People know to talk about repo, but don’t actually know what it is about. What is repo? Why does it matter?
The Eurozone’s periphery has been having a debt bonanza of late, with Spain, Italy, and Portugal seeing investors queuing up to buy their debt issuance. Which is a very strange sentence for anyone familiar with the European debt crisis to be reading (and typing).
Remember the EU Sovereign debt crisis? That continent wide debt conflagration that began sometime towards the end of 2009, raged across Southern Europe until 2012/13, then somehow, gently slipped out of everyone’s minds? The same one that almost saw Greece leave the Eurozone, challenging the integrity of the Euro itself?
From the chart, you can see the increase in Debt/GDP levels from 2011 onwards, when the crisis really started to take hold. This was largely due to the sharp contractions in GDP across Portugal, Spain, Italy, and Greece as soaring debt funding costs severely hampered their economic situations.
From then on, Debt/GDP remained pretty stable, even decreasing in Portugal and Spain, as the years rolled by, until Pandemic 2020, which delivered the double whammy of increased debt levels and decreased economic growth. While final numbers are not yet available, for the year 2020, Greece is estimated to have Debt/GDP hit 205%, Portugal 134%, Spain 114% (actual figure as of 3Q 2020), and Italy at 158.5% for 2020.
Given these eye-wateringly high Debt/GDP levels, one cannot help but wonder how it is that these countries, only slightly more than half a decade out of a crippling debt crisis, can raise debt in record amounts, and at record low yields?
We know that their economies are in dire straits because of Covid, with extended lockdowns over two (three in some places) waves of Covid and the abrupt shutting down of the global tourism industry hitting all four countries hard.
Furthermore, their debt balances have not improved. On the contrary, Covid has caused these countries to borrow even more as they desperately try to prop up workers and businesses left (very abruptly) without sources of income for a prolonged period of time.
Not good on the growth front, and not good on the debt front; bond market participants obviously know this, why then are they falling over themselves to lend these countries money?
The favorite, go-to answer is of course the ECB buying sovereign debt as part of its QE program. ECB demand pushes prices up, lowering yields and hence borrowing costs for heavily indebted Eurozone countries. More importantly, the ECB’s continued willingness to purchase sovereign debt has imbued the bond market with the belief that the central bank will always step in when bond yields of heavily indebted nations get too high. As long as this belief holds, funding markets seem to be willing to remain open to Portugal, Spain, Italy, and Greece. Belief is a powerful thing.
Another arguably more important, but much less well known reason, is that EU debt is also used as repo collateral. While it may seem counterintuitive that the bonds of heavily indebted governments are used as collateral for loans, consider that we are living in an environment where central banks are actively buying large volumes of government debt, leaving less and less for participants in the repo market.
This lack of supply of government debt for use as collateral has led to higher prices for the most liquid sovereign bonds (those in the US, Europe, and Japan), as repo participants bid higher to get their hands on what is left.
As such, and quite ironically, scarcity of collateral due to ECB buying has kept demand for the debt of Eurozone countries high – whether they intended it to, or not!
Wednesday’s FOMC minutes revealed something startling.
Staff at the Federal Reserve reported that takeup of their Overnight Reverse Repo Facility reached $100 billion. Except that this was for their meeting at the end of April.
Now, about three weeks later, takeup has reached almost $300 billion!
Why the sudden and dramatic increase?
Before we can answer that question, we need to first establish what a reverse repo transaction is.
Simply put, reverse repo is the opposite of a repurchase (repo) transaction. Instead of a party selling collateral to buy it back (repurchase it), the party is now purchasing collateral to sell it back.
That is, if a bank is selling US Treasuries in an agreement to repurchase them at a later date, the bank has entered into a repurchase agreement.
If the bank is buying US Treasuries in an agreement to sell them back at a later date, it has entered into a reverse repurchase agreement.
In the context of the Fed’s Overnight (o/n) Reverse Repo transactions, the Fed is selling its USTs to an eligible counterparty, hence the Fed enters into a repo transaction.
The eligible counterparties, on the other hand, enter into a reverse repo transaction with the Fed.
As you can see, the transaction only consists of an exchange of cash for collateral between two parties. Whether a party is considered to be in repo or reverse repo is a matter of which side of the transaction it sits on.
