Is a repeat of the 2019 repo crisis brewing?

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At the end of September there was a big increase in the guaranteed overnight funding rate. This can already put you to sleep, but it’s potentially a big deal, so please stay.

SOFR was created to replace Libor (RIP). It measures the cost of borrowing overnight cash backed by the US Treasury using real transactions, as opposed to the more manipulable vibrations of Libor. You can think of it as an indicator of how tight money is at any given time.

Here you can see how SOFR has generally traded around the midpoint of the Federal Reserve’s interest rate corridor and declined when the Fed cut rates by 50 basis points in September. But on the last day of the month, it suddenly increased.

This is natural, to an extent. There is often a bit of a money crunch around the end of the quarter and especially at the end of the year as banks are keen to appear as lean as possible heading into the reporting data. So SOFR (and other measures of funding costs) will often rise a bit then.

But this was MUCH bigger than normal. Here’s the same chart, but showing the peak at the end of 2023 and small dips at the end of the first and second quarters.

Indeed, Bank of America’s Mark Cabana estimates that this was the biggest increase in SOFR since Covid-19 ravaged markets in early 2020, and points out that it happened with record trading volumes.

Cabana says he was initially too quick to dismiss the surge as being caused by a lack of short-term collateral and unusually large amounts of bank windowing. In a note published yesterday, he admits he overlooked something potentially more ominous: reserves draining from the banking system.

I have long believed that financing markets are driven by three fundamentals: cash, collateral, and dealer capacity. We attributed last week’s spike in funding to the latter two factors. I overlooked the extent of the cash drain to add to the pressure.

Increased cash sensitivity to LCLOR’s SOFR indices.

LCLOR stands for “lowest comfortable level of reserves” and might require more explanation.

In the old days (before 2008), the Fed set rates by managing the amount of reserves that were falling around the US monetary system. But since 2008 this has been impossible due to the amount of money pumped through various quantitative easing programs. That has forced the Fed to use new tools — such as interest on overnight reserves — to manage rates in what economists call the “abundant reserves regime.”

But the Fed has now engaged in reverse-QE – or “quantitative tightening” – by sharply reducing its balance sheet from 2022.

The goal is not for the balance sheet to return to pre-2008 levels. The American economy and financial system are much larger than they were then, and the new monetary instruments have worked well.

The Fed just wants to move from an “abundant” reserve regime to an “ample” or “comfortable” one. The problem is that no one knows exactly when this happens.

As Cabana writes (with FT Alphaville’s emphasis in bold below):

Like the macro neutral rate, LCLOR is observed only near or after it is reached. I have long believed that LCLOR is around $3-3.25 billion given (1) willingness of banks to compete for large term deposits (2) reserves / GDP ratios. Recent funding volume backs this up.

A similar dynamic was seen in ’19. At that point, the correlation of reserve changes with SOFR-IORB became similarly negative. SOFR sensitivity to reserve correlation was reported close to LCLOR. We sense that a similar dynamic is present today.

Unfortunately, when reserve levels drop to uncomfortable levels, we tend to find out very quickly, in unpleasant ways.

Cabana’s mention of 2019 is a reference to a repo market meltdown in September of that year, when the Fed missed growing signs of money market tightening. Ultimately, it forced the Federal Reserve to inject billions of dollars back into the system to prevent a wider calamity. MainFT wrote a great explainer of the event, which you can read here.

In other words, the recent increase in SOFR could be an indication that we are approaching or already at uncomfortable levels of reserves, which could cause a repeat of the September 2019 repo ructions if the Fed does not act preemptively to ease the stress.

Here are Cabana’s conclusions (emphasis his):

Repo is the heart of the markets. The EKG measures heart rate and rhythm. Repo EKG signals change. The outflow of cash supported an increase in repos. Fed should take repo pulse & sense shift. If fed too late to diagnose, repeat 1919. Conclusion: stay short spreads with the Fed trailing on diagnostics.