The great question that is now being discussed within international financial circles is did ‘Economic Armageddon’ (i.e. the expected great economic crisis based on the biggest and most dangerous debt bubble in world history) actually commence in the United States of America (USA) on 17 September 2019? Such speculation has been rife given the unprecedented event that occurred in the general collateral (GC) overnight repo market on the day in question and which since triggered a crisis within the repo market and has forced dramatic policy action by the Federal Reserve Bank of New York (NYFR).
This article is part 2 of a two-part series explaining the current crisis within the repo market. In part 1 entitled “The Significance of the Repo Market”, I provided a technical explanation of what the repo market is and how critical was this market in triggering the 2008 Global Financial Crisis (GFC).
This knowledge provided in part 1 is essential to understanding the key elements and significance of the current crisis.
What occurred in the American Repo Market on 17 September 2019?
On Tuesday 17 September 2019, two extraordinary events occurred within US money markets resulting in significant concern and swift action from the NYFR. These events were:
the federal funds rate (the official interest rate) rose to 2.30% in response to the dramatic move in the repo rate which was 5 basis points above the target band of 2% to 2.25% set by the Federal Open Market Committee (FOMC).
The movement in the GC repo rate was the largest intraday move in the history of the repo market and the 10% rate reached was the highest rate recorded in decades.
These dramatic events in the repo market and in the unsecure lending market forced the NYFR to intervene with a dramatic injection of over $US 53 billion of liquidity on the 17th of September to bring both the repo rate and the federal funds rates within the target bands set by the FOMC.
To underscore how significant this occurrence is and as noted by Zero Hedge, since 2006, the average difference between the GC repo rate and the federal funds rate was 0.25%, whereas on 17 September 2019 the differential reached was 7.7%.
This differential represents at least 40 standard deviations from the average which is an extremely unlikely, if not an impossible, event occurring according to a statistically normal bell-curve distribution.
What did this market phenomenon communicate?
This unprecedented movement in the repo rate signalled that the repo market broke down through a lack of available liquidity.
For the financial system as a whole this is concerning because as the repo rate rose, commercial banks who had approximately $US 1.5 trillion in uncommitted reserves (or 90% of total reserves) deposited at the NYFR should have entered the repo market to take advantage of being able to earn higher amounts of interest income relative to the interest rate paid by the NYFR on deposited excess reserves.
The fact that this did not occur signals that market participants lacked confidence to enter into repurchasing agreements given concerns about the:
financial health of various counterparties; or
credit quality of the underlying collateral.
In the unsecured lending market, the movement in the federal funds rate above the target range by 5 basis points was significant because it signalled that the NYFR was losing its ability to implement monetary policy through one of its main monetary policy channels.
The NYFR Knew Something Was Already Wrong
Shockingly, it appears that the officials from the NYFR and from other regional Federal Reserve Banks within the US Federal Reserve system already knew something was brewing given that issues within the repo market was discussed at the 30 - 31 July meeting of the FOMC as revealed in the meeting’s minutes:
“Market participants pointed to pressures in repurchase agreement (repo) markets as one factor contributing to the uptick in volatility in unsecured rates. These pressures, in turn, seemed to stem partly from elevated dealer inventories of Treasury securities and dealers’ associated financing needs.”
False explanations heightened concerns
However, despite knowing that issues within the repo market were building, the NYFR appeared to be flat footed when the repo rate spiked on 17 September.
In the initial days after this market event occurred, a series of explanations were given by establishment sources such as the NYFR, the commercial banks and the American mainstream financial press to justify what occurred in the repo market.
These explanations were designed to downplay the significance of the observed market behaviour and to suggest that a range of circumstantial factors came into alignment including:
end of quarter regulatory reporting obligations which require commercial banks to hold a particular amount of liquidity on their respective balance sheet;
calendar third quarter federal corporate taxation liabilities (i.e. taxation liabilities which arise from July to September 2019);
the new issuance of new US Government bonds by the US Treasury which drained $US 120 billion from the financial system between 14 August and 17 September 2019 after the US Congress suspended the debt ceiling.
