With the Coronavirus causing economic chaos worldwide, stress continues to mount on financial institutions as bond yields nosedive to record low levels. For the first time in history, a U.S 10 Year Government Bond pays you less than 1%. Plus, considering both the Federal Reserve has issued an emergency rate cut of 0.5% and the Fed Funds futures market is pricing in additional cuts, the collapse in yields is far from over.
Rates falling in spectacular fashion is a sure sign of tightening conditions, and, right now, they’re transforming financial markets. The unwinding of the Fed’s repo injections has created a stock market rout wiping 19% off global equities, while credit markets feel the knock-on effects: The FRA-OIS spread: the difference between 3-month LIBOR (the interbank lending rate) and the overnight index rate (the central bank’s risk-free rate), is widening at a rapid pace, showing building pressure within funding markets. Clearly, liquidity is scarce.
But while financial institutions are facing tough times ahead, if any bank, hedge fund, or insurance firm runs into significant difficulty, their odds of surviving are now greater, thanks to the Fed’s new strategy for preventing future financial panics.
Traditionally, during monetary emergencies, institutions borrow credit from the Fed’s lending facility called the Discount Window. According to the Fed’s website, “The discount window helps to relieve liquidity strains for individual depository institutions and for the banking system as a whole by providing a reliable backup source of funding,” or, in other words, the Fed can rescue insolvent entities that fail to secure a counterparty.
However, there is a problem: the Discount Window is public-facing. If an entity is a public company and applies for emergency funds via the lending facility, the institution exposes it’s insolvency to society, but, more importantly, shareholders. During the financial crisis, both Bear Sterns and Lehman Brothers taught us that stock prices can go to zero when there’s even a hint of distress. A collapse in share prices leads to the inevitable bank run, and due to the fragility of the global, interconnected banking system, financial contagion will spread quickly.
But, if the Fed’s role is to maintain confidence then the discount window becomes obsolete.
Instead, they needed a way to save struggling institutions “off the books” to maintain stability in the financial system. Luckily, the central bank has achieved anonymity by intervening in the repo market: an interbank system where financial institutions trade repurchase agreements (repos): a short-term form of borrowing for dealers in government securities to help meet their reserve requirements.
On September 15th, 2019, the media launched repos into the mainstream. News spread of rates spiking from the long-term average of 2.5% to 10.5% in a matter of minutes, forcing the Fed to reduce rates by injecting additional liquidity.
Contrary to popular belief, Fed policy prohibits officials from intervening directly within the repo market. They must deposit securities — mostly in the form of treasuries — into the reserve accounts of primary dealers: major financial institutions such as J.P Morgan and Deutsche Bank, who then use the collateral to trade with other repo market participants.
Conveniently, repo transactions are completely anonymous, and while the Fed records how much they inject in the repo market, what primary dealers then do with the collateral is a complete mystery. So when any institution gets into trouble, the central bank transfers emergency funds to the primary dealers, who then transfer the funds to the distressed entity: a hidden interbank bailout. It gets more interesting when you realize foreign banks have access to the repo market, meaning the Fed can rescue any global financial institution in secret — hidden from the public eye.
Which makes you think: what happened on September 15th, 2019? Why did the Fed intervene? Was a bank bailed out right under our noses? Was there a deeper technical problem in dollar funding markets? And why, all of a sudden, has MBS (mortgage-backed securities) issuance risen?
While the rate spike event created an abundance of puzzles for economists to solve, there’s one thing we know for sure: As the Fed has injected over a trillion dollars into the repo markets over the past six months, someone out there is in need of some serious funding.
But, we can only speculate. The truth is we’ll never know the real reason behind the recent monetary mayhem as the repo market’s anonymity shrouds any adverse event in eternal secrecy.