It has been quiet out there in the US dollar money markets; maybe too quiet.
On Wednesday, Patrick Harker, president of the Federal Reserve Bank of Philadelphia, shared some thoughts at a New York conference on monetary policy normalization.
He looked back to the dramatic rise in secured overnight funding rates in September and to the steps the Fed had taken to ensure it had not been repeated, with a particular focus on the year-end just passed.
Carefully laid plans for the New York Fed’s open market trading desk to offer two-week term repo twice a week spanning year-end, to ensure plentiful reserves at a time when banks typically conserve cash to make their quarter-end ratios look good, clearly worked.
The effective fed funds rate maintained a virtually constant level at 1.55%, as it has since October, with repo markets staying calm and the secured overnight financing rate (Sofr) at which banks lend against US Treasury collateral staying within a few basis points of fed funds.
“Instead of wreaking havoc, the year’s end was a non-event,” Harker reported. “The money markets essentially rang in the New Year by binge watching Netflix in their PJs instead of with noisemakers and popped corks.”
In its report published in mid-January, the European repo and collateral council of the International Capital Market Association (ICMA) confirmed an almost unusually uneventful turn from 2019 to 2020, repeating one market participant’s comment that it was possibly the most subdued year-end of the decade.
But stirrings can still be heard.
In Europe, users of collateral-backed short-term dollar funding noted a transfer of balance sheet by US banks from their European operations to their home market.
Non-banks, such as asset managers – who have grown used to large G-Sibs reducing lending and hoarding cash to boost their liquidity scores at quarter-end – had done a lot of work to negotiate repo capacity from their dealer banks long in advance of year-end, while also looking to reduce the business that they would need to execute by locking-in term financing where possible.
Lessons being learned
Harker, meanwhile, confirmed that lessons are still being learned from the lending squeeze in September when banks, seeing an unusually high requirement for cash as clients paid tax bills and as they paid the US Treasury for new issues, declined to lend even overnight at very high rates secured against the highest-quality collateral.
From a touch over 1.55%, Sofr rose to 6% and, at one point on September 17, touched 10%.
It was a dramatic squeeze on liquidity, given that, as Harker pointed out, the dates for tax payments and bond settlements are not a surprise; they are fixtures of the fiscal calendar and well known to policymakers and markets. Everyone had been expecting large cash outflows from the banks.
Markets should have been quiet over year-end. Since September, the Fed has supplied $400 billion in reserves, through a mix of asset purchases running at $60 billion a month and $250 billion in repo.
When minutes from the December meeting of the Federal Open Market Committee were published on January 3, they showed that repos outstanding from these desk operations totalled roughly $215 billion per day, consisting of overnight and term operations.
Are some of the market’s pipes rusty? Clogged? Are more needed? Has regulation inadvertently contributed to some erosion or blockage?- Patrick Harker, Federal Reserve Bank of Philadelphia
But tough questions remain unanswered about why liquidity dried up in September and what to do about it.
Harker asked: “Are some of the market’s pipes rusty? Clogged? Are more needed? Has regulation inadvertently contributed to some erosion or blockage?”
A couple of things are now becoming clear.
First, the Fed is developing a slightly clearer idea of the bottom range for ample reserves in the banking system in the aftermath of the expansion of its balance sheet in the era of quantitative easing.
Before the financial crisis, banks typically held no more than $20 billion of low-yielding reserves. In the aftermath of the crisis, as banking regulators sought to prevent a liquidity crisis at the banks, that rose to an astonishing $2.7 trillion in mid 2014.
As the Fed sought to reduce its balance sheet, the notion that $1 trillion of reserves would be ample somehow took hold. By September 2019, they had come down to $1.3 trillion.
But reluctance to lend overnight even against risk-free collateral at rates as high as 10% suggests this was a serious miscalculation. Since September, reserves have trended back up towards $1.5 billion, with analysts putting them on track to climb to $1.7 trillion come April, which may be nearer to the bottom of the range for ample reserves.
Other changes may be coming.
Banks’ liquidity is judged against holdings of high-quality liquid assets (HQLA), comprising cash reserves deposited at the central bank for a low return and typically higher-yield so-called risk-free securities, such as US Treasuries.
It is now clear that banks don’t view the two as interchangeable and prefer higher reserve balances, reasoning these are effectively cash while US Treasuries are not.
The sheer scale of Fed purchases may have impaired liquidity even in short-term Treasury bills, so they cannot be easily sold for cash. This deserves close study. And other banks may only lend cash against them at a punitive rate in a general crisis or even in a single-name-specific one to a bank seen urgently boosting its cash.
That is why calls have grown for the Federal Reserve to operate a standing overnight repo facility, promising to lend cash against Treasuries to banks whenever they need it, perhaps charging a small premium.
David Andolfatto and Jane Ihrig, economists at the St Louis Federal Reserve, brought this discussion into the public gaze in March, long before the September repo dramas, which have since drawn more support for their call for such a facility.
Harker confirmed that having a permanent standing repo facility to turn Treasuries into cash remains a hot topic inside the Federal Reserve system.
“We are in the process of evaluating the potential costs and benefits, and exploring possible designs as well as alternatives, so it is still very much in the discourse, rather than the decision, phase,” he said.
To Euromoney, a standing overnight repo facility now looks if not inevitable then certainly highly likely.
It should make banks more comfortable to hold US government bonds. The US Treasury has lots to sell and can’t have the Fed owning them all. The Fed would have a mechanism to lend on a secured basis to banks in good standing and would not need to pay so much interest on an abundance of excess reserves.
The US financial markets are moving from Libor to Sofr: they can’t have the new benchmark for myriad financial contracts shooting from 1.55% to 10% at a moment’s notice.
But there are potential downsides.
Analysts worry that some banks, more confident of guaranteed access to liquidity, might take greater risks.
More troubling to Euromoney, a standing repo facility might become another case of the central bank not so much augmenting the private money markets… as replacing them.