Recent volatility in overnight funding markets has resulted in unprecedented levels of interest rates on repurchase agreements — so-called “repo rates.” The unexpected turbulence has prompted the Federal Reserve (Fed) to inject billions of dollars of liquidity into the system through open market operations used to control short-term interest rates. But while several factors appear to be pressuring money markets (more about that below), it is important to point out that systemic credit market distress is not one of them.
A supply/demand imbalance drove repo volatility
Invesco Fixed Income’s view is that a simple supply/demand imbalance has been building between the amount of collateral (Treasury securities) in the money market and the amount of cash available to purchase it. On Sept. 17, this dynamic intensified as a large settlement of Treasury securities, a spike in the issuance of Treasury bills, constraints on the volume of securities that primary dealers could absorb, and quarterly corporate tax payments combined to generate an outsize surplus of collateral relative to the amount of available cash.
Cash, in this instance, is bank reserves. The bulk of bank reserves is owned by the four largest banks in the US, which account for about half of all reserves.1 This high concentration of reserves (mostly required to fulfill bank regulatory rules), has created a scarcity of cash available to lend (buy securities overnight) in the repo market.