This box focuses on the distribution of liquid assets in the US banking system and how it became an underlying structural factor that could have amplified the repo rate reaction. US repo markets currently rely heavily on four banks as marginal lenders. As the composition of their liquid assets became more skewed towards US Treasuries, their ability to supply funding at short notice in repo markets was diminished. At the same time, increased demand for funding from leveraged financial institutions (eg hedge funds) via Treasury repos appears to have compounded the strains of the temporary factors. Finally, the stress may have been amplified in part by hysteresis effects brought about by a long period of abundant reserves, owing to the Federal Reserve's large-scale asset purchases.
Since 17 September, the Federal Reserve has taken various measures to supply more reserves and alleviate repo market pressures. These operations were expanded in scope to term repos (of two to six weeks) and increased in size and time horizon (at least through January 2020). [icon] The Federal Reserve further announced on 11 October the purchase of Treasury bills at an initial pace of $60 billion per month to offset the increase in non-reserve liabilities (eg the TGA). These ongoing operations have calmed markets.
It is easy to point the finger for the surge in repo rates last September at the feet of the big US four banks. However, that would be to ignore the fact banks have been forced, through the imposition of greater financial regulations, to hold more treasuries as insurance against another calamity. The low participation in the repo market by its traditional market markets created a dearth of liquidity. The US Treasury’s desire to increase its cash holdings, following the increase in Federal debt limit, was probably the catalyst for the subsequent squeeze.
The Fed’s response has been both swift and large. $60 billion a month in ongoing stimulus is more than the last round of QE. What I find particularly interesting in the BIS report is the use of the word hysteresis. It’s from physical science and describes how the “output of a system depends not only on its input, but also on its history of past inputs.” When applied to the social science of economics we might describe it another way “give them an inch and they take a mile”.
The liquidity environment that has been in effect for more than a decade has resulted in some very large leveraged positions and the Fed’s policy of balance sheet normalisation siphoned a lot of liquidity from the market. They have now reversed course and if the balance sheet expansion persists at its current rate it will be hitting new highs next year. That is a clear tailwind for risk assets and confirms to investors the Powell Put extends to an increasingly large array of asset classes.
This article from Bloomberg detailing expected liquidity injections over the balance of the month may also be of interest.Back to top