Why repo market ructions may matter

Real film buffs will remember Repo Man, a 1984 science-fiction film directed by the UK’s Alex Cox, but it is the repo rate that advisers and clients need to be watching closely right now.

The repo rate is the level at which banks lend to each other overnight, or central banks lend to other banks. It provides banks with immediate liquidity if they happen to need it and enables the lender to make a financial return pretty much without risk, given the extremely short time horizon involved and the collateral that backs them.

It is usually a quiet, uneventful market that forms an important, if unsung, part of the financial markets’ plumbing and tends to run smoothly. And that is why recent events in the repo market require scrutiny.

““It is usually a quiet, uneventful market that forms an important, if unsung, part of the financial markets’ plumbing and tends to run smoothly. And that is why recent events in the repo market require scrutiny.”


US overnight government repo rate spiked suddenly earlier this month

Source: Refinitiv data

In fairness, if advisers and clients had blinked they would have missed it. The repo rate has since come back down. But late September’s surge was not the first spike in this overnight lending rate. There have been four or five of them since late 2017, when, perhaps not entirely coincidentally, the US Federal Reserve launched Quantitative Tightening (QT) and began to shrink its balance sheet.

Sharp spike

Several theories have been put forward as to why the repo rate suddenly spiked and the banks found themselves a little short of ready cash. The most-widely fingered culprits have been corporation tax payments and the sale of lots of new Treasury bonds by the US Government, whose budget deficit has continued to surge thanks to the Trump tax cuts.

“Several theories have been put forward as to why the repo rate suddenly spiked and the banks found themselves a little short of ready cash"


Yet both of these would have been scheduled events, so it was odd that they caused such a scramble for cash. A well-written story on Reuters even went so far as to name JP Morgan as the bank that needed the money because the megabank had run down the amount of cash it had on deposit with the US Federal Reserve and acquired US Treasuries to try and eke out some extra returns on its capital.

That meant JP Morgan, usually a big provider of liquidity to the repo market, actually needed to access it and had to pay up for the privilege.

This is not to say JP Morgan is in any financial difficulty, as it continues to meet all regulatory capital and liquidity requirements with ease. But, assuming the Reuters report is correct, it does suggest that JP Morgan and other banks did not have any excess liquidity to hand, because they had invested their cash and thus could not contribute to the overnight interbank market.

In other words, QT was working as planned and the Fed was draining away liquidity in an attempt to retreat from the unorthodox, emergency policies launched in 2008 to tackle the financial crisis.

Policy pivot

Yet the Fed has already backtracked. It stopped QT in July and, thanks to several direct interventions to provide liquidity to the repo market, its balance sheet has started to gently swell again, adding further monetary stimulus to the pair of interest-rate cuts already pushed through.

This has several implications.

  • The financial markets and the US economy struggled without their fix of cheap Fed liquidity, in the shape of record-low interest rates and record-low interest rates.

  • The Fed is therefore expanding its balance sheet, QE-style, with hardly anyone noticing. It may not take much, therefore, to prod the central bank toward more rate cuts and an official return to QE if even minor policy tightening gums up the financial markets’ plumbing.

  • This could be good for risk assets, if markets decide more cheap cash is coming their way. After all, one of the favourite charts of US equity market bulls is the one that runs the benchmark S&P 500 index against the expansion of the Fed’s balance sheet during the QE era. (Oddly enough, this chart almost disappeared from view when QE was halted and then QE began.)

  • S&P 500 has feasted off cheap Fed cash

    Source: Refinitiv data, US Federal Reserve, FRED – St. Louis Federal Reserve database

  • It could be good for gold (but bad for risk assets) if markets decide any return to unorthodox policy is the result of the very same policies’ prior failure to deliver the desired returns (growth and inflation). Gold did well when investors felt central banks were losing control (2007–11) and less when they took the view the authorities had matters in hand (2012–18).

  • Gold has performed well when doubts over central bank policy have gathered

    Source: Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, US Federal Reserve, FRED – St. Louis Federal Reserve database

    Back to the future

    ““We must accept that the past is no guarantee for the future but little incidents such as the repo ructions need watching, especially if they become more frequent.”


    Advisers and clients must accept that the past is no guarantee for the future but little incidents such as the repo ructions need watching, especially if they become more frequent. Add them to the WeWork fiasco; the high coupons demanded by market participants before they funded Aston Martin and Metro Bank; and Bitcoin’s 25% plunge in the last month, and it is possible to construct a case that either liquidity is getting tighter or markets’ confidence is wobbling a little – or both.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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