In early October, concerns arose regarding the Federal Reserve's repo rate corridor, a critical component of the U.S. financial system, as it showed signs of breaking down. General Collateral rates, which help anchor the entire system, surged well above the reverse repo rate. This reverse repo facility is designed to act as an upper boundary for the Fed's various overnight rates, but during times like month-end or quarter-end, banks engage in what is known as "window dressing" to make their balance sheets appear more robust by absorbing as much liquidity as possible.
During these periods, the vulnerabilities of the liquidity framework become glaringly apparent. On September 30, these weaknesses were fully exposed, revealing just how fragile the system had become. However, a few days later, General Collateral rates did fall back below the reverse repo rate, offering some relief. Yet, the events of that day underscored how close the financial system is to facing another significant liquidity crisis, reminiscent of previous repo market breakdowns. This situation was alarming enough to bring one of the foremost experts on the repo market back into the spotlight: Mark Cabana, a strategist at Bank of America.
Cabana is widely known for his accurate predictions during the onset of the COVID-19 crisis in 2020. Before the Federal Reserve took extraordinary measures to stabilize the financial system, including purchasing bond ETFs, Cabana had foreseen the Fed's likely actions. In the chaotic days of the pandemic, when the Fed was scrambling to figure out its next steps, they even sought out Cabana's insights. The Fed's subsequent actions, including the largest injection of liquidity in history, succeeded in keeping the system functioning. This massive flood of liquidity through various means, such as quantitative easing and reverse repos, helped to unfreeze the financial system and ensure its continued stability.
Although these efforts worked, the long-term consequences, such as rising inflation and record highs in assets like Bitcoin and the stock market, became undeniable. Now, the events of September 30 have brought us to a critical point, where we once again face the possibility of another liquidity crisis.
The underlying issue, according to Cabana's latest analysis, is a striking similarity between the current funding environment and the conditions that preceded the repo market crisis in 2019. One major factor behind the recent stress is the depletion of reserves in the U.S. banking system. A large amount of cash has drained out of the system due to several factors. As this cash was pulled from the system, repo rates soared, mirroring the sudden surge in rates seen during the early days of the COVID-19 pandemic when the financial system nearly froze.
This drain of reserves has had a significant impact on the repo market, leading to higher rates. The situation was exacerbated by several key developments. First, the increase in the Treasury's cash balance in late September contributed to the decline in available bank reserves. Second, a decrease in usage of the Bank Term Funding Program (BTFP), which provides short-term funding to banks, further reduced liquidity. Additionally, the typical quarter-end window dressing by banks led to a reduction in repo activity, straining the system even further.
The combination of these factors has led to a significant reduction in cash available to the system, putting upward pressure on funding rates. This brings attention to an important concept known as the Lowest Comfortable Level of Reserves. This term refers to the minimum level of reserves the banking system needs to operate smoothly without causing stress in the financial markets. When reserves fall below this level, the risk of a market freeze and liquidity crisis increases dramatically. Although the exact level of reserves required is somewhat theoretical, it is believed to be in the range of several trillion dollars.
In the past, when reserves dropped to critical levels, the market experienced significant stress, as seen in 2019. Back then, the Fed had to intervene with a program that became known as "Not QE," an effort to stabilize the repo market by injecting liquidity into the system. This intervention continued until the COVID-19 pandemic necessitated an even larger response from the Fed to prop up the financial markets.
The current situation is similar to what occurred in 2019 but with some key differences. While there is still a significant amount of reserves in the system, there is also a liquidity backstop in the form of the reverse repo facility. However, with ongoing quantitative tightening and the potential for more Treasury debt issuance in the future, it is likely that this liquidity backstop will eventually be drained. When this happens, reserves could once again drop to critical levels, and the Fed may have no choice but to intervene to prevent a full-blown market crisis.
In sum, the events of late September have revealed just how vulnerable the financial system remains, and the possibility of another liquidity crisis looms large. While the immediate threat may have subsided for now, the systemic fragility is still present, and the market may be edging closer to another significant intervention from the Federal Reserve to maintain stability.
