Every few quarters, the repurchase (repo) market seems to experience a new event, with the ensuing headlines fostering a renewed awareness of the importance of this keystone of our financial system. Functionally simple, a repo is a collateralized transaction whereby monies are exchanged, with cash on one side and securities – typically bonds or equities – on the other. Although repurchase agreements are an important source of cash for short-term borrowers and lenders, the repo market has also become an oft-overlooked source of risk, as well as an untimely scapegoat of market volatility over the past few decades.
The global financial crisis of 2008 provided investors with many lessons. Among them was the fragility of our financial system when repo trades were a primary source of structural leverage for many institutional market participants. Concerns were again raised in September 2019 when the “great repo blowup” occurred with overnight funding levels reaching more than 10% annualized, only to have the U.S. Federal Reserve (Fed) step in and use repo operations as a salve for irritated market conditions. Subsequently, in March 2020, the early stages of the COVID-19 pandemic ushered in the “great pullback” of financing, with banks and repo desks hoarding cash, rather than deploying it into the marketplace.
What a difference a year makes.
Prior periods of stress resulted in funding spreads moving markedly wider and aggregate financing rates rising stratospherically in concert with a dearth of liquidity and tight financial conditions. Today we are faced with the corollary and are experiencing a period of abundant cash and liquidity in short-term funding and investment markets.
A flood of liquidity is pressuring repo rates
Cash is so abundant because we are seeing not only easier financial conditions in the macro economy, but also historically low benchmark rates across many money-market indicators. In fact, Libor rates and T-bill yields are now at historical lows. Investors are maniacally searching for a home for excess cash due to a trifecta of lower T-bill supply, a reduction in cash balances at the U.S. Treasury’s general account, and regulatory changes resulting in lower banking reserves. These factors are all contributing to reduced demand for cash.
Repo markets are symptomatic of these conditions. Average overnight repo levels for invested cash had been hovering near 0% for the past few months, with a reasonable volume actually being printed at negative yields later in trading sessions when some investors are left with few options. So instead of difficult financing conditions, investors have been experiencing difficult conditions for investing capital.
Fed proactively using RRP facility as a safety valve
One of the safety valves again being utilized by investors during this unprecedented era of monetary policy is the Federal Reserve’s reverse repo facility (RRP). This facility allows for eligible counterparties – mostly regulated money-market funds – to invest cash at the prevailing benchmark rate for the RRP, which was previously set at 0% until the June FOMC meeting when the rate was hiked five basis points (bps). Much has been made of the RRP’s ballooning balance, which has recently exceeded $800 billion. While some observers view this as a signal that the repo market is about to crack, we do not share this view. The Fed has acted in a preemptive manner by increasing counterparty notional caps and RRP levels to prepare for this tsunami of cash. Furthermore, the RRP is designed to actually grow much larger, which is a good thing given our forecasts for excess systemic cash. We believe current RRP balances may only be scratching the surface.
For context, during 2016-2017, when the RRP was last routinely utilized, RRP volumes occasionally approached 24% of total monetary reserves, whereas current volumes are approximately 20% of reserves. We would argue that the optics of the high RRP prints look worse than they really are. Fortunately, the Fed made these changes in advance and is helping to keep a lid on deep negative investing levels. In short, the RRP is working as it was meant to by functionally maintaining a “soft floor.”
The most recent hike in the RRP rate was likely to prevent the possibility of any “soft” closes at money-market funds, since investing at 0 bps would likely become uneconomical in the long run. A “soft close,” or outright closure of a portion of money-market funds, could have fundamentally altered the foundation of liquidity management and potentially served as an inciting action for further volatility in short-term rates as investors attempted to find “risk-free” homes for their capital. This rate move helps to placate any unforeseen operational issues with funds investing at 0% and earning no income to offset operating costs.
Dealer balance sheets currently open for business but for how long?
PIMCO’s short-term desk believes that exploding RRP volumes do not signal stress but could exacerbate a future stress event once the flood of cash on the front end subsides. The financial markets can maintain this environment for now, but it could lead to future balance sheet pressure at banks.
Financing spreads are so thin and repo desks are generating only a fraction of the revenue earned in recent years. This bears mentioning since many firms’ balance sheets could get deployed to other areas, and if stress returns to the repo market, it will take some time for balance sheets to be properly redeployed, thereby affecting short-term borrowing dynamics. Clearly, dealer balance sheets are an important cog of the repo plumbing. Without their participation, the rest of the financial system could feel the pain.
The road ahead
For investors, even with the recent modest move higher in money-market yields, there are likely valid reasons to pivot away from traditional forms of cash management. For borrowers, while conditions appear to be accommodative due to low nominal rates, we would encourage closely monitoring the risk appetite of banks and financial intermediaries. For the time being, expect bleak returns for repo desks and continued capital re-allocation.