The Federal Reserve cut the Federal Funds rate yesterday by a quarter-point to a range of 1.75%-2.00%. This was the second rate cut in just seven weeks and was a bit controversial, even within the voting members of the Fed, as one of the seven voters preferred a steeper half-point cut, while another voter wanted no cut at all.
This split decision is reflective of the broader uncertainty surrounding the economy right now, as there are clear signs of slowing (both here in the US and especially abroad), but US conditions haven't yet reached the point where they are signalling anything clearly problematic.
The stock market fell initially on the rate-cut news, clearly wanting more, but perked up mid-way through Chairman Powell's press conference and ended the day mostly flat. The turnaround came when Powell said, "It's possible that we'll need to resume the organic growth of the balance sheet, earlier than we thought. That's always been a possibility and certainly is now." That was taken by some as a reference to possibly restarting Quantitative Easing — where the Fed intervenes in markets directly, adding liquidity by purchasing assets (bonds) — which has been the stock market's favorite drug over the past decade.
That said, the word "organic" in Powell's answer seems to imply allowing the Fed's balance sheet to increase gradually as the economy grows, without any dramatic QE resumption. But the market knows getting the QE conversation started is the proverbial crack in the door — the first step toward eventually getting those policies re-implemented.
Repo market mayhem
The context of Powell's answer above regarding letting the Fed's balance sheet start growing again came in the context of a series of questions regarding the "Repo market," which has been acting strange this week. This is a corner of the market that normal, retail investors (like all of us) don't interact with at all, and as a result, don't know much about. That includes me, although I've been doing a crash course the past few days so I'd be able to hopefully translate the recent activity for everyone.
Basically, the repo market is the shortest-term lending market for banks (as well as some hedge funds and other big institutional investors). The "repo rate" is commonly thought of as the rate at which banks lend to other banks on a very short-term basis, like 12 hours. And these loans are highly collateralized as well, which is why "repo" is short for "repurchase agreement." The typical scenario is one bank is a little short on their overnight reserves, so they borrow from another bank that has excess reserves, providing collateral (like Treasury bonds) that will then be repurchased the following day. As you'd expect, with "safe" borrowers (other banks) and lots of collateral, the rate on these loans is normally very low, in line with the Fed Funds rate.
That's how it normally works. So imagine everyone's surprise when this rate spiked from 2.25% to 10% Tuesday morning.
At that point, the Fed stepped in offering $75 billion in excess reserves, of which only $53 billion was used. The rate came down and it seemed like the issue was dealt with. Except that the next night the rate spiked again, the Fed came in with another $75 billion, only this time roughly $80 billion was asked for — meaning not everyone got as much of these reserves as they wanted. And then last night, the repo rate got up near 7% again, and the Fed had to come in for a third night in a row, again offering $75 billion in reserves, with $83.875 billion being asked for.
Before anyone panics, there's lots of additional context required here.
Prior to the Financial Crisis in 2008, the Fed used to routinely do these "temporary open market operations" to keep the repo market running smoothly and nobody thought much of it. After the Financial Crisis, we had a decade of QE, which greatly expanded the Fed's balance sheet and provided massive liquidity to the markets. Over the past few years, the Fed has been reducing the size of its balance sheet, which has been reducing the level of liquidity available to the markets. This repo issue has been building for a while, though it's not clear (at least to me) what has caused the sudden spikes this week. But the idea that the Fed has had to step in and rescue the repo market? Eh, it's true, but that's overly dramatic given this used to be routine business.
However, there are two reasons why people are paying attention to this unusual event (beyond the fact that it's unusual).
First, as Guy LeBas (who offered this Simpsons-themed explanation of the Repo Market) and others have noted, when repo rates spike, it can be a situation where a borrower in an already shaky situation is getting squeezed with a rate that's much higher than expected. Most of the borrowing in the repo market is totally routine stuff. But this is also where a strapped bank, hedge fund, etc. would turn for cheap temporary financing if it ran into a crisis. While the Global Financial Crisis may feel like semi-ancient history to some, there are plenty of bankers who remember vividly when the credit markets dried up rather suddenly as a result of no one knowing which other banks/financial institutions were solvent, after Lehman failed and the web of counter-party risk was impossible to quickly decipher. That liquidity event — not the accompanying stock market plunge — was the Crisis that gave that period its name. When leveraged financial entities who are counting on orderly credit markets suddenly can't get financing, things can get dicey fast.
That's where the imagination runs now when something like this repo rate spike happens. Frankly, it's still a little disquieting that this type of shortfall has happened three nights in a row, and the last two nights someone (or several someones) hasn't gotten the full amount of reserves they wanted from the Fed's action. There's no evidence there's any type of crisis going on, and Chairman Powell certainly didn't seem concerned about it when asked. But it sure is odd.
The second reason this episode is raising eyebrows has to do with the size of the Fed's balance sheet, as noted above. The Fed has a few different ways it can deal with the lack of liquidity in the repo market. It can do what it's been doing this week, and what it used to do pre-crisis, with these "as needed" temporary open market operations. They could also set up a permanent function of some sort to automatically provide liquidity to this market as needed. Or they could resume Quantitative Easing, which would expand the size of their balance sheet, and in so doing provide more liquidity to the repo market (as well as other financial markets). Given how powerfully the stock market has responded to QE efforts implemented over the past decade, the idea that this repo market situation might be an argument in favor of new QE is going to garner attention.
Risk is always with us
That's how all this fits together — this week's repo market craziness, the Fed rate cut, the Powell answer regarding "resuming the growth of the Fed's balance sheet earlier than we thought," and the stock market turnaround when he cracked the door open to that possibility. It seems as though this repo market episode is mostly a plumbing issue that the Fed needs to — and will — sort out. But it's also a reminder that the financial system can be surprisingly fragile at times, and risk is always present.