Repo repercussions: What does the Fed’s quantitative tightening experiment mean for repo markets?
As the US repo market experiences a number of unprecedented trends, it is an important moment for the buy-side to explore its liquidity options.
The US repo market is experiencing a number of coinciding, unprecedented trends. With use of the Federal Reserve’s Reverse Repurchase Facility (RRP) hitting record levels, expectations of further rate hikes, and excess reserves running off rapidly from their COVID QE-induced highs, it seems that something will have to give. It is an important moment for the buy-side to explore its liquidity options as the future remains volatile.
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Cash investors find a new home at the Fed
Since the Federal Reserve started raising interest rates in March, investors have flooded cash into shorter maturity holdings.
With the Fed signaling it is far from done in its fight against inflation, financial institutions want to keep that cash as liquid as possible to be able to take advantage of those higher rates once they arrive. En masse, they have turned to money market funds (MMFs) that are able to access the repo market to earn a return while remaining in the safest assets, such as short-term Treasuries. These large MMFs have overwhelmingly turned to the Fed Reverse Repurchase Facility (RRP), which has consistently offered the best overnight rates throughout the hiking cycle. As of the end of Q3, 92% of the RRP ’s $2.37T in balances came from MMFs. , In comparison to these gargantuan levels of overnight cash, associated Treasury collateral supply remains scarce, even as the Fed’s ongoing Quantitative Tightening (QT) efforts siphon cash out of the market – albeit only at the pace of $95B/month since September.
When too much demand is chasing too little supply, it drives up the price of those assets and pushes down yields, leaving investors with limited options to park their excess cash further out on the curve. It also means that overnight repo rates trade consistently below the RRP level, which is pegged to a new elevated target with every rate hike.
Consequently, the Fed has become the dominant player in overnight markets through its RRP, selling Treasuries to mop up the excess cash.
After a decade of quantitative easing (QE) that exponentially ballooned the Fed’s balance sheet as it boosted liquidity in response to the Global Financial Crisis and the COVID-19 pandemic, the Fed certainly has the bandwidth to reduce its balance sheet significantly through ongoing QT and open market operations. How long it will take for this to have a meaningful effect on the market dynamic is another matter.
The Fed’s enlarged role is a sign of a one-sided market: equity managers have gone from overweight to underweight as rising rates and inflation hurt the economy; bond funds are waiting for higher yields; pension and hedge fund managers are sitting on excess cash amid volatile markets; and money market funds are picking up cash taken from bank deposits, where rates have not risen from record lows in tandem with borrowing costs.
This status quo will not last. But the key questions for investors are: How long is the RRP likely to remain at elevated levels? What factors will tip the balance and lead to cash outflows from the RRP? And what alternative liquidity options should they be exploring?
History suggests we should always expect the unexpected
The recent record volumes in the RRP highlight the importance of the Fed’s role in ensuring the smooth functioning of repo markets as a source of short-term liquidity during periods of economic instability. And since it immediately offers higher rates after every Fed hike, more participants want to take advantage.
The Fed RRP is one of several operations designed to promote overall liquidity, as previous episodes have shown that even when the market seems to be drowning in cash, the tide can turn quickly and unexpectedly. This can be exaggerated when the majority of participants are primarily on the same side.
In September 2019, money market rates spiked as a confluence of factors caused a demand-supply mismatch that sucked liquidity from the market. Firstly, quarterly corporate tax payments were due, resulting in a significant transfer of funds out of money market funds and deposit accounts at banks, whose reserves were already low. Secondly, $54 billion of Treasury debt settled, and needed to be paid for by the primary dealers that bought them, who use the repo market for short-term financing. These were among coinciding factors that drained reserves, leading to a severe liquidity crunch in overnight markets. A similar, although slightly less severe event happened in 2020, as the COVID pandemic prompted investors to dump Treasuries for cash, requiring the Fed to pump in an extra $1.5 trillion.
Although these fears are not the same as the ones affecting the market today, or indeed the Fed itself, that does not mean there are no warning signs. Some market analysts are already suggesting the Fed will overreact to inflation and prompt a recession, requiring it to reverse course and cut rates earlier than expected. That in turn would see asset managers scrambling to lock in higher rates for as long as possible.
Meanwhile, the US Congress is facing yet another debt ceiling debate, which could result in Treasury issuance drying up until the deadlock is broken, or an onslaught of new issuance as a higher debt limit enables renewed government spending.
Another key factor to monitor is the sensitivity of bank deposit rates to further Fed rate hikes. If deposit rates begin to rise more in line with broader interest rates as seen in prior hiking cycles, the rate of RRP inflows may soften.
Recent history suggests that while these events may not be unprecedented, they can still come as a surprise, and the reaction to that surprise usually starts with the repo market. So, while there is still time, it would be prudent for investors to think about how they can diversify their liquidity outlets.
More empowerment for the buy-side
Despite the current enormity of the repo market, opportunities exist to expand into a broader set of collateral types and maturities for a larger set of buy-side participants – ones that would empower them to negotiate terms more closely aligned with their interests.
After a decade dominated by long periods of almost zero rates – and therefore equally low returns – many buy-side institutions reduced back-office funding as the market became uneconomic: Trade costs exceeded the benefits, while regulations increased the burden of credit-risk analysis and balance-sheet allocation.
Given that repo agreements are collateralized in case of counterparty default, each transaction includes important considerations around collateral type, haircut, and rate. Traditionally, negotiation and execution is performed bilaterally, with trades settled directly through an intermediary, often over the phone. That dealer faces exposure to both parties, leading to higher costs that are passed onto the counterparties in the form of wider buy/sell spreads. In addition, each counterparty needs its own internal infrastructure to agree on suitable counterparties, evaluate the risks and process the transactions.
Recently, the first peer-to-peer (P2P) platform emerged, empowering buy-side firms to interact directly by effectively removing the intermediary, while still offering indemnity in the case of counterparty default. Any fee for the indemnity is likely to be much more economic than a bilateral repo as it excludes balance sheet cost. It also allows for the same peace of mind that the buy-side has come to expect in repo markets.
As in other asset markets, the evolution of trading platforms widens the counterparty base by making it easier for the liquidity seeker to find the cash provider on demand and transact in a cost-effective manner. In a P2P marketplace enabled via a seamless electronic platform, buy-side participants that previously may not have had the ability to interact directly, or even access the repo market at all, would be empowered.
In addition, platforms are able to integrate pre- and post-trade servicing needs with an end-to-end ecosystem and central clearing, reducing the operational burden.
Such platforms can help to empower buy-side institutions to seek out new sources of liquidity — which may prove increasingly valuable amid the current market backdrop.