However, given that the crisis in the repo market remains ongoing more than 4 months since the start of the crisis demonstrates that these initial set of explanations were not sufficient.
Alternative explanations have been offered by various institutions and market experts which suggest that either:
a commercial or investment bank (such as Deutsche Bank or JP Morgan Chase); or
one or multiple hedge funds who rely on the repo market as their principle source of financing (especially to fund arbitrage trades)
may have material financial solvency issues.
What has the policy response been?
To date, the NYFR has been engaged in extensive repo operations starting from 17 September 2019 to provide extra liquidity to the repo market which has included both temporary and permanent operations. To date, temporary operations have taken several forms including:
overnight repos; and
term repos which have included two week (or 14 day) and monthly repos.
Alternatively, permanent operations have included the permanent purchases of treasury bills (i.e. US treasuries which have a maturity of one year or less) to the tune of $US 60 billion per month from 15 October 2019 through to at least the 2nd quarter of 2020 as announced by the NYFR on 11 October 2019.
These purchases, according to the NYFR, are designed to ensure an ample supply of reserves are available in order to provide the NYFR with greater control over the federal funds rate and other short-term interest rates to ensure the effective implementation of the FOMC’s monetary policy.
In conducting these operations, the NYFR has been eager to suggest that this program should not be considered as quantitative easing (QE) (or what the NYFR calls ‘large-scale asset purchases’) given that the three rounds of QE conducted between 2008 and 2014:
involved the purchase of US treasuries with maturity dates longer than 12 months; and
were designed to put ‘downward pressure on longer-term interest rates, supporting mortgage markets, and making broader financial market conditions more accommodative’.
Nevertheless, both temporary repo operations and the permanent purchases of treasury bills has led to a rapid expansion of the quantum of assets held by the US Federal Reserve via its balance sheet similar to what the three rounds of QE achieved, albeit the current rate of expansion has been faster.
According to data obtained from the Federal Reserve Economic Data (or FRED) database held at the St. Louis Federal Reserve, the dollar value of assets which are held on the balance sheet of the US Federal Reserve has grown by $US 413.68 billion from $US 3.7599 trillion on 28 August 2019 through to $4.1736 trillion as recorded on 1 January 2020.
Diagram 1 shows the rapid growth in assets held by the US Federal Reserve as recorded by its balance sheet.
Diagram 1: Total Assets of the US Federal Reserve (US Dollars)
The lack of transparency from the NYFR has led to many legitimate questions being unanswered. This includes which precise primary dealers have been receiving the bulk of the liquidity provided to the unsecure overnight interbank lending and repo markets.
Attempts to uncover this information have been made since the start of the repo crisis including by the Gold Anti-Trust Action Committee (or GATA) through a freedom of information request.
However, as noted by GATA on 13 November 2019, the NYFR indicated that:
it is exempt from the freedom of information laws however it does attempt to comply with its spirit; and
they will not be disclosing any details of its counterparties for a period of two years.
This lack of disclosure given how the repo crisis has unfolded undermines market confidence and invites further speculation.
It suggests that the crisis may be more significant than what the chairman of the US Federal Reserve and other central bank and US Government officials have been prepared to admit to date.
What are the implications going into 2020?
As we start the new year, the implications of the repo crisis are potentially significant given that the market is yet still unaware of what triggered the crisis to begin with and what may be required to bring the crisis to an end.
According to the minutes of the FOMC 10-11 December 2019 meeting, there does not appear to be any end to the growth of assets on the balance sheet of the US Federal Reserve. According to the minutes:
“The manager also discussed expectations to gradually transition away from active repo operations next year as Treasury bill purchases supply a larger base of reserves. The calendar of repo operations starting in mid-January could reflect a gradual reduction in active repo operations. The manager indicated that some repos might be needed at least through April, when tax payments will sharply reduce reserve levels.”
