The Repo Ruckus

This is now about three weeks old news, but it is increasingly clear that it is not clear why it happened or if it will happen again.  There was an outbreak of completely unexpected volatility in the repo market, where in the past the Fed had carried out open market operations, although that had largely passed.  Indeed in more recent years when the Fed has intervened in markets it has been in the reverse repo market.  In any case, interests rates shot up as high as 9 or 10 percent at one point, with the federal funds rate also getting out of its allowed range on the upside, although not by that much.  The New York Fed pumped about $400 billion into the market to stabilize it, so there was no immediate fallout from this, and if it happens again, probably the Fed can do it again. Nevertheless, this is a sign of things going on in the markets that are poorly understood, and John Williams, the New York Fed president has come under criticism for not providing any clear explanations.

What we have are several theories, with what happened probably a combination of them.  The blowup seems to have reflected an out-of-the=blue liquidity crunch in the system.  One reason for lower liquidity is due to the gradual drawdown of the Fed balance sheet, which reportedly had declined from $1,6 to $1,4 trillion during 2019.  This was all part of a "normalization" effort by the Fed, which now seems to have halted.  A likely culprit for the crunch was the impending end of the third quarter when financial demands by many firms increase due to needing to pay taxes and also to make various portfolio adjustments prior to making quarterly reports, with these times in the year often seeing at least some increased pressures and volatility, if not usually on this scale.  Another factor some have proposed as playing a role is the capital requirements on big banks from the Basel III Accords, although these have never been a problem before. But the  problems do apparently seem to have emanated from larger banks, which is consistent with this aspect.  It may also be that there are things going on in the shadow banks that are aggravating the liquidity demands, although they remain shadowy as usual.

In any case, the effort to return to a supposed pre-Great Crash "normal" seems to be dead, for better or worse.  We are in a different system now, but exactly how it operates and what are the sources of its apparent new fragility remain somewhat unclear.  Whether this portends more serious upheavals and possible crashes and recession also are unclear.

Barkley Rosser