The Fed’s Growing Repo Problem
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Occasionally, problems reveal themselves gradually. A water stain on the ceiling is usually evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling.” The problem has appeared to vanish.
Every day the stain reappears and the Fed’s work begins anew.
One is left to wonder why the leak hasn’t been fixed.
In mid-September, problems in the U.S. banking system appeared. The problem occurred in the overnight funding markets that serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasury securites was an eight standard deviation event. Statistically, such an event should occur once every three billion years.
For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.
At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that it lacked a reasonable explanation for the disruption. Since then, my surprise has turned to concern and suspicion.
I harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing.