Repo Report: Our Answers to Key Investor Questions

We offer our insights on the recent stress in the repo market, a key source of short-term funding in the United States.

A spike in short-term borrowing costs in the so-called “repo” market—a normally quiet corner of U.S. fixed income that provides overnight funding for financial institutions—on Tuesday, September 17, has generated many headlines in financial media. We have received a number of investor queries about the impact of this short-lived dislocation on financial markets and investment portfolios. Here, we respond to some of the most common questions investors may have.

What is a “repo”?
A repurchase agreement (or “repo”) is a sale of securities, often government-related securities, for cash with a commitment to repurchase those securities at a specified price at a future date. This is a common form of short-term borrowing, typically on an overnight basis.

Banks and broker-dealers try to minimize the amount of excess cash on their books while optimizing the activities that cash is used for. They have several tools at their disposal for making their activities more efficient and the repo market is perhaps the most broadly used. The repo market connects entities that need short-term cash with those who have it, using U.S. Treasuries and agency mortgages as collateral for short-term loans.

How are repo rates determined?
The U.S. Federal Reserve (Fed) acts like a banker for the major banks, and essentially controls overnight rates by requiring that banks keep a certain percent of their assets in reserve at the Fed every night. (Overnight repo borrowing rates are not identical to the fed funds rate; however, they tend to be roughly in the range of the fed funds target rate.) Banks are permitted to lend excess reserves to one another, and the Fed will increase or decrease the quantity of these excess reserves in circulation by lending or borrowing (repo and reverse repo). They target a range for this overnight fed funds rate. While repo rates tend to track the Fed Funds target range, short-term imbalances can cause the rates to diverge. 

What caused this week’s spike?
There were a number of technical factors that may have impacted short-term rates, including the deadline for quarterly corporate tax payments coinciding with the settlement date for a Treasury auction, which led to an estimated decrease of $100 billion in cash available for short-term financing this week, according to a Bloomberg report. At the same time, there has been increased demand for short-term financing, as increased Treasury issuance has led to an increase in Treasury securities being held on dealer inventories. This supply/demand imbalance for overnight funding helped drive the spike in rates.

As noted earlier, repo rates will generally track the fed funds rate. On Tuesday, September 17, repo rates traded well above fed funds, in a few rare cases spiking to the 8%–10% range—well above the Fed’s target of 2.00%–2.25% (subsequently lowered on Wednesday to 1.75%–2.00%). That is what prompted the Fed to intervene in the market.

How did the Fed respond?
The Federal Reserve Bank of New York, the regional Fed bank which handles open-market activities, intervened by announcing overnight repo operations in the fed funds market of up to $75 billion for primary dealers on Tuesday, injecting cash into the market on a short-term basis for the first time since 2009. (While the cash squeeze occurred outside the fed funds market, the New York Fed’s liquidity operations are conducted in the fed funds market.)  Approximately $53 billion of liquidity was accessed on Tuesday, and an additional $75 billion was accessed on Wednesday, Thursday, and Friday. As of the end of the week (Friday, September 20) the markets had calmed down quite a bit, with rates returning to more normal levels.

The Fed likely will continue to monitor the repo market closely after the recent stress. However, as former New York Fed president Bill Dudley noted in a recent Bloomberg commentary, “[t]he incident is not a harbinger of deeper market problems … [r]ather, it provides a useful signal for the Fed, which has been seeking the right level of reserves for the smooth functioning of financial markets.”

What about other segments of the fixed-income market?
Other areas of fixed income appeared to be unscathed by the early-week stress in the repo market. For example, credit spreads on high yield and investment-grade corporate bonds actually tightened over the past week, indicating that there has not been stress in other parts of the credit markets.

What might this mean for short- and ultra short-duration strategies?
The move in repo rates had little if any impact on the performance of securities typically included in short- and ultra short-duration fixed income strategies, such as short-term corporate bonds, asset-backed securities (ABS), commercial mortgage-backed securities, and floating rate notes. If anything, the short-term dislocation in the repo market presented managers with a potential opportunity to lock in some higher than usual yields on commercial paper.

One other point worth noting: The short maturity nature of the securities found in short- and ultra short-duration strategies provides managers the potential flexibility and liquidity to invest every day, and can potentially provide liquidity when the market needs it most.

Are there long-term implications?
The big move in short-term rates was primarily caused by the short-term technical imbalances mentioned earlier and is not, in our opinion, a signal of significant credit concerns. We do not believe the repo market activity this week indicates any material stress in the financial system. Still, given the importance of the repo market to the functioning of the U.S. financial system, the Fed may consider a longer-term fix to ensure that the funding markets can operate properly in the case of similar imbalances in the future. We will continue to keep a close eye on potential Fed moves and other developments in the U.S. overnight funding markets.