Diamond News

The better explanation for why the stock markets have been surging – they are up about 3 per cent already this month – lies with the usual suspect.

It would appear that it has been the US Federal Reserve Board’s response to the seizure in the US "repo" market last September[1] that has driven sharemarkets to new heights. Since that market froze in mid-September, with rates soaring as liquidity disappeared, the US sharemarket has risen almost 11 per cent.

Repo markets provide short-term liquidity to companies and institutions in exchange for high-quality collateral such as US Treasury bills. The borrower sells the securities for cash while simultaneously contracting to buy them back in the near term – as little as 24 hours – for a slightly higher price.

The Fed did two things in response to the malfunctioning of the repo market.

It injected and has continued to inject massive doses of short-term liquidity, providing at least $US120 billion ($175 billion) of overnight and 14-day cash each month in exchange for high-quality collateral through its own repo facilities.

It also, moreover, started buying Treasury bills at a rate of $US60 billion ($87 billion) a month.

It has done so because it believes that, as it reduced the size of its balance sheet by allowing securities it purchased during its three big post-crisis quantitative easing (bond and mortgage-buying) programs, bank reserves – the cash they hold with the Fed – have also fallen to levels too low to enable them to lend enough cash into the repo market.

The story is slightly more complicated than that because a strand of the explanation for the banks' inability to deploy their reserves is the post-crisis prudential reforms that force...

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