Now, looking at the chart above, we can see two massive spikes in usage of the Fed’s o/n reverse repo facility.
The first was in March/April 2020, which was the financial panic that ensued as the world first entered into Covid lockdowns; firmly in the market’s rearview mirror now.
The second spike, however, is happening in real time – now.
When it was first observed by the Fed in April, demand for the Fed’s USTs stood at $100 bn. That has now tripled, over the course of about three weeks (as of time of writing).
That’s a lot of demand in a very short period of time.
There are two different ways of interpreting this spike in demand for the Fed’s o/n reverse repo facility. One is that banks have too many reserves and are using the overnight reverse repo facility with the Fed as a means to manage their bank reserves better.
This makes sense since banks use reserves in the reverse repo transaction, which takes them off their balance sheets momentarily.
While this is a completely valid explanation, and probably does account for some of the sharp rise in o/n reverse repo since US banks are stuffed full of reserves, and have been for the last decade; there just hasn’t been a drastic enough change in this space to cause such a dramatic spike in o/n reverse repo.
To be concluded…
Furthermore, it is important to remember that these reverse repo transactions unwind.
Which means that the reserves will come back to sit on banks’ balance sheets. Banks are okay with this now since the interest rate that the Fed pays for effectively borrowing banks’ reserves is 0%.
As such, from the banks’ perspective, reverse repo moves reserves off their balance sheets for a short while.
In return, they receive USTs, which they can lend out in the repo market for an extra return. Depending on the rates they receive, it may even turn out to be a profitable trade.
But, would this be enough to cause a spike in usage of the o/n reverse repo facility on par with what happened in 2020?
Recall that in March 2020, we saw the repo market fail to clear, mass liquidations in markets across the globe, and even the UST market (a.k.a the world’s most liquid market) freeze up.
That is the context behind the spike in o/n reverse repo in March 2020. The magnitude of demand for USTs, and how quickly that demand spiked, illustrates the sheer desperation financial market participants were experiencing.
Bearing this in mind and looking at the chart above, does it seem like “banks have too much reserves” tells the whole story?
Considering how quickly o/n reverse repo transactions with the Fed have spiked higher than what it was in March 2020, something else is also going on.
Which takes us to the other way of interpreting this – What if this isn’t a problem with overflowing reserves, but one of UST scarcity?
Going back to March 2020, traders and investors were scrambling to get their hands on USTs, only to find that everyone who had Treasuries was hoarding them (hence the breakdown of the UST market).
The reason for this is that USTs, especially T Bills, are the best kinds of repo collateral. And, in times of crisis, lenders in the repo market demand more collateral to protect themselves from losses.
If investors do not have enough cash or liquid assets to obtain more collateral, they would have to liquidate their positions in order to repay their repo borrowings. These initial liquidations cause market prices to fall, and if there is too much leverage in the system, sparks off a mass liquidation and a cascade of even more collateral calls.
Needless to say, when this happens, demand for USTs goes through the roof.
This mad scramble for Treasuries is what led eligible market participants to rush to tap the Fed’s o/n reverse repo facility a year ago – as a means to obtain Treasuries.
In other words, traders and investors enter into reverse repo with the Fed when USTs are not easily obtainable, which in itself is a sign of liquidity problems in the repo market.
Consequently, skyrocketing levels of o/n reverse repo transactions with the Fed hint at potential problems far more systemically significant and destructive than just banks having too many reserves. March 2020, as well as the Great Financial Crisis of ‘08, are excellent examples of just how terrible things can get for markets all around the world, and the global economy.
What are the true consequences of QE?
QE is effectively an asset swap, where the Fed buys Treasuries from banks, and pays them with bank reserves.
In doing so, the Fed removes the preferred form of money (USTs) that the financial system uses to transact in global repo markets.
The result of which is more frequent “liquidity events”, where participants in the financial system, out of fear and a desire to be prepared for the next event, hoard already scarce USTs for themselves rather than lend them out.
This further lowers the availability of USTs for use as collateral, while reducing the amount of USD loans made in the repo market.
Also, scarcity means that more market participants are willing to pay higher prices to secure Treasuries for their own collateral needs, which drives yields lower.
