Standing Repo

January 3, 2022 – Weekly Comment

I’ve felt that yields on treasury securities are too low, especially given inflation rates.  This note is more about open questions rather than prognostications.  When Powell was asked at the last FOMC press conference why longer maturity treasury yields remained so low, he simply said that sovereign yields are low everywhere…”I think a lot of things go into the – you know, the long rates.  And the place I would start is just look at global sovereign yields around the world.”  Brian Cheung (Yahoo Finance) who asked the question, added, “would you prefer the curve be a little steeper?”  Powell ignored that part of the inquiry.

Every time there is a financial problem, the Fed cuts funding rates and steepens the curve, so that the financial sector can quickly rebuild capital.  The recovery is always based on low and certain short-term funding.

Above is a chart of the Fed’s repo operations.  Here’s an excerpt from a Richmond Fed paper from September 2021, which makes a note of the blip on the left hand side of the chart related to the March Covid liquidity operations:

Then, [March 2020] the COVID-19 crisis led to significant stress in Treasury and short-term funding markets, and the Fed’s daily repo operations helped mitigate this stress by providing large amounts of liquidity in a brief period of time. The quantity of reserves in the system rose very quickly also as a result of the Fed’s large-scale asset purchases. By the end of June 2020, market participants became more confident of their assessments of the pandemic effects, and demand for Fed repo operations fell back to zero.

So, if March of 2020 was related to “stress” then what in the wide wide world of sports is going on now?  In July 2021 the Fed established the Standing Repo Facility or SRF.  As can be seen on the chart above, usage of this facility has been a great…um…success, with record usage at the end of 2021 of over $1.9 trillion.  Here’s another clip from the Richmond paper.

Even in periods with calm financial markets, the SRF could become heavily used once the Fed begins balance sheet normalization. Higher money market rates — relative to the facility’s interest rate — could lead the SRF to become the preferred vehicle for funding Treasury and agency securities.10 This is a non-trivial risk given the historical range of repo rates: The median spread between high and low published repo rates between April 2018 and August 2021 is 17 basis points while the spread between the ON RRP rate and the SRF rate is 25 basis points. To the extent that some of the high rates paid in the market reflect credit and other risks, SRF usage could raise moral hazard concerns.

The SRF was put in place prior to the Fed’s reduction of securities purchases. It creates an environment where there is no need to worry about availability of financing, and therefore risks of negative carry are reduced to zero and the private market can easily plug the gap as the Fed’s buying is reduced.

Last week I linked an article that I thought was more recent but was actually from October 14 of 2021.  I am adding the link here

The main thrust of the KC Fed article is that raising the FF rate prior to reducing the size of the Fed’s balance sheet can lead to a flatter curve, and the paper outlines many of the negative consequences of a flat or inverted curve.  “Because movements in the federals funds rate do not fully pass through to longer-term interest rates, raising the federal funds rate mechanically flattens the yield curve, holding other things constant.  …A flat or inverted yield curve may signal pessimism about the economic outlook.  More importantly, however, it can also materially affect firms that profit from the spread between short- and long-term interest rates, such as banks and investment funds.”

Is the SRF is a major consideration in holding down treasury yields, and are yields more or less capped for that reason?  The issue of moral hazard, introduced by the Richmond Fed is a concern that permeates the economic landscape, especially now.  Not only as it relates to underpricing credit risks, but that continued low funding, which is becoming more and more a function of the Fed rather than the market, contributes to moral hazard in the form of increased risk and increased inflation.

Charts like the one above tend to continue until something breaks, requiring a whole new program of monetary intervention to “fix” it.  A break in this case could come in the form of near term hikes which further flatten the curve.  Positive carry is based on the availability of funding and the shape of the curve.  Even if the former condition is met, if the curve is flat then the system might be prone to a serious risk adjustment.  The KC Fed paper appears to acknowledge this issue, though not in connection with the huge SRF component.  At the Dec press conference Powell said, “…I’m not troubled by where the long bond is.”  But maybe he should be giving a lot more consideration to the shape of the curve.

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Posted on January 3, 2022 at 4:32 am by alexmanzara · Permalink
In: Eurodollar Options

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