‘The Levee Has Broken’: Misbehaving Repo Market Underscores Loss Of Fed Control

You can probably expect another IOER “tweak” from the Fed on Wednesday, or even “emergency” action before then, in an effort to alleviate an acute funding squeeze.

“The USD funding levee has broken”, BofA’s Mark Cabana wrote Monday evening, following a spike in GC repo around large coupon settlements and this month’s corporate tax payment deadline, which is expected to suck between $75 and $100 billion out of funding markets.

Monday’s (mis)behavior in GC repo spilled over, with widening in FRA-OIS and X-ccy basis, all indicative of dollar liquidity problems and reserve scarcity.

Read more: Jay ‘Behind-The-Curve’ Powell, And Why The Fed May Have To Start ‘Outright QE’

Overnight repo surged as high as 4.75% on Monday (one desk saw 8%), threatening the Fed’s control of rates, as this could yank the fed funds effective rate higher towards the upper-end of the range. The “problem” continued on Tuesday, with the rate opening at 7%.

(BBG, ICAP)

The effective fed funds rate rose to 2.25%, right at the top of the Fed’s target range. That is 15bps above IOER. That makes Fed intervention to address the situation more likely, although the threshold might be a bit higher.

“Repo pressure is almost entirely a settlement story with $54 billion of net supply in Treasury coupons landing on already very crowded dealer balance sheets”, NatWest’s Blake Gwinn said, in a note.

This unruly action in dollar funding markets is something the Fed has been grappling with for quite a while, and this week’s “chaos” (as one observer put it) means Jerome Powell will need to do something to ameliorate the situation or risk making it worse in “error of omission” fashion.

(BofA)

“Sustained FF pressure will likely raise questions about the Fed’s ability to control money markets”, BofA’s Cabana notes, adding that “the recent FF pressure and expectation that it will persist over coming days now makes an IOER cut at the September FOMC meeting our base case”.

(BofA)

As discussed in the linked post above, another IOER tweak is just a Band-Aid to buy time. Wresting back control will require temporary repos, putting in place the long-rumored standing repo facility or, if that’s not ready to go yet, outright QE.

“Our biggest question is when the Fed starts expanding its balance sheet to address the pressure [and] our best guess is it would do so when FF trades at IOER+15 to +20 bp”, Cabana said Monday, adding that “depending on the severity of funding pressures this threshold could be reached this week”.

As noted, this is a problem that’s been lurking in the background, and it appears to have now boiled over thanks to the collision of liquidity withdrawals (the corporate tax payments and rebuilding of Treasury’s general account) with the ongoing flood of supply unleashed after the resolution of the debt ceiling and maxed-out dealer balance sheets.

And then there’s last week’s bond rout. “Overall, I feel like the rate spike is related to the cash market selloff last week”, Scott Skyrm, VP at Curvature Securities said Monday. “As retail clients sell securities into a down market, the banks accumulate long positions and then need to finance more collateral in the repo market”, he added.

“Monday’s behavior in GC Repo has again exposed the lagging structural effects of 1) the prior QT program, 2) policy rates remaining near 11.5 year highs and 3) ongoing and massive UST issuance, all against an acute near-term liquidity withdrawal”, Nomura’s Charlie McElligott remarked in a late Monday evening client blast.

The fact that this came mid-month (as opposed to month-end/year-end) makes it all the more disconcerting.

So, just one more headache for the beleaguered Fed chair, although one he likely anticipated – or at least so one hopes.

“In light of this horribly-timed $Funding dysfunction, Fed Chair Powell HAS to address this issue somewhere during this week’s meeting, as a ‘head in the sand’ technique of ‘just 25bps and more mid-cycle’ talk could see the pressures in the front-end turn disastrous for systemic liquidity between now and year-end if no further guidance is provided regarding either an acknowledgement of the issue through another IOER cut, and longer-term, a more powerful outright “EASING CYCLE” or discussion of the acceleration of LSAP to expand the balance-sheet once again and in an effort to again provide an ‘ample reserves’ environment”, McElligott chided, summing up this vexing situation, and echoing BofA’s Cabana who has been shouting about this in note after note for months.

Read more: New York Fed Forced To Intervene After Funding Squeeze Goes Mental