An esoteric segment of the Fixed Income market not normally followed by the broad investment community is the Repo market (Repo is short for Repurchase Agreement). Repurchase agreements are the mechanism in which U.S. Treasury note and bond positions are borrowed or lent; the so called “grease” of bond market leverage. During the week of September 16th the Repo market temporarily broke down, wreaking havoc on short term interest rates. When the market is in balance, with the number of borrowers equal to the number of lenders, the RP rate will be very close to the Federal Reserve’s overnight Fed Funds rate. Should the dollar value of borrowers exceed the number of lenders, the borrowers will need to pay a higher than market interest rate to borrow the cash to pay for their security holdings. On September 16, when the problem first came to light the clearing interest rate for repo was as high as 4.75%, well above the 2.30% high rate at which it traded on the previous trading day. Market pundits were not immediately able to offer an explanation other than it was one of the occasional rate spikes that happen periodically; namely on month-end, quarter-end, or year-end. At year-end 2018 the rate spiked to 6.125%. However, on the morning of September 17th, the interest rate at which an investor was willing to pay to borrow cash skyrocketed to 8.75% as a funding panic began to develop. To address the cash shortage, the Federal Reserve dusted off a pre-crisis tool and intervened in the repo market. They initially said they were prepared to lend up to $75 Billion but the appetite amounted to only $53 Billion.
The question is why did the panic take place in the first place and what is the solution to avoid its occurrence in the future. We suspect the answer to the first question is that investors bought more bonds than they had cash to pay for. In the just ended fiscal year, the U.S. government needed to finance the $1.3 trillion of deficit spending and to pay for it they needed the Treasury Department to issue a corresponding amount of new debt. For each dollar of new debt, there must be a dollar of investor money to buy it. So, with an incremental $1.3 trillion dollars of debt the Treasury Department needs $1.3 trillion of bond buyers. Exacerbating the Treasury supply is the onslaught of new corporate and municipal debt that has been rushed to market to take advantage of the ultra-low interest rates. The outcome was the unrealized potential that buyers would have failed to pay for $53 billion of bonds hadn’t the Fed entered into the repo operation.
The next question is what does this mean and how will the Fed address it over the long term. To us, what it clearly means is the idea of Modern Monetary Theory (MMT), the thought that the U.S. can and should borrow as much money as it can because, as the world’s reserve currency, the demand for dollar-denominated bonds is infinite – is false. There was a funding squeeze not because the demand was so great for Treasuries that demand outstripped the ability to pay for them. Instead primary dealers, the banks and brokerage firms required to buy Treasury debt when it’s issued, did not have the room on their balance sheets to absorb the ever growing debt load.
Realizing that they had reached a milestone in debt appetite, the Fed has stated that they will begin to routinely intervene in the Repo market, making interaction another active tool. But in the bigger picture policy makers should take heed that MMT and the various iterations of the idea put forth by the progressive politicians should understand that the appetite for dollar denominated debt is not insatiable.
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