Unusually, the Federal Reserve’s decision to lower interest rates was not the biggest news in fixed income markets this week. The cut was widely expected. Troubling moves in the US money market have been more of a focus. In particular, the cost of borrowing using overnight repurchase agreements (“repo”) surged to a shocking 10%. Repurchase agreements are a form of secured borrowing. Given that this borrowing is very short-term, and typically backed by ultra-safe US treasury bonds, the cost should be much closer to the “risk-free” rate of around 2%.
There are both structural and shorter-term factors that explain the unexpected spike.
The key structural factor is the changing shape of the US money market. The repo market is much smaller than it was prior to the financial crisis, as banks now make more use of stable, longer-term sources of funding. This inevitably makes the market more vulnerable to short-term fluctuations in supply and demand for treasuries and cash.
In recent weeks, an imbalance has arisen. A key driver of this may have been the payment of corporate taxes on September 15. These payments resulted in liquidity being removed from the banking system. Activity in the bond markets was probably also a contributing factor. The rally in US Treasuries over the past few months has lured investors out of cash, again reducing liquidity in the banking system. The situation may well have been exacerbated by a series of large US Treasury bond issues last week, which could have caused a spike in demand for cash.
The money market now appears to have settled down, thanks to support from the Fed. The US central bank has provided a liquidity boost to the overnight repo market for the past four days. It has also said it is considering establishing its own overnight repo facility to help manage any future spikes in demand.