Invesco PMs on Repo Volatility
Invesco Fixed Income's latest "Global Fixed Income Strategy," contains a Q&A on recent repo market volatility with Portfolio Manager Justin Mandeville and Head of Government Portfolio Management Marques Mercier. They write, "Last fall's volatility in the market for repurchase agreements (repos) raised concerns about potential market action at year-end, when pressures are often amplified. We ask the Global Liquidity team to review how year-end 2019 played out and share what they expect in the coming months regarding repo market volatility and the Fed’s ability to control it." It asks, "Following volatility last fall, there was concern about a year-end spike in repo rates. Did it materialize?" Marques answers, "The overnight repo markets were calm over year-end and the anticipated volatility never materialized. Overnight funding rates remained within the Fed's target range, even though the term repo markets had priced in higher repo rates leading up to year-end. This market action dispelled concerns about the Fed's capacity to control rates at the short-end of the yield curve." The piece continues, "What helped mitigate funding pressures at year-end?" Mandeville explains, "The Fed's injection of liquidity into the banking system via USD255 billion in temporary open market operations (TOMO), including overnight and term repo operations, conducted with primary dealers, and USD157 billion in Treasury bill purchases. The preparedness of market participants, who appeared sufficiently funded approaching year-end. In addition, banks adjusted their repo balance sheets toward the end of December, reducing leverage while maintaining sufficient capacity to participate in the overnight funding markets. Finally, the Fed lowered the rate on its foreign repo facility to match the overnight repo rate offered to domestic institutions. This rate adjustment incentivized foreign institutions to reallocate their cash into alternatives such as Treasury bills, putting downward pressure on interest rates at the front-end of the curve." When asked "Now that year-end is behind us, will the Fed continue to provide liquidity to the market through open market operations?" Mandeville says, "Ideally, the Fed would like to remove itself from the repo markets, which we anticipate will occur in a timely and gradual process to avoid market disruption and maintain stability in the funding markets. On Jan. 14 the Fed released an updated schedule of its TOMO, which shows that the facility will remain in place for at least a few more months, but with a reduction in the size of the 14-day term operations by USD5 billion beginning in February." The brief also asks, "What do you expect in terms of market action and Fed moves in the coming months?" Marques answers, "The supply/demand imbalance dilemma within the overnight funding market has been recalibrated primarily due to the Fed's liquidity injections. We expect volatility to remain muted in the coming months, as these injections have also provided psychological assurance to market participants that the stabilization of the overnight funding market is a priority. The Fed has committed to maintaining permanent open market operations of USD60 billion a month through the second quarter, and would gradually reduce temporary open market operations after the April 15 tax deadline. By then, we believe a sufficient level of reserves will have accumulated in the banking system." Finally, Invesco asks, "What has been the biggest takeaway from the September spike in repo rates?" Mandeville answers, "We believe the most important lesson from this experience has been understanding the systemic importance of reserve management and the maintenance of adequate liquidity in the repo market. When the dislocation in repo rates occurred, the biggest concern centered on the Fed's ability to provide sufficient liquidity to the market and the ability of bank reserves to make their way to institutions that do not have direct access to the Fed. We believe the Fed has demonstrated that it has the necessary tools to inject liquidity and return stability to the markets. The Fed's task ahead is to determine the appropriate level of reserves to maintain in the system to avoid a repeat of September's events."
