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The repurchase agreement market calibrates institutional cash holdings and Federal Reserve-targeted interest rates.
Repurchase agreements are temporary loans that allow financial institutions to borrow money by selling securities. These loans have an interest rate called the repo rate, which is calculated based on the difference between the transaction price and the original purchase price of the security. Reverse repos are a type of repo in which securities sellers agree to buy back their own assets for a gain at a later date. Repurchase agreements and reverse repos are used by banks as tools to manage cash reserves and influence monetary policy.
The repo rate turned volatile starting in September 2019.
The Federal Reserve (Fed) sets the federal funds rate, which is a benchmark for interest rates in the United States. The Fed also influences other interest rates by setting specific target ranges for them. However, there was an anomaly with these two rates during September 2019. While the fed funds rate increased by only 0.25%, repo rates rose substantially higher than that amount and even surpassed their normal range of fluctuation (0%-0.75%). Experts say this difference occurred due to greater demand for cash than usual, but they don’t completely agree on why that happened or whether it’s typical behavior during tax season and Treasury auctions.
There are several possible reasons for the abnormal volatility in the repo rate. One reason is that quantitative easing (QE) has been used to manage short-term interest rates since 2008, and it’s still in place today. The QE program allows the Fed to purchase securities, which increases their capacity. Another tool they use is reverse repos, which helps them control short-term interest rates. When the Fed started reducing its QE purchases in 2014, there was less money available for banks to lend out via reverse repos and bank reserves dropped as a result of this lack of liquidity from QEs end. As a result, banks held onto cash instead of using it to buy Treasuries through reverse repos during this time period when reserves were low; thus causing the repo rate to go up sharply due to an increase demand for these loans by investors looking for higher yields on their investments than those offered by conventional Treasury bonds at that time.
Both the federal deficit and financial regulations might be overstretching the repo market.
The US government funds its budget deficit by issuing Treasury securities. Over 2018 and 2019, the US increased its debt by 50%. This could overwhelm the repo market with too much debt.
Financial regulations have changed the way banks operate. Banks are now required to hold a certain amount of money in reserve, and they can’t sell Treasury bonds as quickly as they used to. This has caused them to keep more cash on hand than Treasuries because it’s easier for them to use that money if an emergency arises.
