Back in September 2019, a mini financial crisis had emerged inside the repo market: the elaborate interbank exchange that enables financial institutions including megabanks, pension funds, and hedge funds to carry out their global operations. After lingering at roughly zero since the 2008 financial crisis, the overnight repo rate — the premium that central banks pay to “repurchase” government securities from commercial banks — spiked to a whopping 10% intra-day high, indicating severe stress in the financial system.
For some money-market experts, however, this came as no surprise. They had warned that trillions in cash flowing from the U.S. Treasury’s general account (TGA) into the interbank markets might cause chaos. But although they were proven right, the aftermath was the exact opposite of what they, plus most cynics of the modern system and its supposed stability, were expecting.
They assumed Wall Street would react with fear and panic. But even despite a flash crash in a key interbank market, risk assets barely moved, finishing green on the day. Stocks climbed alongside high-yield (junk) corporate debt, and bullish pundits on financial media, unaware of the inherent risks associated with rates blowing out, saw the funny side.
This was a classic “bad news is good news” scenario we’ve witnessed time and time again in modern-day markets where the Fed’s psychological put has prevented any lengthy financial panic. Since everyone anticipated a swift response following Fed Chair Jerome Powell’s declaration that the Fed had started intervening through “repo operations”, the crisis morphed into a bullish catalyst for markets.
The big myth, however, was that the Fed had actually carried out any “repo operations” at all. Instead, this was doublespeak for more money printing — Fed officials typing digits into a computer, issuing bonds, and offering them to banks in exchange for collateral — while hiding their inability to explain what went wrong in the monetary system’s shadow layer (where the repo market sits). Every year, either something breaks down or goes pear-shaped, and they have yet to fix the underlying cause.
But that’s because they can’t reach it. Over the past few decades, advances in technology have enabled the biggest financial players to exploit the fiat system by creating all kinds of exotic financial instruments, derivatives, and products — from interest-rate swaps to mortgage-backed securities to credit default swaps — in offshore (unregulated) markets, situated outside the Fed’s umbrella. Since these now make up most of the liquidity in the financial system, and especially in the repo market, Fed officials have realized money has become impossible to define.
But instead of admitting this, they had to keep control of the narrative to maintain trust, confidence, and, of course, power. Starting with a none-the-wiser Alan Greenspan in the late 1990s, he began to issue expectation-based policy rather than monetary policy. Greenspan stated that the Fed was going to increase interest rates slightly by a few basis points each meeting, but to this day, there’s no evidence Greenspan’s Fed ever intervened — there were zero OMOs (open market operations) back then. Yet, markets moved in tandem.
What the Fed says is more powerful than what they do. “Monetary” policy acts as a psychological backstop. Nothing more. Their operations in September 2019 failed to fix the problem, causing only excess bank reserves to pile up (so much so they also felt the need to discontinue accounting for these reserves; funny how that works).
Fast forward to today and the Fed still has control over the narrative, plus the financial system appears to be in good shape. The FRA-OIS spread, the unofficial-official health marker of the global monetary system, shows financial conditions remain loose. LIBOR (the rate at which major global banks lend to each other) is resting just above “the risk-free rate” (yield on a three-month U.S. Treasury bill). Lower funding rates allow hedge funds to leverage up, banks to fund more buybacks, and pension funds to venture further out onto the risk spectrum. All’s well, for now.
Except the experts who foretold the last repo crisis have sounded the alarm once again, predicting another one will emerge later into 2021. If you need a masterclass in how the repo market functions day-to-day, look no further than repo superstar, Zoltan Pozsar, who releases a daily note covering the mechanics and activity within intricate parts of the monetary system. He was first to warn about the repo chaos in September 2019, and now he’s blowing the horn again but for a different reason.
While rates spiked during the September 2019 repo crisis after banks failed to absorb excess Treasury collateral entering the system, this time, interbank rates are about to move below 0% for the first time in U.S. history, creating potential chaos in repo land. “Today, the banking system is running out of balance sheet, and money funds are running out of collateral. Soon there will be too much cash in the system; TGA balances will decline from $1.6 trillion to $500 billion by the end of June,” Zoltan says.
Right now, banks won’t have the capacity to add this $1 trillion inflow of deposits, reserves, and Treasuries onto their balance sheets. “J.P. Morgan can’t grow more due to G-SIB constraints; Citibank flat-lined its balance sheet growth …. Bank of America has the capacity to add only $150 billion of deposits … and Wells Fargo’s $500 billion capacity is constrained by its asset growth ban.”
The solution remains for the Fed to remove limits on its overnight reverse repo (RRP) facility allowing institutions to fund additional business, and the central bank must also hike the overnight repo rate by 1.00% to encourage financial institutions to absorb these reserves. Otherwise, it will be the first time commercial banks have had to deal with a negative interest rate policy (NIRP). “Unless the RRP facility gets uncapped, bill and repo rates can trade negative and money funds may turn away inflows, as they won’t invest at negative rates.”
Let’s say Zoltan’s right: Trouble in the repo market ensues, and headlines appear all over financial and social media. Will we experience Armageddon? Unlikely.
Instead, we’ll experience the bizarre reality that any future repo market turbulence will produce a bullish outcome. Tight monetary conditions will spur Fed officials into “action”, providing financial institutions with billions — if not trillions — of liquidity to keep rates stable and markets functional; while the Fed’s psychological put, the real sentiment reviver, works its magic. Wall Street and market participants will not perceive the news as a warning sign but as a signal to buy more en masse.
We must also recognize the response to the chaos won’t be the only element driving markets higher. We don’t want to fall for the narrative fallacy. By design, we choose to follow compelling stories that connect A to B rather than studying the facts, limiting our ability to make informed decisions. We must remember other bullish catalysts exist: An increase in growth and inflation expectations, globalist Biden taking over as U.S. president from populist Trump, vaccine euphoria; the list goes on.
The response to repo market Armageddon 2.0 will only create an additional surge in asset prices, supporting the fakest economic boom of all time. And as market turbulence grabs everyone’s attention, the real crisis will, again, be pushed aside. Americans will have to watch their purchasing power diminish further as Fed officials use this crisis as an excuse to progress onto the next stage of their epic monetary binge.
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This article is for educational purposes only, not financial advice.