Throughout 2019, banks’ end-of-quarter tidying of their balance sheets has resulted in spikes in the U.S. overnight repurchase agreement (repo) rates. This volatility has set the market on edge. The Federal Reserve stepped in, with traders injecting cash into U.S. money markets. As a result, the last day of the third quarter (Monday) was relatively uneventful in the repo market.
Still, this year’s market volatility signals a broader risk. As a recent report from Fitch Ratings puts it: “While the Fed was ultimately able to stabilize repo dollar funding rates through ad-hoc funding infusions, further repo-market volatility could exacerbate global liquidity issues, potentially extending to other asset classes and players beyond the U.S. repo market.”
Large banks shouldn’t be much affected, both because their required liquidity coverage ratios lead to close matching of repo assets and liabilities, and because they rely more on retail deposit funding than on wholesale funding sources. However, smaller broker-dealers, mortgage real estate investment trusts (REITs), and hedge funds may be hit hard if borrowing costs in the repo market spike and remain high. Exposure to a volatile market for funding might also affect those entities’ perceived credit risk, which could have further ramifications for the economy at large.
On the flip side, lenders in the overnight repo market benefit when repo rates rise. In mid-September, money fund investors saw a couple of days of significantly higher yields, with one fund reaching a yield of 5.56 percent.
If repo-market volatility persists, the Fed may have to pull out some other tools, such as a permanent standing facility, according to Fitch Ratings. “This would create an effective ceiling on overnight rates that would allow players in the repo market to obtain sufficient dollar liquidity at reasonable costs,” say Monsur Hussain, senior director for financial institution research; Brian Coulton, chief economist; Nathan Flanders, managing director for non-bank financial institutions; and Greg Fayvilevich, senior director for funds and asset management. “The possibility of resuming organic growth in the balance sheet to boost reserves as currency demand increases might also be considered.”
They conclude: “Keeping price volatility and liquidity risks from spreading beyond the U.S. repo market may be especially relevant—and more difficult—with exogenous event risks such as Brexit-related FX [foreign exchange] disturbances or protracted trade wars.”