctant to accept even more T-bills as collateral. The result was that overnight rates rose to 6%, and SOFR jumped by 70 basis points over the course of one day.
Unlucky timing also played a key role in September’s spike, with corporation tax bills and another larger Treasury issuance both draining market liquidity. But these alone fail to explain the sheer size of the increase in overnight borrowing costs, to 8% on 16 September and 10% on 17 September. For this, we need to look to longer term, structural factors.
A structural problem
The first culprit is the Fed’s balance sheet, which grew to roughly $4.25 trillion during the various post-crisis quantitative easing (QE) programs. From October 2017 to August 2019, the central bank sold large amounts of Treasuries in an effort to “normalise” this figure. While successful in its main aim – to reduce the size of the balance sheet – this normalisation process pulled cash out of the markets and replaced it with Treasuries. As a result, market participants became more reluctant to lend out cash in return for Treasuries.
At the same time, banks are facing stricter capital and liquidity requirements that restrict their ability to lend cash. Combined with the recent removal of the US debt ceiling, which prompted the Treasury to build up its own cash balance, this makes the market significantly more vulnerable to funding shortages during times of stress.
In September, the New York Federal Reserve eventually stepped in to provide liquidity and calm the market, bringing repo rates back below 2.5%. As with QE, though, this “market maker of last resort” role may prove to be a double-edged sword that is difficult to put down. Under current projections, the Fed is expected to have supported the repo market to the tune of over $11.5 trillion by the end of January. The price of stability has been the effective nationalisation of a large part of the market, with risk once more passing from the private sector to the taxpayer.
As for the upcoming year end, even with the Fed’s intervention, the cost to borrow overnight from 31 December to 1 January has already risen to 3.95%. Based on last year’s experience, many expect this to increase further in the coming weeks. Meanwhile, the impact on SOFR remains to be seen – but during the September squeeze the benchmark shot from 2.43% to 5.25% overnight. SOFR may have many advantages over Libor, but being risk-free isn’t one of them.
For more information, please contact Joshua Roberts, Associate Director at Chatham, at email@example.com.