In late September, something occurred which did not garner much attention outside of the financial industry. It pertained to repurchase markets, better known as “repo” markets. You’ve likely never heard of this because it rarely malfunctions. In fact, the last time was during the Global Financial Crisis. In short, repo markets involve financial institutions such as banks & hedge funds who provide short-term loans to corporations (overnight to a few weeks) in exchange for interest (more detailed explanation here). While the repo market does not garner much attention, the global economy needs it to function the way we are used to.

Repo rates are are closely tied to the Fed funds rate, which was between 1.75% to 2% for most of September. Then on September 17th, rates shot up as high as 10% overnight as repo markets experienced a liquidity crunch which forced the Federal Reserve to step in and inject $75 billion. Much of this shortage was tied to demand for cash U.S. companies needed to pay their quarterly corporate tax bills. These amounts were largely known in advance which is why this "malfunction" came as a shock to many.

Why is this happening now?

In 2008 when the Federal Reserve began QE (Quantitative Easing) it was meant to be a temporary measure but continued until October of 2014. This controversial move was put in place with hopes that increased liquidity would encourage banks to boost lending and spur economic growth. The results have been mixed at best and since 2010 total bank reserves have actually been decreasing. The main culprit here is the elevated level of government debt issuances the past four years which have significantly drained reserves out of the financial system. To combat this, the Federal Reserve increased daily injections to as high as $120 billion. These injections are another form of QE and the Federal Reserve is back in the spotlight. Couple this with interest rates reductions and some are wondering if this is a harbinger of things to come. While many consider this troubling they tend to forget that this is why the Federal Reserve was created. Their job is to step in when markets require intervention.

The issue some (including me at times) have is how dependent the global financial system has become on the Federal Reserve and the willingness of the Federal Reserve to "intervene". Their mandate was never to become such and important participant in the day to day workings of the financial system.

While this repo story can sound scary and can make for great clickbait, it does not mean another economic catastrophe is imminent. What it does tell us is things are not running as smoothly as the Federal Reserve had hoped. Their actions have helped push asset prices higher but have not done much to boost liquidity, in fact it has done much of the opposite. Some of this can be attributed to regulations that were enacted since 2010 that required banks to increase their percentage of assets that must be liquid. Oddly enough in October, the Federal Reserve unveiled a package which reduced liquidity requirements for domestic U.S. and foreign banks. This was done to allow banks to provide additional funds if and when needed in hopes of avoiding another malfunction.

While markets continue to soar higher, some problems lurk under the surface. Very few understand why this is happening and while that can be troubling, it’s important to remember that markets are complex mechanisms which occasionally experience “hiccups”. It is important to ensure this does not happen again as that could indicate a fundamental flaw in repo markets which could lead to a much bigger problem if people start to question the systems ability to function.

Economies are complex and so are markets. With anything that is complicated, there is always be something to worry about it. Think about the past 10 years in the global economy. It seems like there was one thing happening after another. Yet, the markets have continued to rise steadily. Not without some drawdowns, mind you. But not every little thing means a crash is coming.

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