Regardless of if and when we go into a recession, it's important to know what makes WallStreet sweaty and nervous.
There’s been a lot of buzz among financiers on Wall Street recently around a spike in the repo market. For most Americans, there’s no reason to know what the repo market is; however, to Wall Street the repo market serves as a canary in the coal mine for forecasting the financial health of the economy.
What is the repo market?
The repo market is short for repurchasing agreement market. This is the market where financial institutions like banks or hedge funds borrow cash in the short term from each other by offering government bonds as collateral. The borrower of the money sells the government bonds to the lender in exchange for cash and then agrees to buy back those bonds in the future. The price difference between the repurchase price and the selling price is the cost of borrowing or also known as the repo rate, expressed as a percentage. Government bonds are very safe investments as they are guaranteed by the government and the cost to borrow is generally quite low.
What happened in the repo market
Normally around 2%, on September 17th the repo rate spiked up to 10% overnight indicating there was a shortage of lenders and for borrowers to get cash, they had to repurchase the bonds back at a much higher cost. For context, a 30-year fixed-rate mortgage, a far riskier loan for the borrower since real estate markets are a lot less liquid and the credit standing of individuals is very different than companies, is currently only around 3.65%.
While there’s no clear culprit of why the rates spiked, what is worrisome is that someone was willing to pay 5 fold the normal cost just to hold cash possibly signaling a perception of a big increase in risk in the financial markets or to cover some upcoming big trading losses. When there is such an imbalance between the demand and supply in the markets, panic selling can happen.
A quick look back in history
The Great Depression was started on a Tuesday also known as “Black Tuesday.” On October 29, 1929, investors started with a second day of panicked selling after a crash in the stock markets just 5 days prior. Millions of shares became worthless as everyone was trying to convert their stocks into cash.
Is a recession around the corner?
While it’s often difficult to predict precisely when recessions will happen, there’s evidence supporting that a recession is not imminent. Consumer confidence, while lower this month due to trade conflicts with China, is still higher than the start of the year¹. Additionally, on September 17th the Federal Reserve took steps to inject more money into the financial system by lowering interest rates. This is a lever that the Central Bank will use to help buffer short-term economic and market movements.
However, it’s important for us to keep an eye on what’s happening behind the institutional scene between hedge funds and banks. I believe there is often information asymmetry and the people who get paid to invest for a living have insights the rest of us do not.