People know to talk about repo, but don’t actually know what it is about. What is repo? Why does it matter?
Skyrocketing use of the Fed’s Overnight (o/n) Reverse Repurchase Facility is more of an issue with collateral scarcity rather than bank reserves.
This comes down to US Treasuries’ status (especially T Bills) as the repo market’s preferred form of collateral. Which also means that changes in levels of demand for USTs will tell us if there really is an ongoing collateral shortage.
Treasury auction data provides valuable insight that cannot be gleaned from simply looking at UST yields set in the secondary market.
Not only is auction data primary market data that shows us levels of demand for USTs from the largest global investors and repo market dealers, it also provides us with information on how strong overall demand is.
If there really is a shortage of collateral in the financial system, the data should reflect strong demand for USTs, particularly in T Bill auctions. Specifically, we are looking at trends in an auction’s “Low Yield”, which reflects how willing participants are to bid high for the Treasuries on offer.
Here’s the data for 4 week Bills, with data going back to when the world first entered into Covid lockdowns last year.
We can see that after spending almost a year above 0%, Low Yields in 4w Bill auctions hit rock bottom again in Feb ‘21, and remain stuck there today.
More worryingly, over the course of the last 4 months, High and Median Yields have converged toward 0% as well, demonstrating a marked increase in demand.
8 week Bill auctions reflect the same circumstance, with Low Yields hitting 0% for the first time since March ‘20 in February this year.
High and Median Yields have also converged towards 0% over the last four months, signaling the same kind of increase in demand as the 4w Bills.
Moving up the yield curve, 2 year Note auctions have seen High, Median, and Low Yields stay in a tight range over the same period.
While High and Median Yields have come down slightly over the last four months, Low Yields have actually moved a little higher, departing from the precedent set by 4 and 8 week Bills.
However, it must be noted that the ranges here are extremely tight, at less than 5 basis points.
Therefore, investor demand for USTs at the short and most liquid end of the yield curve is very strong, but what about in the belly of the curve and further out?
To be concluded…
Interestingly, Low Yields in 5 year Note auctions have dived lower over the last few months, following the same pattern as those set by the Bills (but not the 2 year Note).
While High and Median Yields have not fallen by much, Low Yields are lower by approximately 60 basis points since March.
We observe the same thing in 7 year Notes, with High and Median Yields maintaining their levels (and tight spread), while low yields plunged.
The drop in Low Yield at the most recent auction of 7y Notes held near the end of May came in 80 basis points lower than it had previously. Not only was it a sharp drop, it also pushed the Low Yield back to its lowest levels over the past year, 0.08%.
As you can see in the chart above, Low Yields in the 7y Note auctions sat at 0.08% in the direct aftermath of March 2020’s crisis, and then later for most of the remainder of the year.
In 2021, they fell back to 0.8% in March, and then again in the most recent auction.
Moving even further out the yield curve to the 10 year Note, we observe that auction Low Yields still have not caught up to High and Median Yields; and remain in their 80 basis point range between 0.08% and 0.88%.
Taken together, auction Low Yields across multiple maturities on the UST yield curve have moved lower over the last 3 or 4 months, to levels last seen during March 2020.
2 year Notes are the exception to this, although its Low Yields are still in “ultra low” territory, sitting just above 0%.
Given the sky high use of the Fed’s o/n Reverse Repo, now at $485 billion (as of 27 May), $200 billion more than at the peak of last year’s Covid related financial panic, it really isn’t surprising that auction demand for T Bills is as strong as it is.
What is concerning, however, is the sharp dive in 5 and 7 year auction Low Yields during their most recent auction, as this hints at market participants scrambling to get their hands on collateral other than everyone’s preferred T Bills.
This can be for a multitude of reasons, from traders failing to secure enough Bills for their needs, pushing them to use 5y Notes, to investors purchasing USTs that are further out on the curve in anticipation of a coming “liquidity event”.
Either way, they point toward a shortage of USTs, which negatively impacts collateral availability in the repo market, and by extension, financial system stability.