This in turn sparks a scramble for collateral of the highest quality, Treasury Bills (T Bills), causing a further drop in short term rates that then remain at really low levels. If this sounds familiar, it’s because it describes the reality the world is living in, and has been living in ever since the Great Financial Crisis of 2008.
As such, ultra low/negative short term rates are not indicative of ultra loose central bank monetary policy.
Recall Milton Friedman’s interest rate fallacy: low rates signify an environment where money supply is tight. Low and negative rates at the short end of the US yield curve exemplify this perfectly – there are not enough USTs relative to global demand for them, because the global financial system uses it as a form of money.
Even so, the Fed, and central banks all around the world, continue to remove sovereign debt (also used as collateral, but not as good as USTs) from their banking systems, which stems from their misunderstanding of the role played by bank reserves.
As a result, central banks have added trillions upon trillions of bank reserves into their banking systems, where they sit inert; while simultaneously taking out the form of money that the financial system actually uses to transact.
Is it any surprise then, that short term rates across the developed world are at levels that economists term “ultra low”, or even outright negative?
Hence, the global financial system faces a global collateral shortage, as the central banks in the world’s largest sovereign debt markets, the Fed, ECB, and the Bank of Japan, are all busy gobbling it up.
All of which does make one wonder – did none of them consider second order effects before implementing QE?
If they did not, why didn’t they do so in the intervening decade(s), as short term interest rate markets were yelling that something was not working properly?
More frighteningly, if they did, and yet still went on to repeat the same course of action over and over again, one must ask: do these people understand what they are doing?
To be continued…
If you were offered an investment that promised a rate of return of -0.70% after two years, would you take it?
Most people would say no, yet that’s what German 2 year bonds are trading for in the market (at time of writing).
Let us first consider the “asset management” perspective, which seeks to allocate capital based on rates of return.
Here, negative rates are seen as guaranteed losses on the principal invested, as fixed income investments made by these (large) pools of capital are held long term, if not to maturity.
This is also the perspective through which the financial media, along with most market participants, view negative yields – why would anyone buy a bond that guarantees that they lose money at maturity?
Now let us reframe the question a little.
Instead of asking, “Why would anybody buy bonds that leave them poorer?” Let us instead ask, why would people buy bonds knowing that they would be poorer?
They obviously derive some utility from them, to the extent that they are willing to pay to lend governments cash.
That utility is liquidity from the debts’ use as collateral.
Negative yields do not matter because all these people want is collateral and liquidity buffers that allow them to quickly access dollars in times of financial stress. From this standpoint, negative yields aren’t seen as a liability, just as a cost of liquidity.
Also, because these investors/traders aren’t looking to earn a return from these negative yielding fixed income instruments, they don’t tend to hold them to maturity.
Given the strong trend towards ever lower rates (and thus higher prices) over the past decade or so, this has been a very lucrative trade for them.
This new perspective allows us to see low yields in a more nuanced way.
On top of representing a rate of return (or lack thereof), low yields are also indicative of liquidity scarcity, and thus stress in the broader financial system.
Which brings us back to the global shortage of collateral caused by QE.
For some reason, the Fed and its counterparts decided to purchase assets that the financial system was already purchasing en masse, resulting in a system that is more sensitive to changes in market risk.
What happens when liquidity is scarce and market participants jittery with their collateral and risk exposures?
Markets stampede at the slightest provocation, that’s what.
As downside risk increases, or is perceived to increase, people who have extended leverage to others through the repo market issue collateral/margin calls together. This results in mass liquidations from borrowers who now need to meet these collateral/margin calls.
“Small” episodes of this phenomenon can be contained in just a few markets, and the furious selloff in long dated USTs in 1Q2021 is a result of this (inflation worries are bad for bonds).
“Large” episodes span different markets, as investors/traders sell other liquid assets that they own in order to raise the cash needed to meet their margin calls.
These cross market liquidations are very dangerous, as they can spark further margin calls, to the extent where markets all over the globe are involved, as March 2020 and the financial crisis in ’08 so clearly demonstrated.
As such, negative yields on sovereign bonds represent far more than just an asset management conundrum. They are a warning sign that flashes when demand for collateral, and hence systemic risk, in the financial system is high.
Unfortunately, instead of meeting the system’s demand for more sovereign paper for use as collateral, global central banks choose to actively remove them from markets by implementing QE, making the situation even worse!