Bond focus

QE or not QE ... Is that the question?

John Royden, Head of Research
Darren Richards, Illustration

You may have read about the way that the USA’s Federal Reserve Bank (“Fed”) has been active in the New York repo market. This article explains what is going on.

A repurchase agreement is often called a “repo” and is essentially a short-term secured loan. The repo market enables banks to manage their short term liquidity needs. It generally works by one bank selling a security (like a US Treasury Bond ~ the US equivalent of our gilts) to another bank with an agreement to buy it back at a fixed price in the future. The fixed repurchase price turns the transaction into an effective loan as the difference between the sale and repurchase prices defines the effective interest rate. If I agree to sell you a tin of soup today for £1 and buy it back in a year’s time for £1.10 then that is an effective interest rate of 10%.

In September 2019, the cash available to finance the repo market dried up and the Fed had to act after overnight interest rates spiked to 10% from the more normal 2% level. It appeared that some banks, including one of the larger players in the market ~JP Morgan, found that their new and larger liquidity regulatory capital requirements pushed up demand for cash to the point that there were not enough dollars to go around. The repo market was unable to supply banks with the overnight dollars that they needed, so the Fed had to supply the liquidity. This problem turned into a long term issue and it looks as if the short term Treasury bills that the Fed purchased are becoming a permanent feature.

The repo market was unable to supply banks with the overnight dollars that they needed, so the Fed had to supply the liquidity.

The net effect of this is that the Fed’s balance sheet has grown in line with the Treasury bills that they bought and this looks very much like quantitative easing or “QE”. Its effect has been to lower interest rates by increasing the supply of US dollars. At the same time the Fed, inadvertently, allowed lower interest rates to lower the discount rate used for equities, so making equities theoretically worth more, and it allowed the spare cash to find its way into purchases of US equities. And that, in my opinion, is probably one of the reasons why the equity market rose before coronavirus fears sent it down.

The key for the bond markets is how long this lasts for and the extent to which it will put downward pressure on US interest rates. The Fed denies that this is QE because the Fed is currently operating at the short end of the maturity profile. Other commentators maintain that the stimulus is less pronounced than QE’s traditional bond buying across the maturity spectrum. I disagree with them because rolled over short term Treasury bills develop a degree of medium term permanence; which is what QE is.

Whilst the banks’ capital requirements persist I don’t see this going away and can only conclude that the effect will be to add support to the long end of the US Treasury market and depress medium term rates.

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