I just received the most insightful comment on one of my posts. Here's the original post:
What is the main danger of rate spikes in repo markets?
To answer this question it is important to understand two key concepts: (1) What a repo market is, and (2) What the Fed's open-market-operations are:
A repurchase transaction (repo) is a transaction where a party who needs cash (borrower) would sell assets into the market in return for cash. If the borrower only needed the cash for a short term, they could contract with a lender to buy their original assets back at some future date, thus "repurchasing" them. The lender could then ask a higher selling price for these assets compared to the price at which they bought the assets, thus making a profit. The profit margin made by the lender would be referred to as the repo rate.
The Fed aims to maintain interest rates at desired levels by buying and selling government securities in the free market. These actions are referred to as Fed open-market-operations, and indirectly affect repo rates.
Looking at banks and the repo market: Banks typically raise short-term deposits/liquidity, and then issue loans into the economy over longer tenors. There is therefore a mismatch in the timing of when banks need to repay their short-term borrowings, and when they would have their long-term loans repaid to them. This creates a risk for the banks: The banks borrow at cheap short-term rates in the repo market, and create loans for longer tenors, earning higher margins (this is referred to as "borrowing-short, and lending long"). Say the banks borrow cheap 3-month funding in the repo market at LIBOR + 1%, and lend this money out over longer tenors, earning higher margins (say, LIBOR + 4%). The bank would need to constantly repay and re-borrow their 3-month funding over the 10-year horizon in order to maintain this transaction. The profit spread of 3% (LIBOR + 4% - LIBOR + 1%), would be enjoyed as long as short-term lending rates could continuously be rolled-over at LIBOR + 1%. But what would happen if rates in the repo market were to spike? If the 3-month lending rates were to rise above the LIBOR + 4% level, the bank would be losing money on their loan transaction. The bank would then need to get rid of the 10-year loan asset, which it could do by selling it to another lending institution, probably at a deep discount, thereby suffering a large loss. It would therefore be in the bank's best interests for the repo rates to remain constant, and to remain below certain threshold levels. The Fed would seek to maintain rates in the market at desired levels using their open-market-operations.
I subsequently received the following feedback on this post:
"Dear Perry, Just a point of correction on your post about the repo market, which is something overlooked, is the fact that the FED in changing the effective [Federal Funds Rate] FFR, doesn't actually have to engage in any buying or selling of T-bills. The [Federal Open Market Committee] FOMC simply announces the new FFR target & within a day the overnight rate moves towards the target, without the open-market desk at the NY FED having to buy or sell T-bills; so called 'open-mouth operations'. The other thing is generally to do with the decoupling principle between the FFR and the quantity of reserves in maintaining the actual overnight rate with the target rate. Through the corridor system, simply having the ceiling (discount rate) and floor [Interest on Reserve Balances] (IORBs), the effective FFR doesn't diverge from the midpoint between the two."
Shout out to Hussain Muneer for this post. It's so good that I will need to address it in two separate posts! Hussain is 100% correct. Here's why?
Interest rates are effectively the price of money. As with any good or service, the price of money is determined by its demand and supply. The Fed, through its open market operations (OMO) would aim to buy T-bills in order to increase money supply. This would cause T-bill prices to rise (bringing yields/interest rates down), or also creating an excess supply of money, thereby bringing the price of money (interest rates) down.
The truth of the matter is that the Fed lacks the capacity to meaningfully affect the supply of dollars, since in order to affect the supply of dollars, the Fed would also need to consider the dollars in circulation outside of the USA as well (the Eurodollar Market). No one knows how large the Eurodollar market actually is, with some estimates putting it at over $13.8tr. The Fed therefore lacks the balance sheet capacity to effectively move dollar supply significantly enough to actually affect interest rates via the buying and selling of government securities.
So at the end of the day it is just a game of confidence and perception. By announcing what their overnight rate target is, the market takes this signal and behaves according to how the Fed would have them behave. For example, if the Fed announces that its target is to lower rates, the market would begin to buy government securities anticipating their imminent rise in price (which then becomes a self-fulfilling prophecy).