Money markets were roiled in September due to a spike in borrowing costs in the Federal Reserve’s multi-trillion-dollar overnight repurchase facility. Banks use this overnight “repo” facility to trade U.S. Treasury bills for short-term cash. The spike in borrowing rates occurred because there wasn’t enough cash to go around.

The drying up of liquidity in the repo market is the result of a combination of factors. First, the yield curve in the United States had been inverted for much of the year, meaning the rates on short-term Treasuries were higher than the rates on long-term Treasuries. In this situation, foreign central banks typically shop for the highest rates possible, selling long-term Treasuries and buying short-term Treasuries.

In recent years, however, foreign central banks have struggled to find enough short-term Treasuries from private commercial banks, so they have turned to the Fed’s uncapped foreign overnight repo facility for short-term collateral. This led to cash flowing out of the system and not being replaced. The foreign repo facility saw nearly $100 billion of inflows since the end of last year, which pulled a significant amount of dollars out of circulation.

At the same time, the U.S. Treasury Department has been running record deficits this year, selling hundreds of billions of dollars of Treasury securities and removing even more money from the system. Based on the Treasury Department’s anticipated funding needs, it will likely have to take hundreds of billions of dollars more by yearend.

The cash shortage in the repo market forced the Fed to step in and inject additional reserves into the banking system. It also likely contributed to the Fed’s decision to reduce short-term interest rates twice since September, which removed the yield curve inversion for the time being. While this fix has calmed money markets for now, many experts are calling for a longer-term solution. Such a solution might involve the creation of a standing repo facility that covers all banks’ short-term funding needs at a fixed rate. The Fed will also likely keep an eye on the yield curve inversion, aiming to reduce the incentive for foreign banks to drain more dollars from the vital short-term funding market.

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