The overnight repo market usually doesn’t garner many headlines. That changed when liquidity dried up and rates skyrocketed suddenly in mid-September.
The Federal Reserve had to step in with several lending facilities to restore order. The Fed injected over $125 billion in the first two days alone. Overnight rates spiked to over 5% before the intervention brought them back down. The over $2 trillion repo market is an important source of short-term liquidity for banks and finance firms.
By October, the Fed had brought in more than $330 billion and announced plans for a series of longer-term lending operations to keep the repo market functioning. This has been the first direct Fed balance sheet intervention since the end of the last Quantitative Easing program in 2013.
The scale of the intervention is significant coming less than a year from the last rate increase. The Fed was nearly alone among central banks around the world to have been in a contractionary mode for the past few years. While the Fed raised rates 7 times in 2017 and 2018, several large markets dropped their rates below 0.
This divergence from global markets ended in 2019 when the Fed had to change course with one rate cut in June. Though the headline economic numbers still seem mostly positive, there have been signs of weakness. Most recently, the inversion of the yield curve has created concerns about a potential coming recession.
Part of the reason liquidity is tight among banks is due to primary dealers absorbing so much new Treasury issuance. New Treasury bond issues are averaging almost $45 billion per day. With the budget deficit over $1 Trillion, this rate won’t slow down anytime soon. For the largest primary dealers, this only adds to the squeeze they have been feeling from a flattened yield curve. Expect firms like JPMorgan (JPM) and BNY Mellon (BK) to see higher volatility and continued margin pressure. There may also be more balance sheet concerns than expected due to the speed at which liquidity disappeared.
As I mentioned in the most recent Lead-Lag Report, this could contribute to the selling pressure on long-term Treasuries (TLT). The Fed may be unwilling to increase rates, even though core inflation sits above their 2% target. Economists have even begun raising expectations of a potential rate cut in the near future.
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