The U.S. Federal Reserve cut the short-term fed funds interest rate by a quarter percent and added to its first overnight liquidity injection since the global financial crisis after panic in the bank repo market sent overnight borrowing costs to 10 percent.
Federal Reserve Chairman Jerome Powell, following a two-day Federal Open Markets Committee meeting in Washington DC, announced on the afternoon of Sept. 18 that the Fed had cut the short term federal funds rate by a quarter percent. Powel stated that the Fed’s extraordinary repo action on Sept. 17 was meant to address “upward funding pressure.”
Banks offer “repo” overnight cash liquidity to smaller banks and customers in exchange for collateral and a promise to repurchase that collateral the next day. Repo volume averaged about $1.6 trillion from 2011 to May 2019 at about 2 percent interest cost. But with volume rising to $2.5 trillion by Tuesday, repo interest rates hit a record 10 percent.
The spike in repo rates was initially blamed on the impact of drone attacks by Houthi rebels in Yemen that was expected to shut over half of Saudi Arabia’s crude oil shipments. But after Saudi Aramco CEO Amin Nasser said production capacity would be fully restored by the end of September, analysts focused on weak bank liquidity.
The Federal Reserve through its New York Fed trading desk was forced to step in at 9:30 a.m. on Sept. 17 to calm the panicking financial markets by offering its 24 domestic and foreign primary dealers access for up to $75 billion of overnight repo at a 2.1 percent interest rate. Dealers borrowed $53.2 billion and rates fell to 2.15 percent.
But despite the New York Fed telling traders at 10:10 a.m. on Tuesday that repo interest rates had “re-normalized” at 2.25 percent, Bloomberg reported later that day that repo interest rates for “general collateral,” which includes mortgages, shot up to 3.934 percent. The comparable “Secured Overnight Financing Rate” in Europe also jumped to 5.25 percent.
The New York Fed expanded overnight repo by another $30.3 billion on Tuesday evening to stabilize markets, but overnight repo rates again moved back up to 2.8 percent.
During the 2008 run-up to the financial crisis, the New York Fed conducted an average 5 overnight-repo operations a week offering about $5 billion each day. But Monday and Tuesday’s overnight repo lender-of-last-resort intervention to maintain its policy interest rates was the first series of interventions since 2008.
The International Monetary Fund warned in early September that for the first time in 25 years, China was about to suffer a series of annual current account deficits due to its savings rate as a percent of GDP having fallen from 52.3 percent in 2008 to 45.2 percent currently. Despite shrinking deposit coverage, China increased its capital spending to 45.3 percent of GDP by leveraging up debt.
Concerns of a budding banking crisis somewhere in the world pushed up China’s highly regulated overnight equivalent of repo called the Shanghai Interbank Borrowing Rate (SHIBOR) 0.28 percent by Wednesday to 2.633 percent. SHIBOR rates normally change very slowing, but the overnight interest rate almost doubled from 1.371 percent in June.
Jeff “Bond King” Gundlach who manages $130 billion in fixed income as DoubleLine CEO hosted a special investor webcast Tuesday afternoon to warn that interest rates have bottomed and will move higher.
Gundlach said he believed Sen. Elizabeth Warren was set to beat former Vice President Joe Biden for the Democratic nomination, and that there is an “almost zero” chance of a deal in the U.S.-China trade war before the 2020 U.S. presidential election. The investor added that he expects further international trade turmoil in Europe and suggests gold prices could move much higher.
When asked about repo, Gundlach said, “The freeze-up can only be viewed as a negative.” He called the Federal Reserve’s Tuesday intervention as the first “baby-stepping” to a “quantitative easing lite” crisis expansion of its balance sheet.