Repo volatility raises concerns about quantitative tightening’s future

Stronger than normal volatility in the repo rate at the end of the third quarter could have the Federal Reserve rethinking when it will terminate its quantitative tightening program.

It is typical for some temporary fluctuation at the end of quarter as banks look to clean up their balance sheets. But at the end of the third quarter, they rose to levels not seen in several years.

“The Treasury repo rate increased to 5.22% from 4.86% while agency [mortgage-backed security] repo jumped to 5.45% from 4.89%,” Bose George, an analyst at Keefe, Bruyette & Woods, said in an Oct. 7 report. “Intraday rates were even higher,” although since then, they have normalized.

The MBS supply is one of the influencers of how the 30-year fixed rate mortgage is priced. Between QT and the Fed’s rapid increase in short-term rates, those increased the 30-year FRM by 1-to-1.5 percentage points, George Calhoun, director of the quantitative finance program and director of the Hanlon Financial Systems Center, at the Stevens Institute of Technology, said earlier this year. Calhoun also is managing director of corporate relations for the Center for Research and Financial Technologies at the institute.

In his view, QT is a driver of the abnormally wide spreads between 10-year Treasurys and 30-year mortgages still impacting the market.

Even with the return to a more normal situation, repo rates are still a source of concern for the Fed, KBW’s George said, because one of the impacts of QT is to drain liquidity from the market.

“While QT could end relatively soon as the Fed will likely reassess overall liquidity in the market, it is possible that volatility persists. This appears to be driven by the meaningful level of Treasury issuance as the Federal budget deficit hit $1.7 trillion in 2023 and is expected to hit $1.9 trillion in 2024 (based on the Federal budget forecast),” George said.

The impact on the markets should remain limited, especially for real estate investment trusts that invest in agency MBS, like Annaly, AGNC, Two Harbors and Dynex, he continued, with the caveat that volatility holds to normal patterns.

“While REITs do fund non-agency assets in the repo market, those are generally bilateral repo markets, and pricing and availability in that market have always been based on the strength of the collateral,” said George. “Those repo markets were not directly impacted by the quarter end volatility seen in the government repo markets.”

George was not the only market observer concerned with recent repo developments and how they could impact QT.

“The Fed has tools to inject liquidity into the repo market to help quell volatility, although we think it’s somewhat counterintuitive to prop-up the repo market at the same time it conducts quantitative tightening, which could eventually motivate the Fed to reduce, or altogether end QT if repo volatility persists,” wrote Eric Hagen, an analyst at BTIG, in an Oct. 1 report.

In his Oct. 3 TMSpotlight newsletter, Les Parker commented that the increased volatility in the repo market created “the possibility that the Fed may consider further slowing QT to prevent a 2019-style disruption to money market functioning.