Executive summary:
- Quantitative tightening (QT) has been underway since June 2022, with the Fed shrinking its balance sheet in order to bring reserves and liquidity in the financial system back down to more normal levels.
- The overnight reverse repo facility is now getting down to low levels, raising questions about whether another breakdown in financial market liquidity and stress in short-term funding markets could occur.
- At this time, we believe a repeat of the unexpected rate spike of September 2019 is unlikely. Current liquidity conditions are normal.
What is the repo market and how did it change after the Global Financial Crisis (GFC)?
The U.S. repurchase agreement, or “repo” market, provides more than $3 trillion in short-term funding each day. Most repo transactions are overnight and are collateralized by Treasuries. Repos (to get cash) and reverse repos (to lend cash) are used for short-term borrowing and lending.
With the advent of quantitative easing (QE) in 2008, the U.S. Federal Reserve (Fed) moved from a scarce to an ample reserves regime. The Fed used to control rates by managing the supply of bank reserves so that interest rates would clear at target. But now banks frequently hold substantial reserves. These reserves are now managed and incentivized by the Fed, which pays interest rate on reserve balances (IORB). Non-banks, such as money market funds, can also park money at the Fed’s Overnight Reverse Repo Facility (ON RRP).
These two mechanisms act as a floor system, allowing the Fed to control short-term interest rates. For example, if interbank rates fell below IORB, a bank could make more money using the Fed facility and would do so.
What happened in 2019?
Basically, we saw stresses in money markets appear suddenly when reserves became scarce in September of 2019. The Fed started quantitative tightening (QT) in the fall of 2017, and by mid-September 2019, the Fed had drained $700 billion in reserves from the financial system. On Sept. 16, 2019, $70 billion was withdrawn from banks and money market funds to meet quarterly tax payments, while $50 billion in long-term Treasuries also settled—these securities were purchased by dealers, pressuring their reserve constraints.
Collectively, this resulted in a large outflow of liquidity, and strains emerged in short-term funding markets. For example, the Secured Overnight Financing Rate (SOFR) traded 300 basis points above the federal funds rate, with some repo trades touching 9%. These stresses bled into other short-term funding markets, including A2 non-financial commercial paper, which jumped from 2.25% to 3.7%. Long-term interest rates, however, were not impacted.
The crisis ended the next day—on Sept. 17—when the Fed stepped in with billions of dollars of repo liquidity for markets.
How the Fed responded and why it makes a repeat of 2019 unlikely
First, it’s important to note that in 2019 and 2020, the Fed provided repos reactively as a firefighting tool. Reflecting on these market failures, the Fed created a new standing repo facility, which is always available to meet liquidity needs proactively going forward. In fact, the new standing repurchase agreement facility (SRF) has $500 billion of capacity, which we believe is enough to meet liquidity needs during future stress periods.
At the same time, another Fed repo facility called FIMA was created to allow foreign central banks to access dollar liquidity as well. As a general point, the Fed tries to avoid making the same mistake. Indeed, the Fed announced this month that it would slow the pace of QT on its Treasury securities from $60 billion to $25 billion per month—in part to reduce the risk of another liquidity flareup.
For the longer term, the U.S. Securities and Exchange Commission (SEC) ruling from December 2023 forces a shift to central clearing of repo by June 30, 2026.
What could still go wrong?
The Treasury market appears more fragile than it was before the GFC. At any given point, algorithms make up 60%-80% of Treasury trading depth and algorithms tend to "turn off" when volatility is high during a market scare. Because of this, risk-off events tend to increase fragility, with dealers also constrained by post-GFC capital rules.
There’s an inherent circularity between the Fed and markets. That is, the Fed doesn’t—and can’t—know in advance the point where reserves will flip from being ample to scarce. The Fed looks to markets for signs and pressures that they might be getting close to a tipping point.
In remarks made on March 1, 2024, at the U.S. Monetary Policy Forum in New York, Fed Governor Christopher Waller stated that usage of the SRF backstop may signal when reserves are close to ample. This leaves directional illiquidity risk in markets even if the magnitude of those risks is tempered by the new backstops.
The bottom line
Simply put, we don’t think a repeat of 2019 is likely. What is beginning to happen is that there are new protocols in Treasury markets for trading all-to-all participants. These algorithms will reduce capital, and hedge funds will begin to step in. As these protocols get built out, more non-traditional price makers and market participants will be able to help support unexpected stress in the Treasury market.
The institutional features are in place and these changes in market structure are actually reducing the risk of a repeat of 2019. We will continue to monitor liquidity conditions, which are normal for now.