Federal Reserve suddenly loses control of it's own market
“This just doesn’t look good. You set your target. You’re the all-powerful Fed. You’re supposed to control it and you can’t on Fed day. It looks bad.”
- Michael Schumacher, director rates at Wells Fargo.
If the Fed ever lost control of the repo market, doing so on the very day of the Fed meeting is not the day to do it.
As the Fed was meeting to consider cutting interest rates, it lost control of the very benchmark rate that it manages.
So what the Hell does this mean? I think this is best described here.
It’s a rule of thumb that if you’re even talking about such geeky fare as long-short market-neutral strategies or overnight repurchase agreements, then something has already gone wrong.
You should not even have to be aware of this stuff, and I wouldn't even mention it except that the market essentially broke yesterday, and that might be important. Especially when the Fed basically sets this market.
SOFR is a repo rate: It’s a daily index of the interest rate that banks and hedge funds pay to borrow money overnight, secured by Treasury securities. Repo markets have fallen apart a bit this week, as you might have heard. The Fed’s SOFR data shows some repo trades with interest rates as high as 9% yesterday, and SOFR itself—a volume-weighted index of a broad group of trades—settled at 5.25% yesterday. It was 2.43% on Monday, and had spent the previous month in a range of 2.09% to 2.21%. That’s a normal range, consistent with other short-term interest rates. (The Fed Funds rate is 2.25%, one-month Libor is about 2.04%, one-month Treasury bill rates are about 1.96%, etc.) In the entire (brief) history of SOFR, it had gotten above 3% once, clearing at 3.15% on Jan. 2, 2019. A rate of 5.25% is, in some real but hard-to-define sense, definitely the “wrong” interest rate. It was, however, the SOFR rate yesterday.
So what happened? Yesterday there happened to be less supply and more demand for money, so the rate was high.
That's really what it came down to.
"some weird repo bollocks" happens once every now and then, and the correct response is always¹ to just point and go "hahaha nerrrrd" then go back to some proper work while the roughnecks in the repo mines sort it out.
¹except that one time in 2009 obvs.
— Dan Davies (@dsquareddigest) September 17, 2019
Most times this is not a big thing. The Fed had been slowly shrinking it's portfolio for some time. This helped cause a liquidity shortage.
The Fed responded by doing an emergency repo (which was oversubscribed).
The long-term effect is that the Fed might be restarting it's QE program (i.e. buying bonds), which isn't good because the Fed was never able to 'normalize' it's portfolio, but it isn't a reason to panic.
OTOH, this should never have happened.
The macro explanations might worry you a bit, if you are inclined to worry; they seem to point to an inability of the financial system to smoothly move money from those who have it to those who need it—that is, an inability of the financial system to do its basic job. Weird big spikes in fundamental financial numbers can indicate deep trouble; they can also cause deep trouble, as risky levered borrowers lose access to funding.
So just as I was about to post this I took a quick look at Zerohedge and there's an update.
20 minutes after today's repo operation began, it concluded and there was some bad news in it: as we feared, yesterday's take up of the Fed's repo operation which peaked at $53.2 billion has expanded substantially, and according to the Fed, today there was a whopping $80.05BN in bids submitted, an increase of $27 billion, or 50% more than yesterday.
It also meant that since the operation - which is capped at $75BN - was oversubscribed by over $5BN, that there was one or more participants who did not get up to €5 billion in the critical liquidity they needed
It's unclear exactly where all this credit demand is coming from, but from what I've read the source is probably from overseas. That's what happens sometimes when you have the world's reserve currency, and everyone borrows in dollars.