What is truly frightening, however, is that the shortage keeps growing larger!
The Fed raised the rate it pays on its Overnight Reverse Repo Facility from 0% to 0.05% at the end of its latest policy meeting, held last week.
While 5 basis points sounds miniscule, they’ve already created a $235 billion tsunami.
What are the implications?
As you can see from the chart above, usage of the reverse repo facility spiked the day after the Fed raised the rate they would pay on reverse repo transactions by 5 basis points.
In fact, the total increase was 45%, amounting to just about an additional $235 billion – in just one day!
There are two issues to consider here.
First, that reverse repo usage was already very high, at $520 billion on the day of the Fed’s meeting. For context, usage of reverse repo peaked at approximately $300 billion during the height of the market meltdown in March/April 2020.
Also, this reverse repo redux began in April of this year, and started to really pick up steam in May, when the Fed was still paying 0% for reverse repo transactions.
Which brings us to the second issue.
Since the 45% spike in transactions with the Fed happened immediately after the 5 basis points increase, it is reasonable to surmise that this capital was enticed into using the facility by the higher interest rate.
For reference, 1 month UST Bills are yielding slightly less than 5 basis points, 0.0456%, at time of writing.
This implies that the $235 or so billion that poured into the facility was not already tapping overnight reverse repo with the Fed prior to June 16’s Fed meeting. Or, at the very least, a large proportion of the increase can be attributed to capital wanting to earn higher yields.
This includes market participants who now are actively choosing to use the reverse repo facility as an avenue to generate investment returns.
What does this mean for the $520 billion that was already tapping the facility?
Firstly, and most importantly, it means that pre-existing issues of collateral scarcity have not been solved.
Simply because, if half a trillion in capital was engaging in reverse repo with the Fed before June 16, then that same half a trillion will still be rolling over reverse repo transactions with the Fed on a daily basis after the 5 basis point increase.
Putting it another way, if financial institutions were willing to lend to the Fed at 0% in order to obtain USTs, why would they stop doing so at 0.05%?
In fact, at 0.05%, they can get their hands on USTs for use as repo collateral, while earning interest from the Fed as well! It almost sounds too good to be true.
But does this really change anything or alleviate the scarcity in any way?
Unfortunately, the answer is no, simply because the interest that the Fed pays comes in the form of reserves, which do nothing for repo market liquidity.
In other words, the Fed’s 5 basis points fail to address the issue of why $520 billion was already actively using the reverse repo facility.
What happens when this scarcity reaches a tipping point, and participants cannot get hold of the collateral they require?
Global repo contagion, that’s what.
The Fed has announced that it will establish two new repo facilities, one domestic Standing Repo Facility (SRF), and the other international.
The purpose of which is to ensure that funding markets have ready access to cash during times of acute market stress. While this is a positive step, in the sense that the Fed is actively trying to pre-empt future market meltdowns, it is unfortunately one that will not work.
Firstly, the Fed has gotten the problem the other way round. In times of market stress, people need collateral more than they need another outlet with which to raise cash with their collateral.
Think about it for a minute; market stress is a product of mass liquidations which stem from collateral/margin calls forcing people to sell assets to raise cash.
The stress becomes acute when this initial wave of selling precipitates further waves of collateral/margin calls that lead to even more selling, at which point it becomes a negative feedback loop.
During such times, demand for collateral skyrockets because traders and investors need to post more of it to avoid liquidating their positions. This is a result of collateral requirements increasing as market volatility increases – lenders want more assurance against market uncertainty.
Unfortunately, the increase in volatility also decreases the availability of collateral in the open market as everyone looks to hoard it for their own purposes.
Which is exactly what happened in 2008 and 2020.
As such, during times of crisis, everyone is scrambling to get their hands on collateral. People want collateral, and those who have it are kings.
The UST market seized up in March last year because people were hoarding collateral. That is, they were not willing to sell Treasuries because they needed them either for use as collateral, or as buffers against even more volatility.
