"The $64 Trillion Question: What Happens Next In Repo"
From ZeroHedge:
When it comes to the shady events in the shadow banking world of
collateral assets and repurchase agreements, nobody does it better than
interdealer broker, ICAP, which is not only intimately familiar with
just how the Fed's plumbing vision takes place in the real world, but
also happens to be the go to firm for pricing on such suddenly critical
market stress indicators as repurchase rates.
And sure enough, it was none other than ICAP which first - correctly - said this morning when overnight G/C repo hit 10%...
... that the Fed would announce its first repo hike in a decade, but
also did so with alarming accuracy and detail, as the following note
sent out by Icap's Mike Derrico at 6:45am laid out:
Tax Date Funding Squeeze: Overnight System RPs?
This week’s funding squeeze has raised a number of questions about
the outlook for the Fed’s balance sheet. We’re going to punt most of
the longer-term questions because we want to focus this morning on one
very short-term option that the Fed might consider: for the first time
in many years, we think it is at least conceivable that the Fed’s Open
Market Desk this morning might arrange an overnight system RP with
primary dealers of the sort that was commonplace before the expansion of
the Fed’s balance sheet in 2009.
The Desk has stood by and watched any number of episodes of temporary
repo market pressure in recent years without responding by injecting
cash. (The most notable case was the spike in the Treasury GCF average
to more than 5.00% on December 31.) While the Desk has some leeway to
respond to major market -functioning disruptions (blackouts, etc.), the
FOMC has never instructed it to intervene solely for the purpose of
limiting repo-rate volatility. The Desk’s directive is framed solely in
terms of the FOMC’s effective federal funds rate target.
This week’s episode is different. We think there is a significant
risk that the fed funds rate for Tuesday will set above the 2.25% target
upper boundary of the Fed’s target rate. Our very tentative guess is
that the effective funds rate for Monday, due out at around 9:00 this
morning, will remain within the range, but only because the effective
rate is calculated as a median. A significant volume of activity,
including much that trades directly rather than in the broker market,
may have been booked before the extent of the repo market carnage was
apparent. The mean weighted average for fed funds on Monday probably
moved above the target range, but the median may have been below it.
That probably won’t be true to today. With overnight repo trading at
rates above 3% in the reg market yesterday afternoon, lenders in the
fed funds market are likely to be pickier this morning. Even if repo
market pressure in general eases a bit from yesterday, the effective
funds rate could move up from yesterday’s level. We think the odds
favor a reading above 2.25% for September 17, regardless of whether the
September 16 fixing that will be published around 9:00 AM today is in
the target range or not.
That poses a challenge for the Fed. On the one hand, traditional
funds rate-targeting guidelines would not only allow a traditional
overnight RP with the primary dealers this morning; they would appear to
call for one. On the other hand, the first large-scale system RP in a
decade would raise a huge number of questions in the market, which might
be difficult to disentangle from the broader policy message. We will
confidently predict that many traders in many markets would gloss over
the nuances of the difference between EFFR and GCF volatility, and jump
directly to the conclusion that Fed balance sheet policy had reached
another major inflection point. Even though we think that an overnight
or short-term system RP with the primary dealers would qualify as
“business as usual” in some important ways, we also know that the first
system RP in a decade would reverberate through the markets.
We have been lobbying for months for the Fed to pre-announce its
intention to arrange traditional RPs with the dealers on key pressure
points (mid-month, month-end) as a way of limiting the scope for
overnight volatility and to gather information about how Fed repo
injections would affect broader market conditions. Despite that, we’ll
confess that we are a little daunted by the communications challenges of
making a technical change of this nature purely reactively, and on the
first day of an FOMC meeting to boot. We think a strong argument could
be made for arranging a system repo this morning, but we’re not sure
it’s a convincing argument. Operational Details. If the Fed does arrange an
overnight or term RP this morning, we would expect the operation to
follow the format of the Desk’s most recent small-value “operational
readiness” exercise. As matter of “prudent planning”, the Desk conducts
small-scale test operations with the primary dealers on a regular
basis. The
most recent tests were in May, when the Desk arranged $75 million of
2-day terms RPs on May 8 and $75 million of overnight RPs on May 13.
Both operations were multi-tranche RPs in which the Fed accepted
Treasury, agency and MBS collateral, with potentially different stop-out
rates for each of the three asset classes. (The MBS stop-out was just 1
basis point above the Treasury stop-out in those operations, but the
Desk might impose a wider spread if it were to conduct an operation
today.) We would not expect the Fed to pre-announce a size for any
operation conducted this morning, as there would be a benefit in
reviewing dealer propositions before determining the amount of funding
to provide.
The Desk has generally employed a multi-price discriminatory format
than a Dutch-auction format for its open market repo operations. We
have no reason to expect that to change.
The Desk would presumably want to give dealers some time to think
through their bidding strategy if it were to announce an RP this
morning. The two May operations both closed at 10:00 AM. If the Fed
has not announced an operation by 9:00 AM, the odds of a repo injection
this morning would drop off quickly. (If the Fed’s goal is to prevent
the median fed funds rate from rising above the target range, it needs
to make its intentions clear as early in the session as possible to
prevent early trades from going through at elevated levels.)
So what happens next? Well, now that the Fed has successfully put out
the fire in the monetary basement, if only for the day until the repo
rolls tomorrow, the question is what the Fed will do or say tomorrow to
ease the market's fear that a funding crunch is deteriorating
(immediately catalysts for today's move being temporary
notwithstanding). Here, according to ICAP, there are at least three
other longer-term options that the FOMC could consider in its
implementation note tomorrow afternoon. ...MUCH MORE
