Don’t Fear the Repo

December 18, 2019
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The fourth quarter is winding down, and investors are getting nervous that volatility in the short-term lending market could flare up once again.

Rates on repurchase agreements (repos) jumped in September 2019 amid a shortage of cash available to lend, forcing the Federal Reserve (Fed) to restore balance in the system by purchasing U.S. Treasuries and other securities from firms. We covered that episode in our blog, “The Repo Market’s Perfect Storm, on September 27.

The Fed’s actions eventually stabilized repo rates, and financial markets ultimately shrugged off the issue. The S&P 500 Index has climbed 7.3% since the end of September, and other credit markets barely registered the event.

“September’s bout of volatility was concerning, but it was the perfect storm of unusual circumstances,” said LPL Financial Chief Investment Strategist John Lynch. “Volatility in the repo market could increase as quarter-end nears, but we expect a Fed intervention will smooth any bumps out.”

Here are a few reasons we’re not concerned about a repo-market meltdown:

Repo market volatility has been seasonal. As shown in the LPL Chart of the Day, repo market liquidity gaps are common around quarter-end as corporate demand for cash typically increases.

12_18_2019-Blog-Chart

To be sure, market dynamics could increase the likelihood of liquidity gaps. Treasury issuance will likely remain high amid a ballooning U.S. budget deficit, and companies’ cash needs will persist.

The repo market has shrunk considerably. It’s unlikely that repo market liquidity gaps will become systemic issues. The repo market is a fraction of the size it was before the 2008 financial crisis, when surging lending rates ultimately led to a significant breakdown in fixed income markets.

Even September’s episode was relatively localized. The overnight repo rate jumped about 60 basis points (0.6%), a move that pales in comparison to the repo market swings in late 2007. The 1-month London Interbank Offered Rate (LIBOR) climbed less than 10 basis points (0.1%) over the same period. These rates settled down quickly, thanks to the Fed’s quick action.

The Fed is watching. The Fed has enacted minor liquidity measures in repo markets for several years now. Since September, policymakers have ramped up discussions about long-term repo market solutions. In October, the Fed announced it would buy about $60 billion in Treasury bills per month to boost banks’ excess cash balances. The Fed has also committed to injecting liquidity in the repo markets as needed.

To paraphrase Blue Oyster Cult, “don’t fear the (repo).”

 

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This Research material was prepared by LPL Financial, LLC.

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