It sounds like a story torn straight from the records of the 2008 financial crisis: The Federal Reserve comes to Wall Street’s rescue with mounds of cash in hopes of calming a complicated, yet critical part of the financial market.
But it’s 2020, and it doesn’t look like history is repeating itself — at least from the outset.
You’ve probably heard some talk about an obscure, technical glitch that’s left Wall Street banks, investors and the Fed itself on edge since Sept. 16. Perhaps you’ve also seen some of the blaring headlines about the Fed intervening and injecting hundreds of billions of dollars into the financial system, a first since the financial crisis.
All of this is tied to a clog in the plumbing of a vital marketplace for Wall Street funding and lending: the repurchase agreement, or repo, market. Here, trillions of dollars worth of debt are traded for cash each day by major financial firms, and the activities taking place on this market keep the wheels churning for other various activities on Wall Street.
The Fed announced during its January interest rate decision that it’ll be involved in the repo market until at least April 2020. But the subject is complicated, and experts themselves are still not exactly sure what happened on that day last fall.
“There’s this sudden huge disruption in the overnight market on one particular day that has caused the Fed to intervene for months now with really massive increases in liquidity,” says Dan North, chief economist at Euler Hermes. “It’s worrisome to me that there’s something I’m missing in the banking system.”
Here are the main things you need to know about the cash crunch, including why the Fed is involved and how it could impact you.
What is the repo market?
But to understand how it impacts you, it’s first important to learn some of the basics on how the repo market works, as well as the purpose it serves.
The repo market is essentially a two-way intersection, with cash on one side and Treasury securities on the other. They’re both trying to get to the other side.
One firm sells securities to a second institution and agrees to purchase back that security for a higher price by a certain date, typically overnight. Essentially, it’s a short-term collateralized loan. And just as most loans come with an interest payment, you can think of the difference between the original price and the second, higher price, as the “interest” paid on that loan. It’s also known as “the repo rate.”
Why would two parties want to participate in a process as antiquated as the repo market? Because it ultimately benefits them. Financial firms with large pools of cash would prefer to not just let that money sit around — it doesn’t collect interest, meaning it doesn’t make any money. Meanwhile, it allows financial institutions to borrow cheaply to fund short-term needs. There also (typically) isn’t much risk involved.
Experts estimate that anywhere between $2 trillion and $4 trillion of debt are financed here each day, meaning it’s vital to the overall functioning of the financial system. They’ve even offered up a wide variety of analogies meant to explain how the process works. Some refer to it as the plumbing of the financial system, while others call it the market’s beating heart.
What exactly happened on Sept. 16?
But that work exists largely in the background. You probably don’t think about the amount of work that your heart is doing every day, as it pumps an estimated 2,000 gallons of blood throughout your body. You do, however, start to notice it when things go wrong.
On Sept. 16, a traffic jam occurred at the intersection of cash and securities. Experts say that piles of cash flowed out of the system because corporate tax payments came due. That happened right as new Treasury debt settled onto the markets. Financial institutions wanted to borrow cash to purchase those securities, but supply didn’t match those demands.
This ultimately caused a cash crunch, and the repo rate ultimately soared — reaching as high as 10 percent intraday on Sept. 17. In other words, banks didn’t want to part with their cash for anything lower than that rate.
Why did the Fed get involved?
When the beating heart isn’t functioning properly, you probably need a first responder. In this case, it was the Federal Reserve.
When the repo rate soared, it caught the Fed’s attention. It’s supposed to hold in line with the federal funds rate, which was then in a target range of 2 percent and 2.25 percent, reflecting the first rate cut in more than a decade. At that time, however, officials were just days away from reducing rates for a second time.
On Sept. 17, just a day after the cash crunch occurred, the New York Fed stepped in to stabilize the market. This regional Fed bank is tasked by the Federal Open Market Committee (FOMC) with carrying out its open market operations, so naturally they were the ones who took up the task.
The New York Fed then started taking part in repo trades. On Sept. 17, it injected $53 billion, and by that afternoon, the New York Fed said it would purchase up to $75 billion more the following day. The New York Fed has a complicated word for the campaign: “overnight repo operations.”
