Special Notice 26

BELOW-MARKET INTEREST RATES DISRUPT THE REPO MARKET


By William J. Dodwell  January 14, 2020

Much has been written about anomalies in the repo market since a sharp spike in the rate last September.  Repos (repurchase agreements) are instruments by which financial institutions lend or borrow cash (up to 180 days) to/from one another in exchange for Treasury securities collateral.  Indeed, repos are a $5 trillion market that is crucial for funding bank trading and investment activities. 

Inter-bank cash shortages and Fed intervention

But banks also rely on this facility to shore up brief cash shortfalls created by a raft of withdrawals from the financial system.  They include large scale collective payments, such as corporate taxes and Treasury auction settlements that transfer cash out of banks to the Treasury.  Banks use repos to borrow cash to satisfy more stringent post-crisis regulatory net capital and liquidity requirements.  These thresholds are particularly sensitive at year-end because they may determine whether banks have to raise additional capital to qualify for Fed approval to pay dividends or buy back shares.

Of late, a paucity of capital in the repo market has caused short-term rates to rise creating upward pressure on the Federal Reserve Bank’s federal funds overnight rate which is supposed to be the designated benchmark for all other short-term rates.  In order to keep this rate at the Fed’s desired economically optimal level, the Fed has been infusing liquidity into the financial system through repo loans of its own to borrowing banks needing cash.  This reduces the repo rate to slightly above or below the fed funds rate.

Various forces have created tightness in the repo market causing rate increases and volatility that prompt Fed intervention.  Since repo activity worldwide is highly concentrated in just four U.S. banks, inter-bank repo lending diminishes when they hoard cash to meet regulatory requirements, or when they opt to invest in Treasuries instead of repo loans.  Similarly, many small dealers have stopped repo lending because post-crisis regulation has made cash generally scarcer and thus more costly and onerous to acquire.  And, when cash shortfalls in banks arise causing them to scramble for liquidity, the resulting volatility further increases the cost to borrow by repo.  In addition, strong demand for cash from hedge funds and money market funds has made it less available for banks, sometimes straining operations.

Artificial rates and moral hazard

The result of liquidity infusions by the Fed is to produce artificially low short-term rates which further discourage banks from lending to each other in the repo market.  Once the Fed repo stimulus wears off, market forces raise the rate again to natural and more profitable levels based on the supply and demand for money.  This invites the Fed to intervene yet again and again in a tug of war fashion with the market to lower the rate to maintain its desired fed funds level.  The Fed set the current fed funds rate at the 1.5% - 1.75% target range which in real terms (after inflation) is slightly negative.  This, while the economy is relatively robust with unemployment at record low levels. Why is the Fed keeping rates so low when the market seems to call for higher rates?  Is the Fed skittish about disturbing stock and bond markets?  Is it intimidated by President Trump’s jawboning for minimal rates?

Superficially low rates created by the Fed’s accelerated repo operations induce banks to retain cash in their riskless interest-bearing excess reserves held at the Fed.  Ordinarily, the banks would lend to other banks via higher-yielding repo which carries a modicum of counterparty risk.  This partial bank withdrawal from repo lending causes rate volatility that raises funding costs which crimp bank net interest margins. 

Fed intervention in the repo market is analogous to its much larger quantitative easing program aimed at suppressing long-term mortgage rates in the aftermath of the Great Financial Crisis. The resulting low long-term rates have encouraged investors to seek higher returns in riskier assets such as stocks, high-yield foreign bonds and private-equity.  This practice has misallocated capital to inflated financial assets at the expense of higher-interest bank deposits and business investment that support the real economy of goods and services.  Suppressed long-term rates also have encouraged dangerous debt accumulation by government, businesses and consumers. 

Artificially low short-term rates cause a dearth of inter-bank lending, the lifeblood of the financial system.  Consequently, uneven cash flows among banks are insufficiently corrected causing the Fed to lend repeatedly in the place of other banks in order to maintain operating stability.  The repo assets on the Fed’s balance sheet and the income that flows from them ordinarily reside with the banks to the benefit of their shareholders and the economy.  That income should not accrue to the Treasury via the Fed.  Likewise, the Treasury and mortgage securities the Fed owns as a result of quantitative easing could belong to the banks.

Thus, the larger the Fed’s balance sheet, the more distorted the financial markets become to the general economy’s ultimate detriment.  Right before the financial crisis the Fed’s balance sheet was $900 billion.  It subsequently rose to $4.5 trillion through post-crisis quantitative easing.  Then the Fed reduced it to $3.8 trillion as it stopped QE in 2017 and allowed the portfolio to run off as securities matured, a process that helps to normalize long-term interest rates.  However, in a later stimulus the Fed discontinued the unwinding in 2019 causing its securities portfolio to rise to $4.2 trillion today, including about $250 billion of repo loans (reverse repurchase agreements) to financial institutions to correct their cash shortfalls.    

In a free market the cost of funds should be determined by private-sector lenders based on their risk-return calculus.  The Fed’s job is to ensure short-term interest-rate stability through temporary intervention as needed.  Even the salutary long-term intercession during and after the financial crisis should end eventually.  Ongoing repo loans from the Fed to banks are a crutch for a systemic problem that suggests that short-term interest rates set by the Fed are too low.  The central bank should not become a permanent substitute for financial market participants because this distorts interest rates and asset price discovery.  In case of the repo market, the Fed has become the lender of last resort. Ongoing market desperation is not healthy.

Correctives

There are proposals to revamp the repo architecture to improve the availability of cash to cover bank shortfalls.  One is to establish a facility that triggers an automatic release of funds from a bank’s own excess reserves at the Fed when needed. However, such reliance probably would invite a stigma akin to borrowing from the Fed discount window. Another idea is to require banks to transact repos through clearing houses like Dodd-Frank mandates for swaps.  However, the added cost is likely unwarranted given that repos are fully secured and mainly about liquidity risk.  By contrast, minimally secured swaps involve more dangerous market risk associated with hedging and speculation.

Nevertheless, the current problem in the repo market suggests that post-crisis short-term interest-rate normalization has to resume.  The Fed’s fear of roiling the stock and bond markets from rate hikes must not impede that necessity.  Those asset prices are currently susceptible to some correction because they are inflated by below-market general interest rates.  Stock prices hit record highs throughout 2019 despite negative earnings growth all year. And a near-flat, and sometimes inverted, yield curve does not seem consistent with a reasonably growing U.S. economy, notwithstanding the influences of slow global growth. 

Below-market interest rates have created inflated financial assets for some time.  Now they contribute to dislocations in the repo market which cause repetitive operating cash shortfalls at some banks.  The Fed needs the fortitude to resist political pressures and normalize rates.  Recall the courage of former Fed Chairman Paul Volcker in the early 1980s in raising rates to record levels to extinguish hyper-inflation.

                       

                                                                        ©2020 William J. Dodwell

 

William J. Dodwell is a retired corporate executive, management consultant and financial writer in the finance industry with particular expertise in the capital markets.  Mr. Dodwell has written in professional journals, the trade press and corporate publications. He is a Certified Public Accountant (Inactive) licensed in the State of New York. 

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