Repo (short for a repurchase agreement) is the grease in the wheels of financial markets, where banks lend to one another, but on a secured basis. This week has seen us enter a period of severe dislocation in these markets.
Rather than Lehman Brothers where this was a credit specific issue, recent symptoms stem from market-wide illiquidity (or shortage of cash).
“What is happening to cause this?”
The drivers to this dislocation have been the increased supply of government debt, the shrinking of the Federal Reserve balance sheet and primary dealers holding increased government inventory – by some estimates primary dealer balances have more than doubled in the last 12-18 months. The pulling back of Quantitative Easing has also left the US financial system yet shorter of cash. Banks reserves are tighter as the cost of capital is being driven higher by regulation; and tax receipts paid by corporations this week did not help, with significant funds being pulled from money market funds and deposits. Finally, overseas investors have not increased allocations in line with rising government debt issuance. The good news for the US thus far is that at least foreign buyers have not pulled back. China could be particularly dangerous/the US vulnerable here given the current trade-related negotiations.
“Whilst this is quite interesting, why should I care?”
The real question is…would you like to significantly reduce risk AND get paid to do so?
For those with USD cash balances, who are typically being under-compensated for the unsecured financial risk they are taking in the form of bank deposits, this presents a fantastic opportunity. Moving from unsecured and highly correlated bank risk to a secured position (against government assets), holders of excess cash balances can get paid materially more for taking less risk. However, entering this market directly requires a big infrastructure lift and, in our experience, complicated contract negotiations, new financial infrastructure implementations and additional technology integrations are not typically at the top of most treasury teams’ wish-lists! Our Bank Secured FTFs give all of our clients the opportunity to safely place cash in this market, without the need for any financial infrastructure, at the click of a button.
“What else is being affected?”
Another impact of this market volatility has been on foreign exchange swaps markets, making it more expensive to buy dollars, which has a whole range of other consequences reverberating outside of capital markets. The knock-on effects have also already been felt in short-dated corporate issuance. Any issuer through TreasurySpring’s digital platform is considerably more sheltered from such day-to-day price shocks. We are a stable, robust and friendly partner to navigate these volatile times.
“Have I missed the boat?”
In short, no. The US Treasury department has been issuing record levels of debt, loaded towards the end of the year when funding pressures are at their very highest in financial markets, as banks look to minimise balance sheet usage. Thus, we do not see these elevated levels going away any time soon, or at the very least they will continue bubbling just beneath the surface, until the next time…! Whist the Federal Reserve did cut rates yesterday, further reducing borrowing costs, this will not solve the problem of a shortage of cash in the most important of markets. This week’s price movements in the repo market were discussed by the Federal Open Market Committee but for now, they are perceived to be temporary and exceptional, with the Fed believing that their existing toolkit can manage to get things back under control. Interesting to note, however, is that fewer members voted to cut this time around, with the split being 7-3. Thus, more members will need more convincing should we continue along the current path.