Repo Market: What is it?
We join those who believe the “panic” in the repurchase agreement (Repo) market has been the main reason many markets rose in 2019. Who would have thought the Repo market – consisting mainly of AAA-rated risk-free securities backed by the United States of America – would be a market in turmoil!
So, what is a Repo? A Repo is basically a secured loan – mainly backed by government securities but includes some mortgages as collateral. These loans are typically short-term, usually one day. However, either party can extend the maturity period.
In a Repo trade, banks and Wall Street firms, to finance their trading and lending, offer the aforementioned collateral to raise cash. If it is a one-day loan, borrowers repay the loans plus some nominal rate of interest and get their bonds back – repurchasing or Repo-ing their bonds. The Repo market ensures banks and Wall Street firms have liquidity to meet their daily operational needs – underpinning much of the U.S. financial system.
The big four banks – JPMorgan, Citibank, Wells Fargo and Bank America – account for more than half of all Treasuries held by banks at the Federal Reserve (FED). As such, they have become important providers of funds to Repo markets. The system typically works with the interest rate charged on Repo deals hovering close to the FED’s benchmark overnight rate – ranging from 1.50% – 2.25% recently.
In September, interest rates in the Repo market spiked as high as 10% for some overnight loans – more than four times the FED’s policy rate at that time! Liquidity concerns and the fragility of the U.S. dollar funding markets were raised.
Cash available for short-term funding – the willingness of the top four banks to lend cash – along with a sudden demand from hedge funds for secured funding may explain this spike. The FED was forced to make an emergency injection of billions of dollars into this market to stabilize it. This is the first time this was necessary since the financial crisis of 2008. Not only did the FED inject liquidity into this market in September, but they have continued to do so to this day. Consequently, a lot of this money has found its way into many different markets – notably stock and bond markets being big beneficiaries of this policy in 2019.
History: The size of the Repo market relative to the size of the Treasury market is about 23%, the same level as about 40 years ago. It is too small. The reason for this problem is too many Global Systemically Important Banks (GSIB – too big to fail) rules instituted as a result of the 2008 financial crisis. Specifically, the rules created by Dodd-Frank and Basel III constricted banks from their normal functions. To make a long story short, these rules have prevented large banks from providing the needed liquidity to the Repo market. The FED, as a result, has had to prop up this market by adding billions of dollars.
This liquidity – the FED buying Treasury bills this time around – is Quantitative Easing (QE) 4. We have already had QE1, QE2, and QE3. These unprecedented amounts of money, finding their way into our markets, have elevated the stock market to new highs and extreme overvaluation, and near new lows in yields in the bond market.
Market Commentary:
So, by the FED adding more liquidity to the markets as explained above, what will happen when they decide to exit this strategy? In the past, when they have reduced their exposure through Quantitative Tightening (QT – not buying any more bills/bonds and reducing their balance sheet), as they attempted in the fourth quarter of 2018, the markets corrected a lot and quickly. The FED has wanted for some time now to get out of the business of propping up the markets. Continued uncertainly for future FED actions creates the possibility of unsettling times, but it also presents opportunity for the future. We are keeping some cash reserves while waiting for better valuations and better investment entry points.
We appreciate and thank you for the trust and confidence you have placed in Occam Capital® Management, LLC.