Cash Is Flooding Into Short-Term Markets Like Never Before. Is That a Bad Sign?

The scale of the moves has some analysts warning that the markets for short-term funding are vulnerable to disruption. The cause for this summer’s rush into the Fed’s reverse repo facility appears to be the central bank’s decision in June to nudge up the amount of interest it pays, from 0% to 0.05%—though usage had already been rising in the spring.

Repurchase agreements, or repos, are the market’s main mechanism for moving cash from those who have it to those who need it. The Fed also uses them to influence short-term interest rates; the flood into reverse repo means banks and investors have extra cash and the Fed is vacuuming it up.

A higher interest rate should attract more money, but analysts said they were surprised by the speed with which firms moved into reverse repo from other short-term investments such as Treasury bills and commercial paper.

The swing is also notable because the market and the Fed struggled with the opposite problem in 2019 and 2020: In September 2019, repo rates spiked and the Fed had to temporarily make repo loans to pump extra cash into the system and bring them down. Banks also rushed to the Fed for repo at the outbreak of the pandemic.

A repo transaction is simple: The borrower sells the lender a security, such as a Treasury bill, for cash. At the end of the loan, the borrower “repurchases” the security from the lender for a little bit more. That extra bit is the interest earned by the lender. At the Fed’s reverse repo facility, the central bank is the one giving the security and taking the cash up front.

Worries about short-term funding markets aren’t new. The Fed said in its last meeting it would establish two new permanent repo facilities. The decision aims to brace markets against volatility that could hit when the central bank begins tightening financial conditions in coming years.

Short-term debt sits at the intersection of markets and the economy, and as such the functioning of these markets is central to the health of the U.S. recovery and the broad advance in prices of stocks, bonds and other assets.

While few investors believe repo and reverse repo markets are imminently vulnerable to the kind of breakdown that characterized the 2008 crisis, the sensitivity of these markets to policy changes and economic developments is leaving many portfolio managers on edge. That is doubly so at a time of record U.S. bond issuance, ultralow interest rates and a booming economic recovery that has sent inflation to its highest level in years.

“Repo is a heavily traded market with an enormous amount of turnover on a daily basis, and it represents the bedrock of the Treasury market,” said Michael de Pass, global head of U.S. Treasury trading at Citadel Securities. “It is foundational to the functioning of financial markets.”

Traders say repo is the No. 1 market they watch to gauge short-term bond markets. For the Fed, repo is meant to prevent overnight interest rates from going too high, and reverse repo is meant to prevent them from going too low.

“It helps with policy implementation,” said Darrell Duffie, a professor of finance at Stanford University’s Graduate School of Business. “If there were no overnight reverse repurchase facility, the repo rate would fall and pull other short-term market rates lower—potentially moving the funds rate below the Fed’s target range.”

Despite the market’s evident importance, it isn’t always clear what the dynamics are beneath the surface. Analysts describe the $5.1 trillion repo market as opaque, with little public information on trades, collateral or even participants for a large chunk of transactions, and they say that some aspects of it have barely changed since its inception in the 1980s.

Disruptions in the 2008 crisis and again two years ago reinforced the sense that the market was subject to many competing, often unseen forces. Some investors blamed the turmoil on shrinking reserves at the Fed, dealers holding more Treasurys as a consequence of greater federal borrowing, and postcrisis regulations increasing the cost of repo transactions and forcing out smaller dealers. These rules have also limited how much large dealers may lend.

Michael Feroli, chief U.S. economist at JPMorgan, said repo markets weren’t intended as a central bank tool to control short-term interest rates, but changes in market structure over the past decade have transformed repo rates into a major influence on the Fed’s benchmark federal-funds rate.

“Banks’ desire to hold reserves, regulatory issues affecting the pipes and a withered fed-funds market—a lot of these things weren’t there several years ago, but they are now,” Mr. Feroli said.

Bill Nelson, chief economist at BPI and a former top Fed staffer, said heavy usage of the reverse repo facility increases the systemic importance of money-market mutual funds, a sector the Fed sees as a financial stability risk. It is a sign that financial markets continue to change and that investors and policy makers must redouble their efforts to keep up.

“From its conception up to the great financial crisis, the Fed borrowed mostly from the public in the form of currency. After the crisis. the Fed has also been borrowing from banks in the form of reserve balances,” said Mr. Nelson. “Since March, the Fed is borrowing heavily from money funds.”

Write to Julia-Ambra Verlaine at [email protected]