This is taken from lythoughtsonfinance.blogspot.co.uk
The last few days of news have been particularly interesting. For the first time in a decade, the Fed has had to step into the market and provide overnight liquidity to prevent overnight rates from skyrocketing.
Ok, so that's a bit of a mouthful and one of my friends asked for an explainer, so here goes.
To go back to a fundamental level, to operate the financial system needs money (that's a Nobel Prize winning comment right there), and the overnight rate is a way to ensure that those who need cash in the financial system (think hedge funds, pension funds, money managers, standard investors etc.) can access it. Now, there is only a certain amount of money in the system, so sometimes when investors need a little extra cash, they will go to the overnight markets (e.g. LIBOR - the London Interbank Overnight Rate) and they will swap some of their securities (like treasuries) for cash.
For example, imagine that a hedge fund wants to hold a position overnight, but has to pay some other obligation, and therefore needs money. Instead of exiting the position to realise the cash, they can go to another institution, lets say a big investment bank who has some spare cash, and take a loan.
Given that they only need the money for a very short period of time, the interest rate is usually quite low. In the example, lets say that the hedge fund needs $1 billion, and the bank can provide it. But, without any collateral, the interest rate is likely to be high.
So, to get around this high interest rate, the hedge fund will transfer some of its high-grade securities (like US treasury bills which have a zero (or do they??......) probability of default) and this means if the hedge fund fails to repay, the bank can keep the securities as collateral.
If it helps, repo literally means repurchase agreement - i.e. the hedge fund will buy back the securities the next day - with a small interest payment on top. So, in the example, a one-night loan would probably have only a very small interest payment to make on top. And typically, the repo rate is close to the federal funds rate - which is currently 1.75 - 2.00 % after the Fed cut yesterday.
The repo rate in the United States spiked to almost 10% earlier in the week. A massive increase and caused the cost of borrowing to increase by five times. An extraordinary amount which is bound to be painful to those holding overnight positions.
The chart above which shows the size of the balance sheet of the Federal Reserve (i.e. the quantity of high-quality treasury securities it owns) has been decreasing. Yes, it expanded massively following the financial crisis as the Fed pumped money into the economy during the phase of QE, but it has started doing QT in recent years to undo the previous QE.
This means that the amount of cash in the economy has been shrinking, and consequently this market does not have sufficient liquidity. This problem has been exacerbated because the US Budget Deficit is now so large - at over $1 trillion a year.
This means that investors are being "forced" to buy this US government debt which in turn removes money from their hands and increases the quantity of treasury bills.
So, where is the money?
Well it's not in the overnight markets that's for sure.
As such, earlier this week the New York Federal Reserve has been pumping money into the system and buying back these treasuries to keep the market afloat and bring these rates back down to normal levels. $75 billion was offered on both Tuesday and Wednesday to calm the markets. (Source: https://www.marketwatch.com/story/here-are-five-things-to-know-about-the-recent-repo-market-operations-2019-09-18)
Ok, so why is the market excited by this?
This question at least is easy to answer. Quantitative Easing.
Could the Fed turn the taps back on to solve this problem? It doesn't look like it yet, but if this lack of liquidity continues, they may be forced to intervene. It does appear that the Fed has been too aggressive with its QT, as the financial plumbing is already starting to clog up.