The first question is: what is the actual problem? And then, secondarily, what does the Fed think is the problem? (Or perhaps more precisely, what does the Fed want us to believe is the problem?)
In my opinion, the problem is that some of the collateral in the repo markets is in trouble. The repo markets don't just use Treasuries as collateral, they also use less reliable forms of collateral like MBSs (mortgage backed securities), corporate bonds, CLOs (collateralized loan obligations), and even equities, simply because there aren't enough Treasuries for the system to remain liquid.
All of the collateral used by the banks is itself rehypothecated (think fractional reserve), which means that 1 real bond may get used seven or eight times as collateral on a single day. So if there is a problem with, say, corporate debt---and we are recently learning that there are, in fact, problems in corporate debt at the lower end of the credit spectrum---then suddenly the banks become reluctant to accept this debt as collateral. But, more importantly, depending on how bad the situation becomes, they can also become nervous about the solvency of a borrower if that borrower is carrying a heavy balance sheet of this risky debt.
The last time we saw the repo market act this way was prior to 2008. The same thing happened, the market heavily relied on mortgaged backed securities, and when those became questionable the repo market began to have liquidity issues. It was actually a warning of what was to come, but no one at the time interpreted it that way.
So, in my opinion the problem is with the collateral, probably corporate bonds. We know there has been a bubble in corporate debt similar to the housing market bubble, and the signs point to the weaker end of that spectrum now being in trouble (reminders of how subprime led the housing market collapse).
Now, the second question, what is the Fed telling us they think is the problem?
According to the Fed, the problem is that banks are unable to lend effectively due to shortages in reserves caused by quantitative tightening which removed a lot of reserves from circulation. They don't have enough money to feel comfortable lending it out, in other words.
The Fed's solution was initially---you have to remember, this problem with the repo markets started way back in April---to lower the amount of interest they paid banks to park money at the Fed, under the theory that this would inspire banks to lend more via the repo markets in order to get a better return. Yet despite doing this, it made no difference and the tension in the repo markets only got worse.
What we are now talking about is their latest solution of injected liquidity by buying Treasuries under the hope that by increasing reserves they can encourage banks to lend more.
However, if the problem is actually with the quality of the collateral, the CLOs or corporate bonds, and not reserves, then what the Fed is doing will make no real difference. The huge spike that drew everyone's attention was initially blamed on tax payment deadlines and a recent government bond auction, but those sorts of days happen every year. The reason the effect was so dramatic this year was because of the underlying problems in the repo market that that particular day just made worse. If it had really just been a temporary liquidity problem by a weird convergence of events, and nothing more, the dramatic steps the Fed has taken since wouldn't have been required. No, something is seriously wrong.
The narrative the Fed is giving us is now acknowledging that something is wrong, but it isn't that bad because it is something they can easily fix. Now even this narrative has many people worried because it implies the system can't actually handle any degree of tightening, which means QEternity.
But the problem may be worse if its a problem with the collateral and not actually reserve liquidity. In that case, we are facing GFC 2.0. And the only solution to that would be for the Fed to add all of that bad debt to its balance sheet.
The problem we are facing is that no one is willing to face the pain of a real recession, and so they keep using money printing and other tactics to artificially keep up asset prices. In the housing market they have managed to keep up prices by printing money to prop up MBSs and by letting the majority of delinquent home owners remain on their property without foreclosing. This time around, we may be facing a situation where they allow all of these zombie companies to survive indefinitely by guaranteeing their debt. How long can this party continue before it explodes? And when it explodes, is it going to express itself primarily in the collapse of the monetary system?
It is the monetary system that is primarily using its power to artificially prop everything up. If it continues to do so, and there is no way for prices to come down naturally, the only place the system could implode is with the monetary system itself, the only asset that cannot be bailed out by printing more money is money itself.
