It might not be time to really get nervous about US money markets, but it’s definitely time to pay more attention. Signs of strain emerged as September turned into October this week — it wasn’t completely wild, but the tensions were the worst since early 2020.
The Federal Reserve isn’t yet concerned, but still this shouldn’t be happening right now. This week’s jump in borrowing costs suggests a couple of scenarios: Either large banks need more spare cash than the Fed has assumed, in which case it will have to halt its quantitative tightening sooner than it plans; or there are blockages in the financial plumbing that mean banks’ reserves aren’t as mobile as they should be and the central bank needs to work out why.
Getting this wrong could generate severe disruptions in repo markets, where hedge funds and dealers swap Treasuries for short-term cash loans from money-market funds, banks and others. There were huge spikes in repo rates in September 2019, the last time bank reserves got too low. This matters because these money-market rates are the foundations of borrowing costs for almost everything else, interfering with the Fed’s monetary policy.
Lending capacity in money markets often gets tested at the end of a quarter. This is when banks and dealers rein in their activities and shrink their balance sheets so they can meet capital requirements in their reported accounts.
However, the puzzle is why this quarter provoked repo market strains. US banks still have nearly $3.2 trillion of spare reserves, which is the special money used for payments between banks, the Fed and the Treasury Department. That total is plenty compared with the amount the Fed considers to be ample, which is equivalent to 9% of gross domestic product, or about $2.7 trillion. Plus, the central bank in 2021 created a permanent stigma-free short-term lending facility that is meant to alleviate any emerging strains as they appear and put a ceiling on repo rates.
For three days this week, the secured overnight financing rate (SOFR), which is the cost of borrowing cash against Treasuries, jumped above the 4.9% rate that banks earn on spare reserves they keep at the Fed. That hasn’t happened since the onset of Covid-19 in early 2020. The difference was relatively small, between 0.02 and 0.15 percentage points, but banks could have got paid more by lending cash overnight in exchange for government bonds rather than leaving it idle at the central bank.
On one day, Oct. 1, SOFR hit 5.05%, which is above the 5% minimum cost of borrowing from the Fed’s stigma-free standing repo facility (SRF). Other repo rates were even higher, up to 5.35% for general collateral, according to analysts at Wells Fargo & Co. Banks could have borrowed cash from the Fed, turned around and loaned it straight out for a profit. The facility was used on Sept. 30, but only $2.6 billion was drawn, according to the New York Federal Reserve, which manages these operations.
Why are banks leaving apparently free money on the table? One issue is that borrowing via the Fed’s repo facility isn’t done through a central clearing house, so when a bank relends the borrowed funds, it can’t net off the two trades against each other. The bank either must expand its balance sheet or cut back on some other kind of lending. Each option implies a cost.
This might mean repo rates just need to rise higher before trades like this are profitable enough for banks bother with. Also, even the slightest risk of stigma being attached to borrowing from the Fed might make bank executives reluctant to use it until the arbitrage profit available is so obvious that the trade is a no-brainer, according to Joseph Abate, analyst at Barclays Plc.
Either way, the standing repo facility might not function as smoothly, or ease strains as quickly as the Fed hoped, which is a worry as it’s the first defense against money-market mayhem. If it were tweaked to use central clearing, it would be easier on banks and could be offered to other kinds of borrowers that can’t currently access it, such as pensions, insurers or even hedge funds.
The other issue is that hedge funds’ demand for Treasuries and use of repo have increased enormously since 2019 and are already clogging up the balance sheets of banks and dealers. This is partly down to the growth of leverage used by big multi-strategy hedge funds, as I wrote about recently.
Repo usage by all hedge funds was $2.2 trillion at the end of June, according to the most recent data from the Office of Financial Research, part of the Treasury. That is up from $1.3 trillion at the end of September 2019. To ease pressure on their balance sheets, banks are already putting more repo activity through a centrally cleared sponsored repo platform, where volumes have risen sharply over the past two years, according to OFR data.
But for all lenders there’s another wrinkle that might help explain why money-market funds are also still handing spare cash to the Fed through its reverse repo facility rather than earning higher rates in repo markets. That issue is the caps on how much any lender can offer to any individual borrower, or counterparty risk limits. Even if dealers and money-market funds have spare cash, they might have maxed out exposure to the clients or counterparties that most want to borrow. The money spare in the system maybe can’t move as freely as it once did, as Abate put it.
Some of this could be solved, or at least ameliorated, by dealers signing up more hedge funds and money funds to use centrally cleared sponsored repo, although that does entail higher margin requirements and so higher costs for borrowers. But these strains also signal that banks and money markets are getting closer to becoming more vulnerable to tipping points in liquidity and lending capacity. The Fed will soon have to start treading much more carefully.
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