The Fed on Tuesday announced yet another new facility to help foster stability in the global financial system, amid what might very fairly be described as one of the worst international crises since World War II.
In a statement, the Fed unveiled a temporary repo facility with foreign central banks and international monetary authorities. This is necessary, the Fed says, to ensure “the smooth functioning” of markets “including” the UST market, traditionally the deepest, most liquid market on the planet, but a space where things went awry midway through March.
Under the temporarily facility, foreign central banks and other international monetary authorities with accounts at the New York Fed can post their Treasurys for dollars, which can then be made available to entities in other locales.
The goal here – and the Fed explicitly states this, although not quite in these terms – is to avoid the kind of Treasury liquidations witnessed in March, when market participants sold anything that wasn’t tied down in order to raise USD cash.
Here’s the Fed to explain (and do note the bit about trying to avert a rise in yields at a time when the US government will need to borrow to finance stimulus and the Fed is increasing its holdings):
The facility reduces the need for central banks to sell their Treasury securities outright and into illiquid markets, which will help to avoid disruptions to the Treasury market and upward pressure on yields. By allowing central banks to use their securities to raise dollars quickly and efficiently, the facility will also support local markets in US dollars and bolster broader market confidence. Stabilizing foreign dollar markets, in turn, will support foreign economic conditions and thereby benefit the US economy through many channels, including confidence and trade.
The cynical among you will suggest the Fed is really stretching the limits of what kind of actions can plausibly be couched in terms of “benefiting the US economy”, but then again, we push those limits all the time in the foreign policy sphere. Everything, no matter how controversial, can be explained away by reference to “increasing America’s national security”.
Here, for those who need the visuals, is what “illiquid” Treasury markets look like:
Recall the following bit from JPMorgan’s Josh Younger writing (presciently, it turns out) just prior to some of the worst turmoil in UST markets in recent memory:
Though we have yet to see how broadly and acutely the economic consequences of the COVID-19 outbreak will be felt, pervasive remote working arrangements could impact market operational risk. We are already potentially seeing the first signs of disruption in reduced dealer risk-taking capacity. We show in Exhibit 7 that market depth has already fallen considerably—especially in the long end, where it is worse than 2008 levels—but there are some signs of more troubling cracks in market making. Recent acute, intraday episodes of stressed liquidity have been reminiscent of the “Flash Rallies” of 2014 and portend a further deterioration in orderly price action to come. In principle, one would expect the high-frequency trading activity (HFT) that dominates liquidity provision in interdealer Treasury markets to be more resilient in a WFH construct—it is automated after all. However, these traders are also notoriously skittish when volatility spikes. Though “human” traders have typically provided a backstop in prior episodes, WFH and split working arrangements likely introduce new frictions owing to potentially inefficient communication and systems issues. If that occurs we believe this particular circuit breaker will not function effectively, which could significantly extend the vicious cycle of higher volatility begetting lower liquidity, and so forth. Among other things, this means significantly higher transaction costs, even for benchmark Treasuries are possible.
The forced selling in Treasurys this month added insult to injury for multi-asset investors, whose “balanced” portfolios were besieged on all fronts, from equities to credit to commodities to bonds. “This facility should [provide] an alternative temporary source of US dollars other than sales of securities in the open market”, the Fed said.
In addition, the new facility is yet another source of USD liquidity for a thirsty world. Although the Fed was reasonably successful in tamping down the acute dollar-funding stress that spilled over into the spot market (and pushed the greenback “vertical” earlier this month), some have argued that further measures are necessary.
The new repo facility is meant in part to compliment the swap lines. “[It] should serve, along with the US dollar liquidity swap lines… to help ease strains in global US dollar funding markets”, the Fed said Tuesday.
These are overnight repos, but they can be rolled as needed. The rate is 25bps over IOER, which the accompanying fact sheet notes is generally higher than private repo rates when the Treasury market is functioning normally. That, in turn, means the facility “would primarily be used only in unusual circumstances”, the Fed says. Suffice to say the current circumstances are the very definition of “unusual”.
The new facility will be open from April 6 and will run for at least six months.