How this impacts your finances
If you want to know how the Fed’s repo operations are impacting your financial life, look at your 401(k) statement, says Greg McBride, CFA, Bankrate chief financial analyst.
“It’s helped boost the stock market pretty notably,” he says. “In a favorable economic backdrop with lower interest rates, capital is increasingly finding its way to the stock market as the only place to generate a notable return. Now, the risk there is, what goes up, can also come down.”
This underscores the need for Americans to build up an emergency savings fund. Experts typically recommend having three to six months’ worth of expenses completely liquid and accessible.
That means you might want to think twice about locking down a certificate of deposit (CDs). Use Bankrate’s tools to find the right high-yield savings account on the market, many of which are offering yields 20 times higher than the national average.
But experts are generally humming a confident tune when it comes to the Fed’s interventions. Banks are also not utilizing the entire package that the New York Fed is willing to offer, suggesting that the market has enough liquidity and that the repo market operations are working.
“It’s kind of a wonky thing and not something that most people need to think about on a regular basis,” says Zachary Griffiths, associate rates strategist at Wells Fargo. “The key takeaway is that the Fed has it under control right now, and we don’t expect them to lose control of it again.”
What is the Fed doing now?
Fast forward to the start of 2020, and the Fed is still trying to untangle the mess.
On Jan. 28, for example, the Fed had implemented a $55.75 billion overnight operation in the repo market, as well as a $28.95 billion 14-day repo operation, to keep short-term lending rates in check. Officials in January announced that they plan to continue these operations until at least April, but many experts say that the Fed might have to turn to a more permanent solution, such as creating a standing repo facility. This kind of operation would allow financial firms to turn to the Fed at any time to borrow cash through repo transactions.
But the biggest action out of the Fed didn’t happen until October, when the Fed announced that it would start organically growing its balance sheet again by purchasing shorter-term Treasury bills at a pace of about $60 billion per month. The Fed is also buying up to $20 billion each month to replace maturing securities.
What does this have to do with the balance sheet?
While many experts say that the ill-timed outflows and inflows of cash and securities may have been part of the problem, many have speculated that it isn’t the full story. Some of it has to do with how much the Fed has tapered off its balance sheet — which might’ve been too far.
“Those things highlighted the fact that reserves had fallen too far in order to keep things under control,” says Griffiths. “A shock in a market like that made it clear they needed to reverse course a little bit and provide liquidity to get things back to normal.”
Some context is required to explain how the balance sheet fits into all of this. During the financial crisis, the Fed slashed interest rates to zero to help prop up an ailing economy from the worst economic meltdown since the Great Depression. But it wasn’t enough, so the Fed also enacted a new, unconventional tool: “quantitative easing.”
With this operation, the Fed started purchasing massive amounts of assets, including Treasury securities and mortgage-backed securities. The process was meant to help stimulate the economy even more by pushing down long-term interest rates.
Those large-scale purchases went on the Fed’s balance sheet, and it also dramatically increased the amount of reserves that banks held in accounts at the Fed.
Today, more than a decade later, the economy is in much better shape. Thus, the Fed has been trying to get interest rates and its balance sheet back to normal. That meant gradually raising the federal funds rate, but it also meant selling off the massive amount of holdings it purchased in the wake of the crisis.
That process has frequently been referred to as “quantitative tightening,” and it scales back banks’ reserves. Those same reserves are what financial firms use for repo market lending, keeping the market stable.
“The general theme that caused the repo market volatility has been almost a decade in the making,” says Jon Hill, vice president on the U.S. Rates Strategist team at BMO Capital Markets. “It’s almost difficult to try to draw comparisons just because the entire framework has shifted so much. It’s like comparing apples to koalas — it’s not even close.”
Fed researchers surveyed major financial institutions to determine what level of reserves would be enough to be considered “ample,” but nobody knew for sure just how many reserves needed to stay in the system.
On Sept. 16, the Fed found its answer.
“I don’t believe for a second that you can take nearly a trillion dollars out of the system and something’s not going to go bump in the night,’” says McBride. “What we saw in the repo market was a direct result of that.”
Is this QE?
