Repo’s Era of Calm Is Over as Fed Pullback Reignites Volatility

(Bloomberg) — The era of calm in short-term funding markets is over.

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After roughly four years of orderly trading when banks and fund managers lock-in funding at the end of each month, quarter and year, volatility has erupted again. Gyrations in repo rates sent one benchmark to a record on Thursday, while huge oscillations beset the market for short-term loans collateralized by Treasuries.

The return of these violent swings is largely thanks to the Federal Reserve, which is removing liquidity from the system via quantitative tightening, or QT. That’s reawakened volatility around these key funding periods, when banks pare activity to shore up their balance sheets for regulatory purposes, forcing would-be borrowers to either find alternatives or pay up. At the same time, the glut of government debt sales means more collateral that needs financing from the repo market.

“It’s finally happening,” said Scott Skyrm, executive vice president at Curvature Securities. “With months of balance-sheet runoff and massive Treasury issuance, we are at a point when supply is creating more volatility in the market. I think 2024-2025 will have the volatility of 2018-2019.”

The Secured Overnight Financing Rate, a benchmark connected to overnight repo transactions, rose to a new all-time high of 5.40% as of Dec. 28, according to New York Fed data published Friday. That surpassed the previous record set Dec. 1 and matched earlier this week.

Meanwhile, the rate on overnight general collateral repurchase agreements has fluctuated. On Friday, it first traded at 5.62% before dropped to 5.45%, according to ICAP. That has since plunged to 5%, according to Clear Street LLC.

The market is, in effect, returning to normal after years under the central-bank’s influence, but the sudden adjustment is not without its risks.

Volatility in short-term funding markets can hinder central bankers’ ability to manage monetary policy, for example. Funding dysfunction also poses risks to the broader economy by potentially pressuring borrowing costs for the government and beyond — at a time when benchmark interest rates in the US are already at two-decade highs.

The market ructions of September 2019 provide a salient lesson. Back then, increased government borrowing exacerbated a shortage of bank reserves that was created when the Fed slowed its buying of Treasuries and investors took up the slack. Overnight repo rates — widely relied upon by Wall Street banks to fund day-to-day operations — jumped five-fold to as high as 10%, and order was only restored after the Fed restarted purchases of repos to stabilize the market.

While the volatility this month and last is of a much smaller magnitude, there are some echoes. A pile of Treasuries on primary dealers’ balance sheets — a byproduct of QT and stepped-up government borrowing — has impeded banks ability to provide short-term financing during their month-end crunch. Meanwhile, demand for such funding had jumped thanks to the rally in Treasuries.

The pressures highlight the high-stakes debate over whether the Fed is misjudging how far it can shrink its balance sheet without causing dislocations.

Beyond the wider funding benchmarks, QT is also impacting demand for specific securities. Traders are paying a premium to borrow the most current 20-year Treasury bond in the repo market because the Fed — which previously alleviated any increased repo demand — now only owns about 1% of the issue, with most tucked away in portfolios that don’t lend.

While this pressure will likely ease once the new issue settles next week — and overall funding conditions should also start to unwind — such month-, quarter- and year-end stresses seem back for good.

“This year’s window-dressing distortions have been so acute,” Wrightson ICAP economist Lou Crandall wrote in a note to clients Friday. That rush to find funding may accelerate the peak of the pressures, and “rates could start to edge down as soon as Jan. 2.”

–With assistance from Cristin Flanagan.

(Updates throughout with context, quotes.)

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