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Last Updated on: 16th September 2021, 07:01 pm
The Federal Reserve Bank of New York voted unanimously to add US$40.9 billion in weekend liquidity to financial markets on January 10th, leaving some investors questioning why.
It’s never a good sign when the Feds are forced to pump cash into money markets. It implies that there’s a liquidity shortage among banks and short-term lenders. In other words, there isn’t enough cash laying around for overnight lenders to give out to smaller banks at the Fed’s target rate.
Since September, the New York Fed has injected a whopping US$230 billion (or the GDP of Portugal) into money markets in the form of repurchase agreements (or “repos”). Although this doesn’t spell doom for institutional investors, it’s a cause for concern for anyone who benefits from the stability of financial markets.
The problem this presents is a puzzle—one we shouldn’t yet disentangle without first laying out its pieces.
Table of Contents
What Are Repo Agreements?
The repo market refers to short-term lending between banks and other institutions dealing in government securities. A repo agreement is a contract to sell securities only to buy them back at a slightly higher price the following day. In other words, they’re a quick and easy way to raise capital overnight.
The Federal Reserve offers repurchase agreements to alter the money supply and ensure that banks have sufficient cash reserves to balance their assets and debts. Without repo agreements, smaller cash-strapped financial institutions may be declared insolvent by regulators which can set off a chain reaction of insolvencies and negative downstream economic events. In other words, repo agreements are a stabilizing force in an otherwise unstable lending market.
When you read about the Fed “adding liquidity” to the market, what they’re really doing is entering into repo agreements. Usually, US Treasury bonds are used as collateral, which makes them a relatively safe investment for both the buyer and seller.
Fractional Reserve Banking and the Repo Market
Banks must keep a certain percentage of cash on hand every day per federal law. However, banks are constantly spending deposits on various financial instruments to make money (i.e., equities, bonds, derivatives, etc.). Generally, banks tend to prefer riskier investments for their higher yield potential. However, when their portfolio exceeds a certain degree of risk, they expect the Federal Treasury to intervene and bail them out.
To ensure they have sufficient cash reserves, banks have entire after-hours teams tasked with ensuring that the fractional reserve quota is met every night. They do this by lending out collateral to other banks, in the form of repo agreements, which are repaid with interest at a tenor of 24 to 48 hours.
Although the Fed sets a “target rate” (currently 2.00%) that banks should use when lending to others, the money market is still, well, a market. Buyers and sellers ultimately decide what rates to use.
Enter Quantitative Easing
If there aren’t enough lenders at the target rate, then banks can lend out their collateral. When there’s not enough cash in the market (i.e., a liquidity crunch), banks have to ask for a loan at a higher interest rate, which means they have to pay back more the following day—this is why a liquidity squeeze causes rates to skyrocket as they did in September.
When the federal funds rate, a key area of central bank policy, unexpectedly rose, the Fed is generally quick to intervene. To bring the market back down to the predetermined target rate, the Fed intervenes and offers the cash at the target rate at the taxpayers’ expense. This is a program known as quantitative easing (QE). In these situations, there isn’t enough liquidity to keep the system afloat otherwise.
The Fed’s Rationale: Unpacking the Puzzle
The New York Fed explained that the sudden cash infusion was primarily spurred by a desire to ensure cash reserves remain sufficient during spikes in non-reserve liabilities. Additionally, the Fed wanted to manage the risk of money market pressure negatively impacting policy implementation and general market outlook.
Despite months of QE, banks are still having a difficult time getting the cash they need. The Fed’s first two cash injections in September and October were oversubscribed. Therefore, there’s still more demand for liquidity than there is a supply of it. This imbalance forces the Fed to increase its QE limits even more.
It’s possible that the big banks may be trying to strong-arm the Fed into initiating a full-on QE policy similar to what was seen in the aftermath of the global financial crisis. That would require the big banks to stop lending to the overnight market and instead leave the smaller banks to fend for themselves, scrambling for cash to meet fractional reserve quotas. It’s that, or wind up insolvent by the time the markets reopen in the morning.
What This Means For You
The Federal Reserve Bank is the lynchpin of the US financial system. As such, it’s the Fed’s job to ensure that short-term lending remains widely available. When interest rates unexpectedly spike, the financial world counts on the Fed to get involved via monetary policy.
As of now, the Fed plans to continue intervening in money markets until at least February, with TD Securities experts predicting a continuation until at least May 2020. In any event, the Fed’s exit strategy is uncertain and may bring with it a massively gummed up lending market and sweeping instability in a looming bear market.
If the banks’ balance sheets are askew, they may be deemed insolvent by regulatory agencies, and that’s when the dominoes tip. But repo operations are band-aid solutions to systemic problems. At best, they kick the can down the road until the next election cycle. At worst, they can flood the money supply with liquidity and cause a run-off effect on inflation.
The conclusion here is that US money markets are suffering. There’s a sustainability problem if the Fed is constantly increasing the supply of money to mitigate liquidity issues. Reallocating your portfolio to reduce exposure to government securities and stocks may be a good place to start toward protecting your investments in the months ahead—instead, invest in a reliable inflation hedge such as gold or other precious metals if you want to protect your wealth in times of market uncertainty.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.