Eve is here. I’m still of two minds about calling attention to the Fed’s pre-year-end actions on its repo facility. One of the most notable aspects of the 2019 lipo panic was the number of instances in which commentators raged over the Nothing Burger. This was another one.
Several readers emailed us, citing wild testimony from supposed experts about the surge in repo facility use in late December, and painting it as if it represented a stealth bank bailout. We have receipts from email responses at the time where this reaction was overblown. At the time, we didn’t even want to dignify this idea by expanding it with refutation (research on cognitive biases shows that trying to debunk it is actually very difficult to do effectively; it more often has the effect of reinforcing the message you’re trying to refute).
Wolf presents the data. Like us, he points out that the end of the year is generally a time of low liquidity. Many institutional investors are looking to close their books on December 15th.
Additionally, the Fed has changed the way it manages short-term liquidity, which, as far as I can tell (expert comments welcome), seems to make matters worse in times of crisis. After the crisis, there was a shift from managing short-term liquidity primarily through daily open market operations to paying interest on reserves, a completely unfair gimmick for banks. This approach works well operationally in easy monetary conditions, but not in tight monetary cycles. Three months before the 2019 repo panic, the New York Fed “lost” two of its top traders on its money desk. I think by this they are saying that the department’s role is being reduced. My understanding, based on subsequent events, is that the Fed has been, and continues to be, incompetent at using repo facilities as an alternative to money desk intervention. The decline in the role of the New York Fed’s once-all-important money desk may also have led to a loss of market intelligence.
Additionally, towards the end of this year, CME will significantly increase margin requirements for some metals. It’s not hard to imagine that some banks were hoarding liquidity in case hedge companies misplaced by this move slashed their borrowing limits to meet margin calls.
We asked Satyajit Das, then the guru of derivatives, to read it. From his reply:
1. The situation in the money market is unstable mainly because it is the end of the year and because the Ministry of Finance relies on Treasury Bills for funding. There is also serious uncertainty surrounding the Federal Reserve and interest rates. We are aware that banks’ funding costs are increasing for these reasons. An additional factor is concerns about trust “cockroaches” (to use J.P. Morgan CEO Dimon’s expression) lurking in the system, which could result in greater credit losses than specified. Exposure to hedge funds and commodity businesses is a concern due to increased margin calls due to heightened price volatility.
2. I am aware that the Fed is ramping up repo operations to “smooth out” short-term fluctuations. This is part of your normal responsibilities. The amount mentioned in the article or the scheme as a whole is not that large.
Written by Wolf Richter, editor of Wolf Street. First appearance: Wolf Street
The balance of the Fed’s Standing Repo Facility (SRF), an asset on the Fed’s balance sheet, returned to zero today, with all repos from Friday unwinding as expected, and today’s two auctions resulted in zero new repos.
SRF jumped from zero before Christmas to $75 billion on Dec. 31 as part of a year-end liquidity shift, and that $75 billion was the largest contributor to the $104 billion jump in the Fed’s weekly balance sheet as of the close of business on Wednesday, Dec. 31.
However, this surge has now been completely reversed. And the Fed’s next weekly balance sheet, released Thursday, will show a significant decline in total assets.
At the end of the year, a large amount of liquidity moved into the market, creating tight spots in some regions as reflected in the sharp rise in repo market rates such as SOFR, and excesses in others as reflected in the sharp rise in the Fed’s overnight reverse repos (ON RRP), which drained liquidity from the market.
A tight spot appeared in the repo market interest rate tracked by SOFR, which emerged at the end of December, and some transaction rates reached 4.0% on December 31st. On that day, SOFR (median rate calculation for the day) jumped to 3.87%.
This spike in repo rates allowed banks to profit by borrowing $75 billion in SRF at 3.75% on Dec. 31 and lending to the repo market at higher rates through the holiday and into Friday morning.
On Friday, January 2, repo market rates fell (highest at 3.87%, SOFR fell to 3.75%), the profit opportunity disappeared, banks unwinded most of the repos in SRF on Friday, the rest today, and the balance returned to zero today.
However, the Fed’s weekly balance sheet, which shows balances as of Wednesday’s close, recorded a $75 billion one-day wonder increase in SRF that occurred on Wednesday, and was the primary driver of the $104 billion jump in the Fed’s total assets on the balance sheet released Friday.
But the Fed got its $75 billion back, its counterparties got their collateral back, and that $75 billion is now completely unwound and gone from Fed assets.
The excess liquidity that occurred in other parts of the market on December 31 also manifested itself in the Fed’s overnight reverse repo facility (ON RRP). And it almost completely unraveled.
This excess is reflected in the Fed’s ON RRP facility surging to $106 billion on Wednesday, December 31st.
ON RRP primarily reflects surplus funds deposited with the Fed by money market funds. They essentially lend their excess cash to the Fed and earn a 3.5% return on it. Because the Fed owes them this cash, ON RRP becomes a liability on the Fed’s balance sheet.
On Friday, January 2, ON’s RRP balance plummeted to $6 billion from $106 billion on December 31. It currently stands at $6 billion. So, as expected, things have calmed down.
These two Fed programs, SRF and ON RRP, are part of the Fed’s short-term interest rate control system to keep short-term interest rates within the monetary policy rate range (currently 3.5% to 3.75%).
The SRF rate acts as a ceiling rate, one of the tools used to keep overnight rates from exceeding the Fed’s range ceiling (3.75%).
ON RRP interest rate acts as floor interest rate. This is one tool to ensure that short-term interest rates do not fall too far below the lower end of the Fed’s range (3.5%).
And because these two facilities don’t have the same trading partners, interest rates affect different parts of the market. SRF trades with 43 large banks, broker-dealers, and credit unions (I posted an updated list in the comments below). ON RRP’s counterparties are mostly money market funds.
After three years of QT removed $2.43 trillion in liquidity from the market, these types of short-term liquidity changes will be visible at key days of the year, such as year-end, quarter-end, and month-end, and especially tax days, such as around April 15th.
