Key Points
- The Fed’s Standing Repo Facility (SRF) is designed to provide backup funding to the repo market during periods of liquidity stress.
- The $12 trillion repo market is secured by government securities, normally USTs, and has largely replaced unsecured interbank lending.
- However, hedge funds are taking advantage of the SRF to finance highly leveraged basis trades.
Unsecured interbank lending has largely been replaced by repo financing after the breakdown of trust in the global financial crisis of 2008.
A repo is short for repurchase agreement, where the borrower sells government securities, typically US Treasuries, with an agreement to repurchase them at a slight discount the following day. The repo (discount) rate, formally known as the Secured Overnight Financing Rate (SOFR), has increased in importance as the repo market has grown to almost $12 trillion, overshadowing the widely known Fed Funds Rate (FFR). Both the SOFR and FFR are managed by the Fed through its open market operations.
A sharp spike in the repo rate in 2008 threatened to collapse the entire financial system. The Achilles heel of the banking system, and the reason for the Fed’s existence, is maturity mismatch. Borrowers take advantage of low interest rates in the short-term market and invest in long-term assets, capturing the wide spread. That works well until the yield curve inverts. Short-term rates spike upward as available credit contracts, causing a fire sale of long-term assets as borrowers scramble to raise cash to repay loans. A spike in the repo rate effectively serves as a margin call on long-term assets.
The first instance occurred during the 2008 subprime crisis, when the repo market ceased functioning, leading to a panicked sale of assets. Then, in 2019, repo rates spiked after the Fed’s QT had lowered bank reserves, reducing the supply of bank credit available to fund repos. The spike led to the famous Powell pivot, where the Fed abruptly ended QT and expanded its balance sheet (QE) to inject liquidity into financial markets.
Again in March 2020, repo rates spiked during the COVID pandemic, causing a sell-off of US Treasuries financed through highly leveraged basis trades.
The chart below shows the spread between the repo rate (SOFR) and the fed funds rate (FFR) in 2019 and 2020.
The Fed responded by establishing the Standing Repo Facility (SRF), through which borrowers can obtain repo finance directly from the Fed when there is a shortage in the repo markets. The SRF acts as a market stabilizer, limiting increases in the SOFR and preventing a repeat of earlier repo market collapses. The underlying purpose is to avoid a fire sale of US Treasuries if the repo market ceases to function.
Hedge funds have increasingly tapped the repo market to finance highly-leveraged basis trades, which take advantage of the spread between repo rates and the implied discount on Treasury futures. The SRF has encouraged these trades by limiting the downside risk. Hedge funds pocket the spread when repo rates are low, and rely on the SRF to save them if rates rise.
We suspect that the size of leverage investment in US Treasuries is greater than commonly believed. Over the past decade, offshore investment in US Treasuries has swung from foreign central banks to private sector investment, primarily through offshore financial centers favored by hedge funds.
Basis trades are likely to continue growing as long as the Fed maintains a standing repo facility to stabilize the repo market. The SRF enables hedge funds to enter profitable leveraged trades on US Treasuries with limited downside risk.
As Charlie Munger said, “Show me the incentive and I’ll tell you the outcome.”
Stocks
The S&P 500 remains tentative after last week’s contraction in financial market liquidity.
A contraction in the ADP’s four-week moving average of private sector job creation to -11,250 has not helped.
Financial Markets
The secured overnight financing rate (SOFR) remains above the rate paid to banks on reserve balances (IORB), indicating financial market stress.
Bitcoin is re-testing support at 100K, warning that liquidity remains tight.
Dollar & Gold
The dollar is weakening as prospects for a December rate cut improve.
Silver rallied to test its previous high at $54 per ounce.
Gold followed, with a rise to $4,230 per ounce. A breakout above the resistance level at $4,400 would offer a target of $5,000.
Conclusion
Basis trades funded through repo markets are expanding as the Fed’s standing repo facility (SRF) enables hedge funds to profit with limited downside risk while the Fed acts as a backstop.
Basis trades increase the vulnerability of US Treasury markets as hedge funds are highly leveraged short-term holders of USTs. In the past, unwinding basis trades have caused a sharp rise in Treasury yields when repo rates spike. The SRF may prevent a repeat of past spikes but provides an incentive for hedge funds to take on greater risk, expanding the size of their basis trades and increasing Treasury market vulnerability.
Financial markets remain unsettled, with Bitcoin testing long-term support at 100K. Gold and silver rallied, and breakout to new highs would offer targets of $5,000 and $62 per ounce, respectively.
Acknowledgments
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
