Grim repo: how the Fed plans to return crucial market to normal - Financial Times

When a crucial US financing market went haywire in September, the Federal Reserve resolved to do everything in its power to avoid a repeat at the end of the year.

On the final day of 2019 — often a fraught time for the “repo” market, where cash is borrowed in exchange for high-quality collateral such as Treasuries — the central bank’s actions proved successful.

By injecting tens of billions of dollars into the financial system in the intervening months, in the form of daily and longer-term repo loans and outright purchases of Treasury bills, the Fed ensured there was enough cash swilling around to prevent market rates from spiking higher.

Now, investors and policymakers alike are eager for a longer-term fix: one that brings some normality back to funding markets without requiring heavy-handed interventions by the Fed.

“I really think they hope to be in a place where they get the money markets operating in a way that they don’t have to frequently intervene and inject liquidity,” said Nathan Sheets, a former US Treasury official who is chief economist at PGIM Fixed Income, which manages $838bn in assets.

The question is how the Fed can remove that support. “The market doesn’t have clarity there and really wants it,” says Mark Cabana, an interest rate strategist at Bank of America.

Crucial to any plan is the level of bank reserves, which is indicative of the available cash in the financial system that could be supplied to other bank investors in the repo market. It is widely thought that September’s cash crunch coincided with reserves dropping too low.

The Fed has since intervened by buying short-term Treasury bills. As the Fed buys securities, more cash enters the financial system, boosting banks’ reserves. Once reserves have increased to a level able to withstand short-term shocks to money markets, the thinking goes, the Fed will be able to step back from its current repo operations.

Last month Fed chairman Jay Powell said that once reserves reach a sufficient level, “it will be appropriate for overnight and term repo [operations] to gradually decline”. But that level remains unspecified. Banks currently hold $1.5tn in cash reserves at the Fed — up from $1.3tn in September when funding markets seized up.

Moreover, Mr Powell has opened the door to expanding beyond the Fed’s current bill-buying programme and purchasing other short-term securities to bolster banks’ reserves.

Investors have begun to consider what kind of impact such purchases could have on asset prices, given the parallels to the “quantitative easing” programme of the post-crisis recovery.

Buying Treasuries pushes their prices higher, lowering the yields on offer to investors and potentially encouraging them to seek out riskier assets — such as stocks and corporate bonds — to boost returns. This effect is more pronounced if the Fed increases the maturity of the government debt it buys, say investors. “As you move out the curve, at some point it becomes operationally equivalent to QE,” said Mr Sheets of PGIM.

Kathy Bostjancic, chief US financial economist at Oxford Economics, said the best option is for the Fed to remain involved in the market. She favours a standing repo facility: a permanent programme allowing institutions to exchange their Treasury holdings for cash at a set interest rate.

“If banks feel at any given time they could swap Treasuries for cash reserves, that should eliminate any hoarding of reserves,” she said.

The Fed discussed this option during its policy-setting meeting in June, raising concerns over how it would determine who can access the facility and at what rate of interest. Half a year later, it does not appear the central bank is any closer to making real progress. “I think the standing repo facility is something that’ll take some time to evaluate . . . and put into place,” said Mr Powell last month.

Bank executives have seized on the recent repo stress to pressure regulators to ease liquidity requirements put in place following the financial crisis. They argue that these rules have dissuaded banks from lending into short-term funding markets despite being flush with cash.

Regulations have reduced “flexibility” at financial institutions, said Dan Ivascyn, group chief investment officer at Pimco, which manages nearly $1.9tn in assets. “You can’t rely on risk to be transferred as seamlessly as . . . in the past.”

Fed officials have tentatively engaged with questions like this, but investors are sceptical there will be any immediate change given political resistance from the likes of Democratic presidential candidate Elizabeth Warren. The senator from Massachusetts has cautioned against using the repo flare-up as an “excuse” to weaken banking rules.

Whatever direction the Fed ultimately takes, investors are keen for it to act quickly.

“The plumbing of the financial system is critically important to the functioning of markets and the broader economy,” said Ashish Shah, co-chief investment officer of fixed income at Goldman Sachs Asset Management.

2020-01-02 04:01:10Z
https://www.ft.com/content/8ffb6f9a-2be9-11ea-a126-99756bd8f45e