MNI: Fed's Standing Repo Facility Tested By Market Rate Spike
MNI (WASHINGTON) - Banks tapped the Federal Reserve's new funding backstop for the first time last week amid a shortage of cash at the end of the third quarter, but the small take-up raises questions about the facility’s suitability to meet liquidity needs during times of market stress, former Fed economists and market participants told MNI.
The first use of the New York Fed's standing repo facility after two years of sitting dormant was an encouraging sign that it can dampen volatility and allow the central bank to shrink its balance sheet further, they said. But they noted that it saw only USD2.6 billion of borrowing on Sept 30 as trading volume surged to a record USD2.5 trillion and SOFR shot up 12 basis points.
Repo rates spiked another 9bp the next day, breaching the top of the Fed's target range.
"Repo rates drifted outside of the Fed's target range for the first time in a really long time, and that's quite significant. The first real usage of the standing repo facility was also a notable development," Deutsche Bank strategist Steven Zeng told MNI.
"Volatility in repo markets has increased over the past months and quarters. We know there's a strong linkage between repo and the fed funds rate markets, so by helping dampen the volatility in repo rates, which the standing repo facility is effective at doing, it keeps the fed funds rate more stable and allows the Fed to continue its balance sheet unwind for longer."
QT CONTINUES
The factors that drove repo rates higher at quarter end were predictable – dealers refrained from lending to show strong balance sheets, it was the same day that large Treasuries auctions settled, and certain operational preferences added to upward pressures – but the magnitude and persistence of the stress was larger than expected, Zeng said.
Violent swings in repo rates in 2018 and 2019 – the last time the Fed shrank its balance sheet – culminated in crisis, requiring Fed intervention, in September 2019. But Zeng and others said a repeat of 2019 is unlikely. The Fed's balance sheet is much bigger, market participants more prepared and despite more than two years of QT, reserves plentiful.
"This is just a normal quarter-end spike we have had for over a decade. It went away for a few years but now seems to be back. I don't think the Fed takes any signal from it other than balance sheet limitations have become a bit more binding," former New York Fed analyst Joseph Wang said.
The Fed's overnight reverse repo facility also saw inflows of USD466 billion on Sept 30, the most since June. That's another indication of excess liquidity, as money funds needed to put their money somewhere and had less ability to do so as dealer stock shrank, former senior Fed Board economist Bill Nelson noted.
"September 2019 was more about a demand-supply mismatch in the repo market, aggravated by perhaps reserve balances being somewhat less abundant than before. In this instance I don’t see any of that," Nelson, now chief economist at the Bank Policy Institute, said in an interview. "Currently reserves are not scarce, so it should not cause anyone to rethink QT."
BIGGER TESTS LOOM
Whether the standing repo facility can be an effective ceiling tool when bigger shocks hit funding markets is still up for debate, the analysts and economists said. (See: MNI: Fed Repo Facility Seen As 1st Step To Address Market Clogs)
Last week, banks borrowed only USD2.6 billion at rates near 5.0% on a day where USD94 billion of Treasury GCF repo traded at an average rate of 5.22% and USD74 billion of MBS GCF traded at 5.45% on average, according to a Wrightson ICAP note.
Some of the facility's operational parameters acted as a hindrance. It is structured as a daily afternoon auction open to primary dealers and commercial banks who have registered for access. The vast majority of large dealer transactions conclude by morning and not all banks have signed up.
A more fundamental issue is that access is limited to banks when nonbank investors are now major players in the repo market. Sponsored repo trades involving hedge funds have ballooned to USD1.4 trillion from USD300 billion before the hiking cycle, according to a Wells Fargo note. The Fed has been reluctant to open access to nonbank counterparties despite the high-quality collateral required to transact.
"It’s a marginally useful facility that will never be an effective facility for limiting spikes to repo unless they open it up to the large borrowers, which include hedge funds," Nelson said.