Repo market spikes, but remember 2019?

Spikes in a key short-term interest rate are raising eyebrows in the arcane but vital overnight funding market, drawing unsettling comparisons with turmoil that rocked the space more than four years ago.

Strains started showing up late last week. The bond-buying frenzy that stoked November’s U.S. debt rally led to a surge in demand for financing in the market for repurchase agreements, where participants engage in short-term lending or borrowing that’s collateralized by government securities.

This led to a large jump in short-term rates on the final trading day of November, with yields on overnight general collateral repo soaring above 5.5%. Even more unusual, the elevated levels persisted as December began. 

The latest spike in repo lending rates is, of course, still orders of magnitude smaller than the market ructions that occurred in September 2019.

Back then, increased government borrowing exacerbated a shortage of bank reserves that was created when the Fed stopped buying as many Treasuries and investors had to take up the slack. Overnight repo rates in funding markets — widely relied upon by Wall Street banks to fund day-to-day operations — temporarily jumped five-fold to as high as 10%.

The Fed briefly lost control of its benchmark rate and ultimately intervened by restarting purchases of repos to stabilize the market.

“It looks, walks, and talks like September 2019, but yet I don’t think it’s being driven by quite the same reserve scarcity reasons this time around,” said Gennadiy Goldberg, head of U.S. interest rates strategy at TD Securities, who said he fielded several calls about the market on Monday.

Nevertheless, the most recent episode provides a pointed reminder of the outsize, and underappreciated, role that repos play in the smooth functioning of the global capital markets, as well as all that could go wrong if overnight funding continues to seize up.

Volatility in short-term funding markets is a concern because at the end of the day, it can hinder central bankers’ ability to manage monetary policy. Funding dysfunction also poses risks to the broader economy by potentially pressuring borrowing costs for the government and beyond — at a time when benchmark interest rates in the US are already at two-decade highs.

The recent spike was caused by a confluence of events. The Treasury rally and demand for financing was one factor. On top of that, banks were paring back their repo market lending, as they tend to do at month-end for regulatory reasons. Meanwhile, a pile of Treasuries on primary dealers’ balance sheets — a byproduct of stepped-up government borrowing and the Federal Reserve’s efforts to shrink its balance sheet — impeded their ability to provide such short-term financing.

The squeeze rippled through other key funding benchmarks, including the Secured Overnight Financing Rate, or SOFR, which rose to 5.39% as of Dec. 1, according to Federal Reserve Bank of New York data published Monday. That’s the highest fixing since the benchmark made its debut in April 2018 as a Libor replacement. 

“The move higher in SOFR appears to be a perfect storm of Treasury supply, balance sheet constraints, increased sponsored/DVP pressure and a month-end overhang,” wrote Citigroup Inc. strategists including Jason Williams. “We expect SOFR to normalize over the next week but there are risks into Q1 2024.”

The funding issues suggest that at a time when the Fed is looking to pare back its balance sheet — a process known as quantitative tightening — banks’ balance-sheet capacity will play an increasingly critical role. And this is happening against a backdrop of increased government borrowing due to swelling US federal deficits.

As of now, there doesn’t appear to be a major cause for concern. Bank reserves at the Fed are around $3.4 trillion, a level that policy makers consider to be abundant. And there’s still about $815 billion parked at the monetary authority’s reverse repo facility, or RRP, where money-market funds keep cash at the Fed. This represents excess liquidity that’s still sitting in the financial system, though it has been in decline.

“This might be a dealer balance-sheet story than a shortage of reserves story,” said Subadra Rajappa, head of US interest rates strategy at Societe Generale. “A bunch of collateral consistently hitting the market over the last few months heading into month-end is probably contributing to the spike in repo.”

Still, Barclays’ Abate expects the Fed’s reverse repo balances to continue declining even as dealers work to regain post-month-end flexibility and adjust to the higher demand for funding. This should keep rates elevated for a little longer and ultimately pull more cash out of the reverse repo facility, which has already declined by roughly $1.2 trillion in June as counterparties such as money-market funds opt to invest in higher-yielding assets like Treasury bills.

Funding rates have eased from last week, but not by that much. Rates on overnight general collateral repo opened above 5.4% on Tuesday, while SOFR’s Monday fix of 5.37% was still near its all-time high. 

Abate said the behavior in the funding markets raises two questions: Whether demand for leveraged funding continues to rise, outstripping capacity of dealers to provide without a significant backup in overnight funding rates, and how far into 2024 the Fed can continue quantitative tightening if the reverse repo facility is effectively emptied by January. 

“While history may not repeat, it could rhyme,” Abate wrote in a note to clients on Monday. “While we expect current funding strains to settle down later this week, the speedier decline in the RRP, coupled with crowded long positioning, suggests that risks are mounting.”