September 27, 2019
Recent stress in the short-term repurchasing (repo) market has raised concerns about a potential “liquidity crisis” in the financial system.
As shown in the LPL Chart of the Day, interest rates on repo market agreements jumped last week amid a shortage of cash available to lend, forcing the Federal Reserve (Fed) to inject liquidity into the market to stabilize rates.
In a repo agreement, a holder of a U.S. Treasury security sells it for cash for a short period of time, often overnight, with an agreement to buy the security back for a slightly higher amount. This is treated as a short-term cash loan, with the security acting as collateral and the rate determined by the difference between the selling price and the price at which it is bought back.
Corporations and financial firms typically tap this market for short-term financing needs, as well as a way to pick up yield on cash. The repo market was much bigger before the 2008 financial crisis, but regulations and capital requirements since then have crimped banks’ excess cash. Because of this, the market frequently has experienced liquidity gaps, especially around month-end and quarter-end, when businesses tend to need cash the most.
Last week, however, the repo market experienced one of its biggest liquidity crunches in years. There was a corporate tax deadline September 15 that required businesses to pull a large amount of cash from the repo market. That coincided with a large settlement of U.S. debt, which many banks are obligated to step in and buy as primary dealers. Suddenly, many businesses were looking for a cash infusion, but firms that typically provide repo loans didn’t have enough cash on hand to satisfy the market’s needs.
Basically, there was a large imbalance of supply and demand, and the Fed had to restore balance in the system by purchasing Treasuries and other securities from firms in exchange for cash.
“Last week was the perfect storm of unusual circumstances,” said LPL Financial Chief Investment Strategist John Lynch. “Volatility in the repo market has been concerning, but this liquidity shortage doesn’t look like systemic weakness to us. Last week’s stress appears to be temporary, and the repo market will likely calm down through quarter-end with the Fed’s help.”
Liquidity crunches of this magnitude could happen again, though. Treasury issuance will likely remain high amid a ballooning U.S. budget deficit, and there are few things more certain in this world than (corporate) taxes. Fed policymakers, who have enacted smaller measures to stabilize the repo market, will likely need to explore a longer-term fix after recent events—possibly a standing repo facility or a small bond-buying program to soak up Treasury supply.
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