There Is Good Reason to Fear the Repo

A market repurchase agreement, or repo, is a critical weapon in a central bank’s arsenal. Repo sales are used to stabilize markets and interest rates by providing essential liquidity.

Unlike interest rate setting, which is a part of the normal operations of a central bank, repos are tools generally reserved for emergencies. With the Federal Reserve diving into repo sales for the first time since 2008, there is good reason to start worrying.

Fear the repo

Let’s begin with a quick discussion of how repos work. Alasdair Macleod of Macleod Finance has offered a simple explanation of the operations involved, and what they are meant to achieve:

“For the avoidance of doubt, a reverse repo by the Fed involves the Fed borrowing money from commercial banks, secured by collateral held on its balance sheet, typically US Treasury bills. Reverse repos withdraw liquidity from the banking system. With a repo, the opposite happens: the Fed takes in collateral from the banking system and lends money against the collateral, injecting liquidity into the system. The use of reverse repos can be regarded as the Fed’s principal liquidity management tool when the banks have substantial reserves parked with the Fed, which is the case today.”

Reverse repos are commonplace enough. The Fed does it all the time with little cause for raising eyebrows among market participants. However, when the process goes into reverse, that is a different matter entirely.

The last time the Federal undertook repo sales was in 2008, when markets were thrown into turmoil by the eruption of the financial crisis. Yet, over the past two weeks, the Fed has leaped into action once again, engaging in hundreds of billions of dollars of repo sales, as Business Insider reported last week:

“The Federal Reserve on Wednesday sold another $75 billion in market repurchase agreements, or repos, in a continued effort to calm money markets and bring interest rates within its intended range. The round was oversubscribed, as banks requested nearly $92 billion in overnight repos, signaling strong demand for the asset. The bank began a streak of repo offerings last week, marking the first time such assets were sold since the 2008 financial crisis. The central bank said the offerings would continue through early October ... The offering followed a $105 billion injection on Monday, which included $75 billion in overnight repos and $30 billion in repos expiring in 14 days.”

Trouble with the transmission

The Fed’s efforts to enhance liquidity during the past two weeks have been hampered by serious structural issues in the repo market itself. One key problem stems from the Fed's reliance on a small number of massive financial institutions, such as Bank of America (BAC, Financial) and JPMorgan Chase & Co. (JPM, Financial), to handle the actual transmission of liquidity into the financial system. When those institutions fail to pass the liquidity on (i.e., they continue to hold the cash being essentially “created” by the repo), the Fed is left with little recourse.

As The Wall Street Journal reported on Sep. 26, Fed economists are very concerned about the increasingly concentrated repo market:

“Activity in the market for repurchase agreements, or repos, where banks and investors seek more than a trillion dollars in cash loans every day, has increasingly concentrated at large banks. When those banks hoard reserves, it can drive borrowing costs higher for smaller firms, according to a study by Fed economists published last year. The five largest banks hold more than 90% of the supply of total reserves and a more even distribution would help cushion against such shocks, the study found. That is one challenge confronting Fed officials as they try to get funds flowing through the financial system following last week’s surge in overnight interest rates, which climbed as high as 10%. As the Fed has increased lending in the repo market, it is reliant on a small group of bond dealers to recirculate that money through the financial system, increasing opportunities for channels to get clogged.”

The scale of the structural problem in the repo market has become apparent during the past week. Big banks have proven to have an insatiable hunger for repo cash, suggesting that a profound pricing dislocation is occurring under the surface of the market.

Dangerous dislocation in evidence

If the Fed’s economists were worried about repo market transmission problems last year, they are likely on the verge of apoplexy today. As Dr. Ben Hunt of Epsilon Theory has mused publicly in recent days, there is an observable dislocation evidenced by the Fed’s repo sales. On Sep. 26, he offered a rather frightening assessment of the situation:

“Overnight repo is where the interest rates that central banks SET meet the interest rates that real economic actors USE. The dislocations we're seeing in repo are the result of a new common knowledge about central banks. And yes, it changes EVERYTHING ... I think this spike in demand for overnight and short-term financing is a direct result of real economic actors trying to figure out what it MEANS when interest rates are a symbolic communication to markets rather than a clearing price of money in the real world. I know what it would mean to me. It would mean that I want the cash, not the securities, and I’d be willing to pay up to get it. But if the real world price of overnight money is higher than what central bankers SAY is the real world price of overnight money … well, that breaks the world. So it can’t happen. So no matter how much demand there is for the cash instead of the securities, the Fed will provide as much cash is necessary – truly, as much cash is necessary – to satisfy that demand at the price that the Fed SAYS is the right price of overnight money. It’s not a crisis per se. There is literally no limit to the liquidity – i.e. cash – that the Fed can and will provide. But it is absolutely indicative of a profound shift in the common knowledge – what everyone knows that everyone knows – regarding the Fed and monetary policy. And that shift will change everything. Not tomorrow. Not the next day. Not in the form of a market ‘crash’. But it will change everything.”

In other words, the Fed appears to be losing control of the fundamental narrative that undergirds much of its power as the setter of American monetary policy. When banks believe the price of money is different from what the Fed says it is, something has to give.

So far, the Fed’s nigh-infinite capacity for providing liquidity has resulted in the banks soaking up repo sales with singular abandon. These institutions clearly value money and liquidity very differently from how the Fed wants it to be valued. That is a big problem. Indeed, if the trouble in the repo market continues to mount, it could have dire consequences, as Alasdair Macleod observed last week:

“If the repo troubles escalate, there is a danger the investment management industry will start to move these funds from banks perceived to have increasing counterparty and operational risk, with potentially devastating consequences for all involved. Cynics have thought for a long time that the ETF industry would end in disaster for investors, without having a convincing explanation of how it would happen. Perhaps we are now beginning to see early evidence pointing to the ending of the ETF phenomenon, and to therefore be able to anticipate the knock-on effects on financial and derivative markets generally.”

Essentially, if perceived risks escalate and financial institutions continue to favor cash over securities, it could result in the cascade failure in the passive investment market that many analysts have feared for some time, and which we have discussed at length previously.

Verdict

The explosion in repo sales over the past two weeks, which the Fed plans to continue through Oct. 10 at least, is a serious warning sign for investors. The big banks with the clearest understanding of the global macro environment are signaling very clearly that there is trouble ahead.

Perhaps more than anytime in the past decade, investors would be well advised to move and act with extreme caution.

Disclosure: No positions.

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