Lack of collateral is the problem here, not the ability to use collateral to raise cash.
The Fed’s new SRF clearly demonstrate that they view the latter as the problem, not the former, hence them getting the problem the other way round.
Furthermore, the financial system itself is shouting about their lack of collateral, at progressively louder volumes. All one has to do is look at the explosion in usage of the Fed’s Overnight Reverse Repo Facility (RRP), which is almost at $1 trillion now.
Which brings us to our second consideration, that the new repo facility might not be large enough.
While a daily cap of $500 billion sounds high, it is important to remember that trillion dollar markets seize up during financial crises, and Overnight RRP use is also almost at a trillion. $500 billion would be enough if markets worked in a predictable, linear, and smooth fashion.
Unfortunately, they do not.
As such, it’s not about the smooth provision of medium-sized amounts of credit, but rather the ability to provide massive amounts of credit to meet massive amounts of demand for it, arising at the same time.
From this perspective, $500 billion is like a sea wall trying to stop a tsunami.
Lastly, the Fed already conducts daily repo operations, and over the course of the crisis period last year, conducted more frequent repo operations at larger amounts. This is an important psychological factor, because the market is, at this point, conditioned to the Fed taking some kind of action during market meltdowns.
It might not even be an understatement to say that, since 2008 and all the QEs that were implemented between then and now, market participants all around the world expect the Fed to intervene when markets convulse.
But, despite this expectation, 2020’s crisis still happened, and the UST market still froze.
Why then, would another $500 billion facility work now?
To be continued…
While the Fed has misdiagnosed the collateral issues plaguing the repo market, it is important to understand that its new Standing Repo Facility (SRF) can alleviate some pressure in the financial system during times of crisis.
It is possible that during periods of collateral stress, or, more colloquially, market meltdowns, repo counterparties will refuse to transact in anything except the highest quality collateral – T Bills.
Should this occur, normally widely accepted forms of collateral such as Agency MBS and Agency debt may no longer be accepted for repo. The end result being holders of such securities will no longer be able to use them as collateral to borrow cash in the repo market.
This is where the SRF can help by providing an invaluable source of last-resort repo liquidity for Agency related securities. Unfortunately, as illustrated in the chart below, the share of Agency debt and MBS securities used in repo transactions just isn’t very high.
Consequently, any positive effects arising from the Fed’s new facility providing last resort repo liquidity for Agency related securities will not be very significant.
This last-resort repo liquidity could also extend to Treasuries.
Not all forms of collateral are created equal, even within the UST asset class. In general, tenor and liquidity are the main factors in determining the desirability of collateral types ,and the same applies to Treasuries.
Which means that, in times of severe stress, some types of USTs can fall out of the bucket of “acceptable” collateral, as demonstrated in 2020 when Off The Run Treasuries were shut out of the repo market.
This collateral “divergence”, for lack of a better term, within the UST asset class is where the SRF can really shine. Traders and investors who find themselves holding Treasury securities that were once widely accepted as collateral in the repo market, but are suddenly not, can turn to the Fed’s new facility.
This will alleviate the pressure on this subset of market participants during a financial crisis, and could prove to be valuable in helping some of them avoid falling into insolvency.
In a semi-related way, another possible scenario where the SRF can be effective is when holders of USTs (the shorter tenor ones that are still accepted) need to borrow cash in the repo market but deem repo counterparty risk to be too high. Posting their collateral to borrow from the Fed then becomes the best option.
However, this could lead to the opposite of what the Fed intends by exacerbating illiquidity in the repo market, as collateral holders refuse to transact with anyone but the Fed, leaving those scrambling to get hold of collateral with even less chance of doing so.
Should this happen, it could lead to more severe sell offs across global markets as traders and investors are forced to liquidate positions in whatever assets they hold in order to raise cash to meet collateral/margin calls.
Ultimately, while the scenarios mentioned above are instances where the SRF can make a difference, it won’t be enough.
Because for all that the Fed and market folks want to believe in it, the SRF simply does not solve the underlying problem of collateral scarcity!