But the Fed’s balance sheet growth isn’t to be confused with those large-scale asset purchases it fulfilled during the financial crisis.
And that’s for one main reason. The Fed is purchasing Treasury bills, which mature within 12 months. The Fed says these provide less stimulus than long-term securities, meaning it won’t lower longer-dated Treasury yields. Quantitative easing, however, was designed to put downward pressure on those longer-term rates.
That’s not to say the process doesn’t look outwardly similar. When the Fed purchases these Treasury bills, they automatically expand the size of the balance sheet. And since organically growing the balance sheet in October, the Fed has already taken back about half of what it initially sold off.
The initiative is also pushing up asset prices, as more investors flock to stocks and bonds. That’s also what happened when the Fed instituted its QE programs.
Since Oct. 11, when the Fed announced its plans to start organically growing the balance sheet, the S&P 500 has risen by about 10 percent.
Is it a bad sign that the Fed feels it must intervene?
Beyond the QE vs. not-QE debate, some market watchers are also fearful that there’s something more sinister lurking in the shadows. That’s partly because it brings back bad memories of the 2008 financial crisis.
But many experts say the cash crunch in the banking system has nothing to do with a lack of resilience in the banking system, but more so these technical matters surrounding the balance sheet.
“The reduction of liquidity in 2008 was a result of panic about the resiliency of the banking system, which proved to be not resilient at all. Banks had taken too many risks,” Griffiths says. “This time around is much much different and should not incite the same type of concerns.”
It’s also important to note that the Fed’s efforts are “not necessarily printing physical cash,” Griffiths says. “It’s increasing reserves on a temporary basis.”
But that’s not to say it hasn’t worried some economists. Some experts say the liquidity issues are largely the result of the Fed experimenting with many unconventional tools that it hadn’t yet fully understood. And with interest rates already at historic lows, that cycle may be hard to break, meaning more unconventional tools are likely going to be introduced.
“Part of my thinking is that the Fed and other central banks have gone on this wild experimental policy for the past decade on zero percent interest rates and quantitative easing,” North says. “My idea all along was, those are very risky policies put in place to help a sputtering economy.”
Other experts say that the repo market mess is more illustrative of a problem with the U.S. government, as the federal deficit balloons. The deficit is expected to surpass $1 trillion this year, according to the Congressional Budget Office, which would be the first time since 2012.
How does that relate to the repo market? When the government borrows money, it issues Treasury securities. The Wall Street investors who buy these Treasurys often sell them on the repo market. But amid new post-crisis bank regulations, banks are not as willing to lend out.
To put matters in simple terms, there’s too much debt coming onto the market and too little money. Thus, lenders increase their repo rates.
How long will the Fed keep intervening?
Eventually, the Fed will reach a point at which it feels comfortable with the level of reserves in the system, meaning it will stop expanding its balance sheet. Powell during the Fed’s January press conference said the minimum level of reserves is likely around $1.5 trillion, but he didn’t quite know where the ceiling would be.
That also implies that the Fed will scale back its repo operations, but it may face some challenges when that time comes. Volatility could occur if the Fed ends the interventions too soon or scales them back by too much. Some experts say the Fed will be forced to create a standing repo facility.
“It should not have broader implications unless the Fed were to pull back on its repo operations too quickly without a standing repo facility in place,” Griffiths says. “That could cause more volatility and reduce people’s confidence that the Fed has a grip on what’s going on.”
In records of its December meeting, Fed officials discussed the idea of creating one as a permanent solution. Details, however, still need to be hammered out, including which firms are eligible to participate.
BMO’s Hill expects the Fed to wrap up its repo operations sometime in the second quarter of this year. But before the Fed lets go, a standing repo facility will likely be necessary, due to the “huge issuance needs of the U.S. government,” he says. “Some demand is likely to persist,” he says.
Nonetheless, the Fed is going to have to walk the tightrope on all of these issues. It’ll likely have to find a way to continue intervening in the repo market while also reaffirming to markets that its balance sheet expansion isn’t the same as quantitative easing.
“Some conflate the Fed’s actions with a quantitative easing program,” Hill says. “This points to the importance of communication for the central banking community to explain actions in the modern operating framework.”