The US Federal Reserve announced on Friday, October 11, 2019, that it will buy $60 billion of treasury bills (T-Bills) each month to build its reserve. Jay Powell, the Federal Reserve Chairman, said that this decision was made to address the spike in the recent overnight repurchase agreement (Repo) rate. In this week’s blog post, we will talk about Repo, the recent spike in the Repo rate, the Fed buying T-bills, and how does buying T-bills increase the Fed’s reserve. Let’s dive in.
First, what is overnight repurchase agreement (Repo)? Let’s say there are 2 institutions: Alpha and Beta. A repurchase agreement is a type of short term borrowing where Alpha borrows cash from Beta in exchange for a security (collateral). Alpha intends to repurchase that security (collateral) from Beta at the end of the term. When Alpha repurchases that security, Alpha has to not only give back the borrowed cash but also pay interest to Beta. If Alpha is unable to repurchase that security, then Beta can liquidate that security and get its cash back. An “overnight” Repo implies that this short term borrowing period is only limited to one day. So, an institution would go to the overnight Repo market when it is in dire need of cash at that moment, but that institution is fairly confident that it should have enough cash the next morning to buy back its collateral. You can actually think of the Repo market as a pawn shop; institutions pawn assets for the time being, and later come back with cash (plus interest) and regain ownership of those asset.
Back during the financial crisis of 2007-08, the financial institutions used Mortgage Backed Securities (MBS) as their collateral in the Repo market. When the home default rates increased, banks needing cash tried to unload the MBS from their books to someone else’s. The repo interest rate spiked up at that time because institutions did not want any MBS as collateral. So now, when people hear Repo rates spiking up, they automatically think that there is something shady going on.
So, why was there a spike in the Repo rate in September 2019? The Repo rate usually hovers around the federal funds rate (about 2%), but on September 17, 2019, the Repo rate spiked up to 10% for some transactions. The short answer to why this happened was because liquidity dried up. In other words, there were way more borrowers (institutions needing cash) than there were lenders (institutions lending cash). There was a surge in demand for cash from companies making tax payments as well as investors that had to make large amount of Treasury settlements on that day. Additionally, it is believed that due to the unexpected attack on Saudi Aramco, investors, including Saudi Arabia itself, were seeking cash. In order to bring the Repo rate back down, the Federal Reserve had to step in and make cash easily available to the borrowers.
This was a wake-up call for the Fed as sudden spike in the Repo rate pointed out the lack of cash in the system. In the past 12 months, the Federal Reserve reduced its Treasury holdings and MBS securities by more than $400 billion. In other words, the Fed took out $400 billion out of the $3 trillion that it injected into the economy following the Great Recession. The Federal Reserve seems to have contracted its balance sheet a little too much too quickly. It is interesting to note that while the Federal Reserve was tightening, the bank reserves reduced by over $330 billion. Simply put, as the Federal Reserve took $400 billion out of the economy, the banks took $330 billion out of their “deposit boxes” (physical vaults at the local Federal Reserve that hold banks’ cash) and put it back into the economy. So, when Chairman Powell said that he wants to increase the amount of reserves that banks hold, he is say talking about those “deposit boxes”. Powell wants the “deposit boxes” to have more cash, and how is he going to do that? By buying treasury bills (T-bills) from banks.
Now, how does buying T-bills help increase the cash reserve? The Federal Reserve has decided to buy $60 billion of T-bills per month for atleast 6 months. When the Federal Reserve buys T-bills from banks, it pays for the purchase by crediting the banks’ reserve accounts. Let me give an example. When you buy a government bond, you pay $1000 in return for it. Similarly, when the Federal Reserve buys $60 billion of T-bills from a financial institute, it pays $60 billion cash in return for it. This is precisely how buying T-bills from banks increases the banks’ cash reserves. By having abundant cash reserves, the Repo rate would not spike up since banks would tap into their reserves rather than go pawn their assets in return for cash.
Additionally, on October 11, 2019, the Federal Reserve reduced the reserve compliance burden and stress testing requirements for smaller domestic banks and for foreign banks operating in the US. This rule easing for domestic and foreign banks will increase the available “free” liquidity and keep the volatility in the repo markets at bay.
In conclusion, the reason for the spike was due to low available liquidity/cash among institutions. If the banks had ample cash reserves, the Repo rate would have never spiked up to 10%. In order to address the overnight Repo rate spike, the Fed decided to buy T-bills and inject some cash into the “deposit boxes” (reserves). This way banks would use the cash in their “deposit boxes” rather than pawning their assets for cash in the Repo market. Lastly, since T-bills are backed by the US government (little to no risk), this type of buying is different from the MBS asset purchases that followed the Great Recession.
Hope you learned a little and found this blog post helpful. We talked about the Repo market, the spike in Repo interest rates, the reduced liquidity in the system, and the Fed buying T-bills. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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