The extraordinary growth of federal government debt has fostered the use of the repo market as a financing vehicle.
The use of repurchase and reverse repurchase agreements among primary dealers reached $8 trillion in January, according to an analysis by the Securities Industry and Financial Markets Association (SIFMA).
This level results from a surge in deficit spending following the pandemic. Estimates of the gross size of the repo market were $13.9 trillion, according to an analysis by the Federal Reserve last July.
We expect its use to continue as the government issues additional Treasury securities to finance its debt.
The link between the budget deficit and the repo market can be seen as a straightforward bond market strategy of borrowing at low rates and investing in higher-yielding securities.
As of mid-February, borrowing in the repo market at 3.65% and purchasing long-term Treasury bonds results in yield pickups of 45 basis points for a 10-year bond and up to 100 basis points for a 30-year security.
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As it turned out, the repo market is playing an important role in absorbing the Treasury’s rising issuance of debt.
In addition, it shows the importance of the intermediation role played by the largest banks in the repo market.
According to the Federal Reserve analysis, shifts in hedge-fund borrowing or money market fund lending are driving most of the fluctuations in dealer repo activity, underscoring the repo market’s function as a conduit.
The takeaway
The government’s use of unfunded spending has expanded the roles played by the major banks and the repo market in financing that debt.
Primary dealers now support an $8 trillion repo market, providing the incentive to fund purchases of U.S. debt while the gross size of the repo market is nearing $14 trillion.
Under such conditions, funding strains reappear and smaller players may be forced out of the market, resulting in a distortion of Treasury pricing, which would adversely affect broader liquidity conditions.
