Markets have experienced some topsy-turvy momentum the last several weeks for various reasons and the repo market is showing some signs of stress. The alleged attacks from Iran on Saudi Arabia moved oil futures as much as 20% in one day. In case you were counting, that is the most oil has moved in one day since futures were created in the 1980s. Movement like this puts pressure on the system, and cracks appear that normally don’t. The attack disrupted 5% of the world’s production, which is not a tiny amount, but for it to move between 10% and 20% in a day is preposterous. That’s why over the last several weeks, the global slowdown is being realized in how fast the price has come back down. Many countries have reserves and can pick up the slack in the meantime. When many of these oil-producing countries get desperate because government can’t meet obligations, some mysterious attack happens to push the price upward.
When prices rise, these governments receive more capital to fund operations. Is this one of those times? This drastic increase in oil has put some pressure on dollar reserves, I would imagine. Several reports from various news outlets are discussing the Fed operating in the repo market. This is the first such instance of the Fed stepping into the repo market in 10 years. Essentially what this means is there is a short-term dollar shortage and the Fed needed to step in to provide liquidity in the short-term funding market. It’s almost like a light form of QE, but at some point in the near future, you will hear that QE4 is back on. The Fed was to conduct operations in the repo market, where $53 billion would be injected into the system and then an additional $75 billion.
Over the last several days, the Fed announced that this standing repo facility would be part of market operations every day until October 10th. These injections are now up to $100 billion per day. If all of this funding and short-term rates are needed to keep the cracks from showing and avoid the next crisis, we are in some trouble. Demand for dollars is extremely high, and institutions can’t find liquidity fast enough to grease the banking wheels. The New York Fed posted this chart on their website for anyone’s perusal. Metrics can be described as the upper bound in the Fed funds rate sitting at 2.25%. Between 9/13 and 9/17 shows the effective Fed funds rate at 2.25% to 2.30%. At one point overnight, rates increased 10% from 2.14% to 2.37%. Some possible reasons for cracks to show up in the plumbing include dollar strength versus other currencies, structural issues where a credit freeze could be imminent, or banks not trusting each other.
When banks don’t trust each other, they tend to deposit money with the Fed to insure a guaranteed return instead of depositing with another bank at a higher rate. The repo market is a collateralized interest rate market that banks and institutions use to fund short-term operations. Institutions use assets they have as collateral to receive short-term cash for the liquidity problem they’re having. This graphic shows the Fed accepted Treasury-, agency-, and mortgage-backed securities. By buying these assets and pumping cash in the system, the repo rate will settle back down near zero. The Fed tried this a few weeks ago and after several failed attempts, the transmission went through.
Severe stress in the system has led investors into bonds as a normal recessionary tactic. The benchmark 10-year Treasury has bounced between 1.45% and 2% much of the last few months. This quite volatile movement in bonds has led to liquidations and margin calls, all while the Fed was reducing the balance sheet. This volatility has put many investors, institutions, and average Joes in a precarious position.
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