The US Federal Reserve's surprising and massive stimulus program for the repo market has been a popular financial headline topic since its launch in September last year when the overnight interest rate spiked from an average of 1.5 - 2.5% to almost 10%. The professional pundits behind these headlines will talk about this interest rate anomaly with dreaded curiosity but rarely leave readers satisfied with an understanding of its significance to the laymen. Sure, almost anyone can appreciate the enormity of $500 billion of cheap funding from the Fed but financial literature rarely connects these financial system shenanigans with day-to-day life.
So what the heck is the repo market, why did interest rates spike, and how does an injection of $500 billion into the repo market affect the Average Joe?
To understand this "repo market madness", we first need to understand the repo market and overnight loans. Overnight loans are basically super short term loans (hence "overnight"). Repos, or repurchase agreements, are a type of overnight loan where the borrower gives the lender collateral in exchange for cash. At the end of the agreement, the borrower buys back (i.e. "repurchases") the collateral at a higher price. This difference in price is the interest rate for the loan. Because repo agreements are short term and collateralized with typically safe assets (e.g. US Treasury securities), they have some of the lowest interest rates on the market.
The repo market is huge, with daily volumes often exceeding $1 trillion. Participants include the largest institutions in the financial system. On the borrowers side are usually leveraged market participants like hedge funds and investment banks (e.g. hedge funds like to use the low interest rates of the repo market to make leveraged bets in the broader financial market). On the lenders side are usually risk-adverse institutions such as commercial banks and money market mutual funds seeking secure short-term investments.
Why is the repo market important?
When all is working well, there is a sh*t ton of cheap money (often referred to as "liquidity") available to be lent in the repo market. Liquidity is the primary value that the repo market offers the financial system. The market enables highly capitalised and risk-adverse institutions to quickly and safely put their money to work while riskier market participants (i.e. have more volatile blanace sheets) like hedge funds, investment banks, commerical banks, and large corporations have access to cheap funding which is paramount to smooth operation.
Repo market and the 2008 Global Financial Crisis (GFC)
Interestingly, the repo market was a key channel through which the Global Financial Crisis (GFC) was transmitted. As asset prices fell, lenders required more collateral for loans. Borrowers could no longer borrow at the rate they were before, forcing them to deleverage by selling assets, which contributed to further declining asset prices.
Why did repo interest rates spike?
It's surprising that seemingly nobody has a definitive explanation for this.
The Fed's official explanation is that two events lined up to cause the funding squeeze in the repo market. First, quarterly tax payments for corporations were due on September 16th, pulling more than "$100 billion out of bank and money market accounts". At the same time, the US Treasury minted and sold new Treasury securities that increased its long-term debt by $54 billion. Both of these events allegedly sucked enough liquidity out of the system to cause a shortfall in lendable funds.
However, the "Big Boss Central Bank" aka the Bank for International Settlements (BIS) located all the way in Switzerland published a report that offered a completely different reason for the lack of funding. In direct contradiction to the US Federal Reserve, the BIS writes:
The reasons for this dislocation have been extensively debated; explanations include a due date for US corporate taxes and a large settlement of US Treasury securities. Yet none of these temporary factors can fully explain the exceptional jump in repo rates.
The BIS report claims that the sudden contraction in repo market funding is caused by the reluctance of the "four largest US banks" to lend and an increase in borrowing demand from hedge funds. Since the Fed started unwinding its balance sheet in October 2014, these four unnamed US banks significantly increased their repo market lending activities while smaller banks and money market funds significantly reduced their repo market exposure. The BIS didn't explain why this shift occurred. At the same time, the balance sheets of these four banks started to skew heavily towards US Treasury securities instead of cash reserves.
When the demand for repo market funds increased, allegedly driven by hedge funds, the four banks were hesitant to lend with their low cash reserves. Because they were the largest lenders in the repo market, interest rates had no where to go but up.
How does the Fed's response affect Mr. Average Joe?
When the repo market's interest rate spiked in September, the Fed started intervening in the market by becoming an active lender. This makes sense since the Fed's mandate is to ensure that the Federal Funds Rate (FFR) is within a target range and a spiking repo market rate will indirectly push the FFR above this range. The logical course of action to prevent this is to reduce the repo market rate by making money cheaply available again in the repo market. The Fed has been an active repo market lender for the past few months now and continues to be.
Along the same course of action, the Fed also started buying Treasury securities, which expands its balance sheet, for the first time since October 2014.
This also makes sense, since there is an inverse effect between the size of the Fed's balance sheet and the amount of cash reserves banks have. I'm going to describe this in criminally simple terms, partly because I want to keep this article short and partly because I also don't exactly know why, but the more Treasuries the Fed buys, the less Treasuries the banks buy, and thus the more money banks have in their reserves.
Both these actions have calmed the repo and broader financial markets but you're probably also interested in knowing how they affect Mr. Average Joe. For starters, the financial system didn't seize up and collapse because no one could borrow money cheaply anymore. More pertinently, the billions of dollars in extra money that the Fed injected into the system have quickly been channeled by market participants to the stock market, as is consistent with history. Since September 2019, the S&P 500 has increased by 10% in a matter of 4 months. This market rally happened despite a massive coronavirus epidemic happening in the most industrialized country on this planet that led to the quarantine (with varying degrees) of 10% of the world's population. Hooray for our 401ks and investment portfolios.
As for how long this Fed intervention will last, some say that it'll end by the second quarter of 2020. I feel like this might last until November 4th 2020.