Plumbing problems

Even seasoned market professionals have a difficult time explaining the repo rate spike issue. That said, it’s an important event to understand because it could have some real consequences for US monetary policy going forward.

In the most basic terms, on the evening of September 16th, there weren’t enough US Dollar excess reserves—cash held at the Federal Reserve that isn’t required as collateral for existing loans—which could be lent out to be used as collateral for new transactions, so the price of overnight Dollar borrowing skyrocketed—and we mean skyrocketed. The price move was described as a six standard deviation move, which is a one in 506,797,346 likelihood—no wonder the Federal Reserve has been stepping in every day since and providing for any Dollar shortfalls.

To understand why this is happening, it is important to know that Basel III capital rules have increased the proportion of collateral that must be held in cash against bank’s short-term lending.  This is crucial because money market lending, usually defined as less than three months but is truly concentrated at the overnight point, is where this cash requirement becomes most severe. 

This new standard also includes a slew of bank liquidity snapshots—at a specific date bank balance sheets are compared against a barrage of liquidity metrics—which encourages banks to hoover up Dollars on that day. There are also a host of other events which may cause a shortage of Dollars in the system, like the day when corporate taxes are all paid. In total, the result is a relentless and massive requirement for Dollars, but it only becomes a problem on those rare days when multiple cash-intensive events occur simultaneously… Like Monday the 16th.

But it goes even deeper than that. The Fed controls interest rate policy by setting the Fed funds rate, an overnight lending rate, and by defining a target band where the interest rate should remain. If rates move outside of the band, the Open Market Operations desk at the New York Fed will step in and increase/decrease the availability of Dollars to bring it back within the tolerance. The inability of the Fed to get ahead of this and maintain control of the rate casts doubt on its ability to control monetary policy as whole. 

It is by comparing the Fed funds rate against a US treasury security of some duration, that we can determine what market expectations for monetary policy may be over that time period. For instance, If the Fed funds rate exceeds the three-month instruments yield by 25bps we would expect the Fed to reduce interest rates by 25bps within that time frame. When market liquidity is thin—the number of willing buyers/sellers in the market is low—prices widen to compensate, and our view of this market pricing becomes muddy. The Fed uses market pricing like a sounding board when setting policy, but if it is obscured by liquidity premiums it becomes a less effective tool and that is problem.

Bottom line: This is a complex issue with loads of moving, interconnecting pieces but what is clear is that the Fed will have to act.  The bank simply can’t afford to let this issue become a permanent fixture of prices, especially with quarter-end next Monday.

The week ahead

GBP

Last week, Sterling closed above the 200-daily moving average on its trade-weighted index, meaning the level may be a significant support level over the coming weeks. With less than six weeks left until the Brexit deadline, the British currency is becoming increasingly vulnerable to sharp movements as Brexit details emerge in headlines. This week, there are no significant economic data releases for the UK, although on Thursday Bank of England Governor Mark Carney will speak in a panel discussion at the European Systemic Risk Board conference.

EUR

The Euro Index has been largely range-bound in September, but the common currency looks set to close the week at the lower end of this range. Another light week of data for the Eurozone may bring a week of low volatility for the currency. The major data release came in on Monday morning as detailed below, aside from that, the focus will be on European Central Bank (ECB) President Mario Draghi who speaks on Thursday afternoon

  • The week kicked off with a slew of disappointing European PMI’s, particularly German manufacturing, which posted its lowest reading since June 2009. In fact, Services, Manufacturing and Composite PMI’s for Germany, France, and the Eurozone as a whole all fell below expectations.

USD

This week, the data calendar is busier for the US Dollar than the other majors and could extend recent Dollar strength, which is supported by the 50-daily moving average on its trade-weighted index. Also scheduled this week are talks from multiple members of the Federal Open Market Committee.

  • At 2:45pm on Monday, US flash Manufacturing and Services PMI’s will be released. The expectation is for a slight expansion in manufacturing at 50.3, and a more pronounced expansion of 51.5 in the services sector.
  • On Tuesday afternoon, CB Consumer Confidence will catch investors’ attention as markets assess how the US consumer is coping with a deteriorating global economy. The expectation is a reduction from last month.
  • Final quarter-on-quarter GDP growth is released on Thursday at 1:30pm, expectations are for 2.0% growth.
  • The week ends with month-on-month Core Durable Goods and Personal Spending, and expectations are a 0.2% and 0.3% increase respectively. These forecasts suggest an uptick out of contraction for Core Durable Goods and a downtick in personal spending.