Repo Market Rate Spikes, Bank Regulation and the QE Misnomer
Recent stress in repo markets reflect the confluence of a shrunken Fed balance sheet amid steady economic growth and increasing capital and liquidity regulations on banks.
The recent turmoil in U.S. short-term funding markets will likely continue until the U.S. Federal Reserve either establishes a so-called “standing facility” to quickly inject liquidity into the money market or, better still, lets its balance sheet expand again, though don’t call it quantitative easing.
In mid-September, overnight repurchase (repo) market rates, which are typically secured with the safest forms of capital such as U.S. Treasuries, shot to as high as 10%, and caused the Federal funds effective rate to blow through the top end of its target range. The spikes compelled the Fed to conduct repos for the first time in a decade, took many market participants by surprise, and, for a rather esoteric corner of the market, briefly dominated financial media headlines.
U.S. Federal Reserve Chairman Jerome Powell downplayed the sudden scramble for cash, suggesting it was a technical snafu. That was a fair assessment as far as it went. “The immediate cause seemed to be an abnormally large U.S. Treasury settlement coinciding with a quarterly tax payment day, with U.S. firms and, to a lesser extent, individuals pulling cash from money market funds,” says Thornburg Portfolio Manager Lon Erickson. “That supply/demand mismatch caused rates to spike.”
But as Erickson and Thornburg Portfolio Specialist Danan Kirby explained in this video, the Fed’s intervention was “a bit of a Band-Aid on a bigger wound.” While some may have worried that a large financial institution was in trouble, that wasn’t the cause of the dislocation in the roughly $4 trillion repo and reverse repo markets, where banks turn to manage short-term fluctuations in cash balances. The Fed’s liquidity injections clearly helped bring rates back into the targeted ranges. But loose language to suggest that its interventions were akin to “QE-lite” are off the mark. Quantitative easing (QE) aimed at stimulating economic growth is different from supporting the economy through appropriate monetary aggregates, though both expand the central bank’s balance sheet.
Fixing the Plumbing in Clogged Short-term Markets
A decade ago, “QE had a very specific purpose: bring down rates in the front end of the curve and later on at the long end of the curve,” Erickson notes. “It was trying to grease the wheels and get money moving again in an economy that had stalled.” Rather than addressing a major credit crisis, the Fed’s repo market interventions were simply an effort to “fix the plumbing” in short-term money markets to get liquidity flowing again. However, the fact that banks didn’t step in to arbitrage the spike in rates against risk-free paper, preferring instead to hang on to their cash reserves, does indicate strains in those markets and potentially more turmoil to come absent new Fed measures.
Why didn’t banks with “excess reserves,” on which the Fed currently pays a paltry 1.8%, lend them out? A confluence of factors is likely at play. Since the Global Financial Crisis, liquidity coverage and capital requirements have been beefed up to such an extent that the aggregate $1.3 trillion in banks’ excess reserves parked at the Fed may seem high historically. But the banks themselves may consider them “encumbered” to comply with expanding capital rules. From the 2010 Dodd-Frank Law to the Basel Committee capital adequacy reforms, the third round of which banks are now slowly girding to integrate, may in practice mean that excess reserves aren’t seen as excess anymore, despite their categorization as such.
When the Fed was engaging in QE and expanding its balance sheet, rising capital and liquidity regulations weren’t evidently problematic. But in late 2017, the Fed started to contract its balance sheet from roughly $4.3 trillion to around $3.6 trillion by the middle of last month. That, in effect, drained cash reserves out of the banking system: excess reserves have fallen to the $1.3 trillion currently from around $2.2 trillion two years ago. All the while, the economy has continued to grow at an annual pace of just more than 2% on average since late 2010.
Fed Should Go Organic with its Balance Sheet
Source: FRED Economic Data, St. Louis Fed
While Powell has called reserves “ample,” he, Vice Chairman Richard Clarida and New York Fed President John Williams have all recently suggested that the Fed will examine its balance sheet at its October 30 monetary policy meeting, at which the Federal Open Markets Committee is widely expected to cut its benchmark rate another quarter point to 1.75% at the upper bound. At the last policy meeting on September 18, Powell said FOMC members will assess “when it will be appropriate to resume the organic growth of our balance sheet.”
For perspective, from 1994 to 2007, the Fed’s balance sheet grew a cumulative 103% to roughly $850 billion.
While a standing repo facility can help in times of stress, estimates of near-term Treasury purchases by the Fed needed to ensure that cash reserves are indeed ample run from $250 billion to $500 billion. But those are guesses. The easier, longer-term solution, Erickson says, is for the Fed to allow its balance sheet to grow with the economy. “The economy grows over time. Currency in circulation grows over time,” he points out. “The Fed needs to allow its balance sheet to support that growth by growing at a natural rate, which isn’t the same thing as QE.”
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