Repo Madness 2.0? Not Yet, But Forget About Fed Tapering

(Bloomberg Opinion) -- As if Federal Reserve Chair Jerome Powell didn't have enough on his mind, repo is getting weird again.

You remember repo, of course: It's the critical part of financial-market plumbing that Powell and other policy makers had to fire a bazooka at last year after a nasty flare-up in mid-September. In fact, the New York Fed released a report this week that serves as something of post-mortem on the funding stresses during that period. They thought they had it fixed.

Perhaps not. The New York Fed's overnight system repurchase agreement operation was oversubscribed for the second consecutive session on Wednesday, with dealers submitting about $111 billion of bids compared with the maximum $100 billion on offer. Before this week, that hadn't happened since October. The New York Fed's 14-day term repo offering on Tuesday was even more strained, with dealers submitting more than three times as many securities ($71 billion) as the bank was willing to accept ($20 billion). 

Powell, of course, just delivered the Fed's first emergency interest-rate cut since 2008 to combat the growing threat of a coronavirus pandemic, a shock that monetary policy isn't well-equipped to handle. And yet bond traders are already demanding further easing after he and other policy makers meet later this month. He can't seem to win.

The same goes for repo and the Fed's $4.2 trillion balance sheet. Bloomberg News's Alexandra Harris reported that money-market funds were one step ahead of Powell and the Fed's 50-basis-point interest-rate reduction. They pulled cash from repo and piled into Treasury bills before the easing, ensuring a higher rate. Ian Burdette, managing director at Academy Securities, told Harris that the Fed was “taunting the market” and it “gave people enough of an incentive to get some duration, which of course left a hole in available repo.”

That sort of yield-curve steepening is precisely what worries Zoltan Pozsar at Credit Suisse Group AG. He was the talk of financial markets last year for warning about a potential repo squeeze before September's episode. He's back, this time expressing concern that aggressive interest-rate cuts from the Fed will cause dollars to move from money-market accounts into longer-dated bonds, which curbs the capital needed to offset funding strains. Pozsar says, among other things, that the Fed should pledge to use an uncapped repurchase facility and outright quantitative easing if necessary.

Open-ended liquidity injections are quite the opposite of what the Fed had in mind just a few weeks ago. Powell had this to say about the central bank's vast repo operations and monthly Treasury bill purchases after January's Federal Open Market Committee meeting:

“Based on current projections, we expect that the bill purchases will durably bring the underlying level of reserves to the ample level sometime in the second quarter of this year. And when we see that we've reached that level, we'll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities. As our bill purchases bring the underlying level of reserves up to an ample level on a sustained basis, the necessary quantity of overnight and term repo will gradually decline.

We've already begun the gradual reduction in the quantity of repo, and we'll continue to reduce those offering amounts gradually as conditions permit. At some point, we'll also raise the minimum bid rate. Even after we reach an ample level of reserves, it's possible that repo operations might play a role as a backstop and support effective control of the federal funds rate. And we'll continue to discuss that issue and review it under our implementation framework.”

Clearly, the worldwide coronavirus outbreak and the ensuing financial-market volatility and central bank actions have rendered this assessment meaningless. The Fed won't be in a hurry to reduce its Treasury bill purchases after April. Not when bond traders are pricing in an additional two quarter-point interest-rate cuts by mid-year, at a minimum.

“Forestalling tapering the non-QE bill buying program is low hanging fruit and, frankly, is exactly the type of liquidity injection which would benefit the front-end of the market and delay the transfer of tighter financial conditions into funding constraints,” wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.

After U.S. stocks fell last week by the most since 2008, I made the point that markets are in crisis, not the financial system. That's still true, but a closely watched spread known as FRA/OIS continues to widen by the day in what could be an early indication that funding markets are tightening. 

To Pozsar, the coronavirus poses another unique risk to the market's plumbing. Some Fed watchers have argued that the central bank can't fight a supply shock, only a hit to demand. But “the supply chain is a payment chain in reverse,” Pozsar wrote. “A mass drawdown of corporate credit lines due to missed payments could push the U.S. banking system back into deficit in short order.” 

St. Louis Fed President James Bullard said in an interview Wednesday with Bloomberg TV's Kathleen Hays that the Fed would be reviewing its repo policy after April, adding that the central bank could look to use the operations as a way to take pressure off interest-rate cuts. That seems like wishful thinking — it's more likely they'll have to do both.

Whether this latest bout of repo market turmoil quickly dissipates or lingers for weeks, one thing is clear: Don't expect the Fed to taper its “not QE” program anytime soon.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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