The pillars of the U.S. financial system are showing cracks, and another repo crisis is looming...
At the beginning of October, an extremely unsettling event occurred in the market: the Federal Reserve's repo rate corridor, which serves as the backbone of the entire U.S. financial system, broke down— the general collateral rate once soared to nearly 40 basis points higher than the reverse repo rate. The reverse repo rate is the upper limit of various overnight rates set by the Federal Reserve, and this "cap" is usually only exceeded at the end of the month or quarter, when banks absorb as much liquidity as possible to embellish their accounts.
Although the general collateral rate has fallen back below the reverse repo rate after a few days, some analysts have pointed out that this event is alarming enough, and investors are so close to another collapse in the reverse repo market and a systemic liquidity crisis.
Former Federal Reserve trader and current U.S. bank interest rate strategist Mark Cabana warned that the U.S. may be facing a new repo market crisis.
Is the 2019 crisis repeating itself?
Cabana pointed out that the current financing situation is extremely similar to the period before the 2019 repo market collapse. At that time, the overnight interest rate in the U.S. repo market soared, and the money market faced severe short-term liquidity risks.
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In March 2020, he boldly predicted that the Federal Reserve would introduce "wartime measures" to take over the entire market, and a few hours later, the Federal Reserve announced that it would begin to monetize bond ETFs.
Since early September, due to the increase in Treasury cash (TGA) balances at the end of the quarter, the decrease in BTFP balances due to the Federal Reserve's recent rate cuts, and the embellishment of accounts at the end of the third quarter, about $260 billion in reserves have flowed out of the U.S. banking system. Subsequently, as reserves left the system, the repo rate suddenly soared to the highest level since the financial system was paralyzed by the COVID-19 pandemic.
Cabana also said that he may have overlooked the impact of reserve outflows on market pressure before. Currently, the sensitivity of reserves to SOFR rates has increased, suggesting that it may be approaching the minimum comfortable level of reserves (LCCoR). Theoretically, when reserves fall below this level, the market liquidity will face the risk of drying up, the Federal Reserve will panic, and a "crisis" usually occurs.The depletion of reverse repos is only a matter of time.
For a long time, Cabana and other Federal Reserve experts have believed that the Large Commercial Banks' (LCLoR) reserves are around $3-3.25 trillion.
Cabana stated that a similar situation occurred in September 2019, when the changes in reserves also experienced a similar correlation with SOFR-IORB (Secured Overnight Financing Rate - Interest on Reserve Balances), peaking under the Federal Reserve's "non-quantitative easing" policy. After lasting for a few months, the market received the largest liquidity injection in history.
However, some analyses point out that the "similar situation" in 2019 does not mean it is exactly the same. This time, in addition to the $3.09 trillion in reserves, there is an additional $300 billion in liquidity support, namely the reverse repo facility.
Nevertheless, quantitative tightening has not yet ended, and the upcoming new round of U.S. Treasury issuance will impact the market. Analysts believe that the depletion of reverse repos is only a matter of time, especially if the Treasury injects Treasury bonds into the system again during the next crisis, the total reserves may fall back below $3 trillion, at which point the market may face another liquidity crisis.