The Federal Reserve is rapidly growing its footprint in the all-important Treasury repurchase agreement (repo) market. What exactly does that mean? In short, the Fed has amassed a quarter of this trillion-dollar market, which is used by financial institutions across the world to borrow dollars overnight. It has done so to prevent short-term interest rates from falling into negative territory, an unintended consequence of the Fed’s other policies. In fact, a perfect storm might be brewing. If Congress allows the debt limit suspension to expire on July 31, pressures for negative rates will intensify.
Over the last 15 months, the Fed has nearly doubled the size of its balance sheet. It stood at $4.2 trillion in March 2020, up from $0.9 trillion prior to the 2007-2008 financial crisis and close to its $4.5 trillion high-water mark in January 2015. This month, the Fed’s balance sheet stands at $7.8 trillion. Its increased size is due to the Fed’s pandemic response. The Fed has purchased a tremendous volume of Treasury bills and mortgage-backed securities. Similar to its response after the financial crisis, the Fed’s recent purchases are an attempt to calm markets and lower long-term interest rates.
The Fed has primarily financed these securities with reserves, electronic cash held by private banks at the Fed. Since March 2020, reserve balances have grown from $1.7 trillion to $4.0 trillion due to these purchases. Think of the Fed as the bank for banks, and reserves as the banks’ checking account deposits. When the Fed purchases an asset from a bank or its customers, it simply credits the bank’s account balance. It is creating money “ex nihilo,” Latin for “out of nothing.” These purchases continue at a pace of $120 billion of securities each month. As a result, the banking system is not only awash with liquidity, it is positively flooded.
As I discussed in March, this flood of liquidity has had a predictable effect. With Fed policymakers already holding short-term interest rates near zero to boost the post-COVID economic recovery, the increase in liquidity has softened overnight interest rates and threatens to push them into negative territory. Already, the interest rates on some Treasury repurchase agreements (repos) have fallen below zero. Indeed, up to 25% of overnight Treasury repos are occurring at marginally negative rates.
Why care about repo? The repo market is one of the world’s most important markets. Financial institutions use repo to obtain short-term financing: They sell an asset under an agreement that they will buy it back tomorrow at a fixed repurchase price. The repurchase price is usually higher than the sale price meaning that the interest rate is positive and the lender makes a profit on the transaction. Like Treasury bills, overnight repos secured by Treasuries are essentially risk-free: If the borrower doesn’t repurchase the collateral as agreed, then the lender can sell it. Low risk means low rates, and so repos are a common way to borrow cheaply. Negative rates occur when the repurchase price is lower than the sale price. In other words, a negative rate means it pays to borrow and costs to lend.
Why care about negative rates? Most people—myself included—first balk at the idea of a negative interest rate. Imagine if you earned a negative rate on your savings account. You would be paying for the privilege of saving. But in theory, the idea is not so crazy. Imagine a world awash in savings with limited opportunities for safe investment. You might be willing to pay a small premium to keep your money safe, particularly if you were planning to spend it in the near future.
Some economists have advocated for negative interest rates to better recover from deep recessions. Following their advice, the European Central Bank and the Bank of Japan have had negative policy rates for some time. Other economists and policymakers are skeptical. The Fed has a short-term interest rate target of zero to 0.25%. Summarizing his views on negative rates in 2020, Fed Chairman Jerome Powell said, “There’s no clear finding that it actually does support economic activity on net, and it introduces distortions into the financial system, which I think offset that.”
The Fed’s defense against negative rates is its Overnight Reverse Repurchase (ONRRP) facility. Each afternoon, the Fed offers pre-selected institutions (banks, government-sponsored enterprises and money market funds) the opportunity to lend to the Fed overnight. These loans are structured as Treasury repos. In order to keep short-term interest rates out of negative territory, the Fed sets the interest rate on these loans at zero percent. Why lend at a negative rate, and lose money, when you can lend at zero to the Fed? Here’s another way to think about it. The pressure for negative rates is the result of the Fed’s asset purchases flooding the banking system with liquidity. Using ONRRP, the Fed sells Treasury securities daily in order to drain liquidity temporarily. The Fed is doing with one hand and undoing with the other.
Use of ONRRP has increased tremendously since the start of March 2021. On Wednesday, ONRRP usage totaled $293 billion, up from zero on March 1. Combined with the Treasury repo tracked by the New York Fed’s Secured Overnight Financing Rate (SOFR), ONRRP volume amounted to 25% of overnight Treasury repo market loan volume. And this figure doesn’t include the roughly $200 billion of additional repo, conducted daily by the Fed with its foreign official and international account holders, an administrative workaround to pay them interest.
How successful has the Fed been at keeping short-term rates above zero? A primary indicator is the SOFR mentioned above. A key reference rate published by the New York Fed, SOFR is a broad measure of Treasury repo rates calculated as a volume-weighted median of eligible transactions. SOFR has held steady at 0.01% since March 11, 2021 and has never dipped below zero. That’s a win for the Fed.
However, because SOFR is a median, half of Treasury repo volume has occurred at rates lower than 0.01%. The New York Fed also publishes data on the 1st and 25th percentiles of SOFR-eligible transaction rates. The 25th percentile has mostly bounced between zero and 0.01%. The 1st percentile has gone as low as minus 0.05%. These figures make clear that anywhere from 1 to 25% of SOFR repo transaction volume is occurring at marginally negative rates. However, without more granular data, we cannot know the true percentage with greater precision.
The problem may worsen over the summer when Congress and the administration must once again address the nation’s debt limit. If the debt limit is not raised or resuspended by July 31, the Treasury Department will attempt to delay default by redeeming Treasury bills using its limited cash on hand. These actions put downward pressure on interest rates with a one-two punch. First, redeeming Treasury bills lowers the collateral available for Treasury repo. Second, paying off Treasury bills moves cash balances from the Treasury’s hands into the banking system, boosting reserves. The combined effect: Suddenly there’s more money chasing far fewer safe investments.
As we move into the summer, additional data would provide greater transparency about the repo market, the Fed’s growing role in it and the effectiveness of ONRRP. This would help policymakers and the public assess whether the Fed’s strategy to prevent negative rates is working or needs to be modified. Here’s a simple way for the Fed to start: Publish additional percentiles of the SOFR distribution. In other words, release a more granular picture. The current five-number summary is too simplistic for such an important financial market.