There has been a recent conversation and appropriate concern focused on the underlying stability of the Repo markets. A ferocious spike in rates recently set off alarms and getting to the bottom of the cause continues to be a difficult task.
A Repo is a corner of the financial markets that is relatively unknown to most people. Overnight Repo markets are generally used by banks and financial institutions to fund short term/overnight liabilities using assets such as U.S. Treasuries, securities or other intangible property as collateral. It is where financial institutions go when they need short term cash, in exchange for some collateral, like Treasuries or mortgage securities, for a short-term loan. Rather than having to sell off assets to pay or fund liabilities, institutions can use these overnight markets to access liquidity.
Repurchase Agreement (Repo):
“A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, the dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day.”
The Repo market is considered the backbone of Wall Street, and markets worry if it doesn’t work correctly or shows increased stress. The read-through is that disruptions within the Repo market may be a red flag to other tensions percolating up within the financial system.
Recently, the Federal Reserve has provided liquidity through injections of funds into the Repo markets in order to calm them. However, there has been some confusion as to why these markets have come under pressure in the first place. This is precisely why we wanted to gain a better understanding of what was really going on. We decided to call on Kris Moreton, Fixed-Income Portfolio Manager with Columbia Threadneedle Asset Management to see if she could shed some light on the situation.
As we have portfolio positions with the Columbia Floating Rate Fund within the Horowitz & Company Global Allocations, the main goal of the inquiry was to see if there has been, or expected to be, any concern for this specific sector. Additionally, we were looking for insights into the reasons for the lack of liquidity within the overnight lending markets. While the floating rate/bank loan market is not directly related to the overnight Repo market, there is always the potential for contagion. We believe that even as these two markets aren’t perfectly correlated, the bank loan market could be the first to be impacted as these loans are usually lower in quality and have less liquidity.
We began the discussion addressing some of our concerns with both the Floating Rate/Bank Loan market as well as those related to the Overnight Repo/Money Markets. We were initially looking to drill-down into the reasons
that the Federal Reserve stepped in to provide approximately $200 Billion worth of liquidity to the Overnight Repo market during the week of September 18, 2019. Just prior to the Federal Reserve stepping in, the normally calm overnight Repo market suddenly saw yields spike to 10% after liquidity seemingly dried up. That rate was more than four times greater than the normal rates (2.00% – 2.25%) quoted recently.
Columbia Discussion Highlights:
- During a recent roundtable with various portfolio managers across Columbia, this was the first time since 2007/2008 that the portfolio manager of Columbia’s money market funds had a significant topic of discussion. As Kris recalled, the last time money markets came under scrutiny was when many thought that money market funds could “break the buck”.
Why did this spike in rates occur?
- It is being said, or potentially marketed, that this was a “technical imbalance”.
- There was an unusual amount of demand and a lack of supply due to corporations requirement to pay quarterly tax bills. Concurrently, there were large sales of money market funds as investors needed to settle-up from a previous session purchase of $78 billion in U.S. Treasuries during the previous week.
- Lenders, therefore, had less cash causing rates to spike with an imbalance of supply and demand.
Could there be a ripple effect to other lower liquidity markets like bank loans?
- There is always the potential for contagion, however, Columbia noted that mid-September was the first time in 43 weeks that the bank loan market saw positive flow back into the market.
- Columbia did note that they saw some ripple effect due to the transition from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate).
Concerns that noted as markets are reaching a peak in the credit cycle.
- Terms are becoming less attractive and leverage is rising.
- Triple-C, or lower-rated issuance, has increased dramatically and that is concerning.
- Despite the economy, Columbia believes that monetary policy is too tight right now.
Conclusions and Observations:
- This is going to be a wait-and-see situation. The Fed appears to now have a Permanent Open Market Operation (POMO) in place to alleviate liquidity and funding concerns in order to sooth market participants.
- It is not clear if this is a one-off technical condition or a reaction to current global monetary policy trends.
- Bond markets have not seen stress from this issue. However, monitoring the yield curve will continue.
- The impact of negative-yielding debt may have something to do with the tight overnight lending markets – this may lead to lower rates on U.S. debt issues in the future.
- No significant impact has yet to be seen within the fixed income space, inclusive of floating rate positions or lower grade “junk” bonds.
Downloaded the full commentary below.