(Bloomberg Opinion) -- The repo market madness lives on for a ninth day.
The Federal Reserve Bank of New York announced Wednesday that it would increase the size of its next overnight system repurchase agreement operation to a $100 billion maximum, from $75 billion previously, and also raise the limit on its 14-day term repo operation to $60 billion from $30 billion. Simply put, the bank wants to flood the funding market with enough cash to soak up all the securities that dealers submit and leave no doubt that the critical financial-system plumbing is in fine working order ahead of the end of the quarter.
By now, just about everyone has heard the explanations for this persistent liquidity squeeze, which has lasted long enough to refute the earlier notion that it was merely a one-day confluence of unfortunate events. To some, the main structural issue is that banking regulations are disrupting the financial system’s inner workings. Others say the Fed has simply found the lower bound for reserves necessary to control short-term rates and can move forward accordingly.
In addition to those two assessments, I’d offer another angle that’s largely flown under the radar: The chaos in repo markets was a long time coming given the widening U.S. budget deficits and the lenders that are financing that shortfall.
Deficits, while nothing new, add up over time. And while they declined each year from 2011 through 2015, both overall and as a percentage of gross domestic product, the gap has widened again under President Donald Trump. Put it all together, and the amount of U.S. Treasury securities outstanding has roughly tripled since the financial crisis:
This growth was mostly under control in the years after the financial crisis because the Fed had been buying up large chunks of the Treasury market through its quantitative easing programs. But it was gradually reducing the size of its balance sheet from late 2017 until July, precisely at the same time that the Treasury Department was increasing the size of its monthly auctions to finance the bigger budget shortfalls. All told, the Fed now holds about $2.1 trillion of Treasuries, down from almost $2.5 trillion previously:
The Fed remains the largest single holder of Treasuries. But combined, Japan ($1.13 trillion) and China ($1.11 trillion) own more. And yet, even with those huge stakes, the two countries haven’t been keeping up with the growth in the world’s biggest bond market. In fact, on a percentage basis, Japan’s U.S. Treasury holdings are close to the lowest in at least 20 years, while China’s are the lowest since mid-2006:
So if it’s not the Fed, it’s not China and it’s not Japan, where are all these Treasuries going?
U.S. commercial banks are certainly a place to start looking. They’ve done their part since the financial crisis, but especially lately, with holdings of Treasuries and agency securities climbing to almost $3 trillion as of Sept. 11:
Primary dealers, a select subset of banks that are obligated to bid at Treasury auctions, were saddled earlier this year with the most Treasuries ever — an outright position of almost $300 billion. Even now, their holdings are more than double what they were a year ago as they’re required to take down larger pieces of the U.S. government’s debt sales.
There are simply too many bonds (or, in the language of the repo market, “collateral”) sloshing around in the financial system and not enough cash on the other side of the trade. America’s budget deficits are being financed domestically and leading to a relentless drain on reserves:
All this goes to show that fiscal stimulus — which I’ve argued that bond markets are begging for — doesn’t quite work by itself. Without the Fed helping to finance deficits by accumulating Treasuries, the financial system seems doomed to seize up. Someone has to take what the Treasury is offering, and given that the 24 primary dealers are by definition the buyers of last resort, it falls on these critical institutions to pick up the slack.
JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said that the banks “have a tremendous amount of liquidity but also have a tremendous amount of restraints on how they use that liquidity.” As former Minneapolis Fed President Narayana Kocherlakota wrote for Bloomberg Opinion, requirements like holding a certain amount of liquid assets and maintaining a minimum leverage ratio, which sound perfectly reasonable in theory, can distort lending and borrowing in unforeseen ways.
Boiling down the New York Fed’s repo operations to their most basic level, the central bank is effectively coming into the market every morning, taking excess securities from dealers and giving them cash instead. This is a quick fix to offset the liquidity imbalance, but it’s not a permanent solution. Fed Chair Jerome Powell said last week that it’s “certainly possible that we’ll need to resume the organic growth of the balance sheet earlier than we thought,” and indeed it seems likelier by the day that policy makers will announce such a move by their next interest-rate decision on Oct. 30.
Wall Street strategists have gone to great lengths to say that such organic growth is not QE. I’m fine with that distinction. But ultimately it comes down to the fact that the Fed seems to have little choice but increase the size of its balance sheet in the face of trillion-dollar budget deficits, whether in good economic times or bad ones. U.S. banks can’t afford to have the Fed out of the market entirely.
The financial system, as it is today, is choking on Treasuries. And only the Fed can perform the Heimlich.
By contrast, the New York Fed wasn't able to do that on Wednesday. Its overnight repo operation was oversubscribed as dealers submitted about $92 billion of securities, but it only took $75 billion.
To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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