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The Fed is well-equipped to handle year-end repo volatility

Invesco Fixed Income believes
the Federal Reserve (Fed) will add sufficient liquidity to the banking system to
alleviate rate pressure in the funding/repo markets that typically arises at year-end,
and avoid  the severe volatility
experienced in September. In the press conference that followed the Fed’s December meeting, Chairman Jerome Powell was
clear that the Fed will do what is needed to keep the federal funds rate in its
target range and repo rates under control. Soon after, the Fed also provided
an update on its year-end operations:1

  • The Fed will provide up to $490 billion in liquidity
    available through
    term and overnight repos through year-end. The Fed has been conducting daily
    overnight repo operations and offering periodic term repo since the first signs
    of repo market pressure emerged in September. (See our blog “Temporary
    measures have stabilized repo markets.”
    )
  • T-bill purchases are expected to reach $150 billion by year-end. The Fed has been purchasing US Treasury bills in
    the secondary market to inject liquidity into the banking system.

Therefore, by year-end, it is anticipated that the Fed will provide up to $640 billion in total liquidity, including $490 billion via open market operations (OMO) repo and another $150 billion in outright T-bill purchases.1

Figure 1: General collateral Treasury overnight repo rates have normalized since September

Source: Bloomberg L.P., data from April 1, 2019 to Dec. 13, 2019.

Will these
measures be sufficient to smooth expected year-end pressures?

The challenge the Fed faces is that,
although we believe it has offered sufficient liquidity to primary dealers to
fund themselves over year-end, it cannot extend this liquidity directly to non-primary
dealers and other market participants who are not eligible counterparties to
the Fed. The uncertain liquidity needs of non-primary dealers could cause some
repo volatility at year-end, but we believe the Fed has the tools in place to
avoid a spike in rates similar to what we experienced in mid-September.

Is a
permanent solution possible?

The Fed has also discussed the possibility of implementing a
standing repo facility (in which it supplies banks with reserves in exchange
for Treasury securities). This facility could provide a long-term solution to
alleviate funding pressures in the markets by establishing a ceiling on repo
rates, however, Powell has noted that this facility is not currently a
priority.

Conclusion

We believe the Fed is monitoring the year-end situation closely and
will likely make adjustments, if necessary, to ensure sufficient liquidity. We
believe such flexibility reduces the risk of extreme volatility in the federal
funds rate and repo rates at year-end.

1 Source: Federal Reserve Bank of New York, Dec. 12, 2019

Important information

Blog header image: Nick Fewings / Unsplash

The federal funds rate is the rate at which banks lend
balances to each other overnight.

The repo (or repurchase) rate is a form of short-term
borrowing at a designated rate, whereby a financial institution lends money to
a commercial bank. The repo rate can be used by monetary authorities to control
inflation.

The opinions referenced above are those of the author as of Dec. 18, 2019. These comments should
not be construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations.

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