Meanwhile, repo was in the headlines due to a significant funding squeeze in the US, resulting in overnight repo rates jumping to 10%. On the face of it, the combination of the corporate tax date, bill supply and coupon settlements were the cause, however these are not one in a million events and merely served to draw attention to an underlying issue with bank reserve scarcity. Reserves have fallen by around 50% from their peak and these are distributed unevenly across banks further exacerbating stresses. In times past, the market for trading reserves acted as a smoothing mechanism, however regulations such as the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR) have made this virtually untenable. In order to relieve the pressure, the Federal Reserve was forced to step in via Temporary Open Market Operations (TOMOs), however this is only a stopgap measure. To reduce the likelihood for funding spikes in the future, a longer-term solution is required, for example Permanent Open Market Operations (POMOs), an increase in the Fed’s balance sheet or potentially a standing repo facility.
The market’s view of where long-term rates could move to in the future is encapsulated in forward rates. The chart below shows the six-month swap rate at spot, one-month forward, three-months forward, six-months forward, and one, two, three, four and five-years forward. Rate expectations have fallen dramatically as the consensus is for cuts to the UK Base Rate over the next few years. 1-year forward rates have now fallen by 0.216% since the previous quarter.