These minutes suggest that:
temporary repo operations (i.e. overnight and term repos) will continue through to at least April 2020;
the quantum of temporary repo operations may be scaled back, given the ongoing permanent purchase of treasury bills (i.e. treasuries with a maturity of 1 year or less); and
the quantum of assets on the balance sheet of the US Federal Reserve in all likelihood will continue to rise throughout at least the 1st quarter of calendar year 2020.
Something went terribly wrong on the 17th of September 2019 inside the financial plumbing at the centre of the world financial system in New York.
It remains to be seen whether what occurred was akin to the Titanic hitting the iceberg or whether it is a containable event.
The lack of transparent information and discussion from the US Federal Reserve and other major financial institutions has sapped market confidence and has fuelled numerous theories and explanations as to what is occurring within the US financial system, some of them of a conspiratorial nature.
The ongoing injection of cash into the repo market by the NYFR via temporary repo operations and the permanent purchases of treasury bills as well as the continued growth of assets on the US Federal Reserve balance sheet suggests that the turmoil in the repo market has not been contained to date.
Given how the collapse of the repo market in 2007 contributed to the 2008 GFC, ongoing liquidity injections by the NYFR are necessary otherwise it is likely that a default of a major financial institution (i.e. commercial bank, investment bank or hedge fund) would eventuate which could spread and infect the whole financial system through the contagion of counterparty risk.
Nevertheless, the rapid expansion of the US Federal Reserve’s balance sheet, which in effect is a form of debt monetisation, does not come without costs and consequences.
If the expansion of the US Federal Reserve balance sheet is not curtailed and ultimately reversed, then the:
confidence in the ability of the US dollar to maintain its purchasing power will begin to erode; and
confidence in the credit quality of the underlying assets (i.e. US Government bonds) will also come into question.
As noted by the early 20th century economist Ludwig Von Mises, if ongoing credit expansion is used to delay the final collapse of a boom, then a final and total catastrophe of the currency system will ultimately eventuate.
John Adams is the Chief Economist for As Good As Gold Australia
 The repo rate is the interest rate which is charged through repurchasing agreements which reflects the cost of borrowing credit that is secured through low-risk liquid collateral (this form of collateral is referred to as ‘general collateral’).
Note that the repo rate was recorded at 2.19% on Friday, 13 September 2019 and then experienced a 13 basis point move on Monday, 16 September 2019 to close at 2.42%.
 The federal funds rate is the interest rate which commercial banks are charged to borrow unsecured credit on an overnight basis from other commercial banks using the reserves held at their respective national central bank.
 The Federal Open Market Committee is the official policy committee of the US Federal Reserve which reviews economic and financial conditions, determines the appropriate stance of monetary policy for the United States of America economy and assesses the risks to its long-run goals of price stability and sustainable economic growth.
 Note that the Federal Open Market Committee cut the federal funds rate to 1.75% to 2% on 19 September 2019 and then again to 1.5% to 1.75% on 31 October 2019.
 After the 2008 GFC, the NYFR begun paying interest on excess reverses (otherwise referred to as IOER) as an alternative mechanism to implementing monetary policy compared to the previous mechanism of Open Market Operations.
 This argument which has been put forward by several economists and financial market analysts suggests that the large fiscal deficit of the US Government is ‘crowding out’ the private sector.
 See the following YouTube presentation which suggests that Deutsche Bank may be effectively receiving a bailout via the repo market to cover losses stemming from its 43 trillion Euro financial derivatives book - https://www.youtube.com/watch?v=MFhQNugglXk
 See the BIS report as noted in footnote 10. The BIS noted that in the lead-up to 17 September 2019, the repo market experienced increased demand from leveraged financial institutions such as hedge funds.
 Permanent purchases mean that it is not intended that purchased treasury bills will be returned to the market as is the case with the ‘far leg’ of a standard repurchasing agreement.