The Federal Reserve injected US$75 billion into U.S. money markets as policy makers’ benchmark rate broke outside their preferred band, ratcheting up the pressure on central bank officials to find a long-term fix for the financial system’s plumbing.
There is evidence things are calming down. For instance, the rate for general collateral repurchase agreements has dropped to 2.175 per cent, down from Tuesday’s record high of 10 per cent, and about where it was last week.
Now attention turns to this afternoon’s Federal Open Market Committee decision to see what, if any, further steps are taken to remove pressure from the overnight lending business and ensure higher rates don’t harm other parts of the economy. Action is nearly certain after the New York Fed said Wednesday that the effective fed funds rate busted through policy makers’ 2.25 per cent, cap the day before, coming in at 2.30 per cent. That’s bad because it shows the Fed is losing its grip on short-term interest rates, undermining its ability to guide the financial system.
Adjusting something called the interest rate on excess reserves, or IOER, is one likely remedy. Longer-term solutions include expanding the Fed’s balance sheet to replenish reserves in the banking system.
“These money markets are a very powerful part of the financial system and everything flows through,” said John Herrmann at MUFG Securities in New York. “What the Fed has been doing so far to address the issues is like being a fire department chasing the fire instead of sort of installing fire hydrants through facility. They need to do more.”
The New York Fed declined comment.
The Fed’s dose of cash Wednesday follows a $53.2 billion liquidity injection Tuesday. It had been more than a decade since traders at the central bank jumped into U.S. money markets to add cash. And they seemed to get the reaction they wanted Tuesday morning, instantaneously driving down key short-term rates that had spiked, threatening to muck up everything from Treasury bond trading to lending to companies and consumers.
But the move didn’t last long.
By the end of the trading session, rates were grinding back up, prompting Fed officials to fire off a second missive late in the day: They would be back Wednesday morning to offer another $75 billion of cash.
The moves underscored just how deep the structural problems in U.S. money markets have become. Namely, there is often not enough cash on hand at major Wall Street firms to meet the funding demands of a market trying to absorb record Treasury bond sales needed to cover U.S. budget deficits. The solution, according to longtime observers, would be for the Fed to continue to inject cash on a regular basis.
“The underlying problem is that there isn’t enough liquidity in the system to satisfy the demand and the job of the central bank is to provide such liquidity,” said Roberto Perli, a former Fed economist and partner at Cornerstone Macro in Washington. “What the Fed did was just a patch.”
A couple of catalysts caused the liquidity squeeze in this esoteric, yet vital, corner of finance known as repurchase agreements.
There was a big swath of new Treasury debt that settled into the marketplace -- adding to dealer balance sheet holdings -- just as cash was sucked out by quarterly tax payments companies needed to send to the government. If left unchecked, the escalation in rates could do damage to the broader economy by hiking borrowing costs for companies and consumers.
The timing couldn’t have been worse, with Fed leaders and many key New York Fed staffers gathered in Washington for a two-day policy meeting that will end Wednesday. Fed officials are widely expected to cut their target rate by a quarter-point. But the money-market problem threatens to overshadow that, as Wall Street is ready to find out the Fed’s long-term solution is.
“The increase in repo and other short-term rates is indicative of the reduced amount of balance sheet that financial intermediaries -- particularly primary dealers -- are either willing or able to provide those in search of short-term financing,” said Tony Crescenzi, market strategist at Pacific Investment Management Co. and author of a 2007 edition of “Stigum’s Money Market,” a widely read textbook first published in 1978. “It serves as a reminder of the challenges that investors could face in other ways if and when they seek to transfer risk -- sell their risk assets -- during a risk-off mode.”
This is far from the first bout of volatility in the over $2 trillion repo market, but eye-catching moves tend to happen only at quarter- or year-end when liquidity sometimes dries up -- not in the middle of the month, as it is now. Even setting aside this week’s huge spike, turmoil has been more pronounced following the 2008 crisis because reforms designed to safeguard the financial system have driven some banks out of this market. Fewer traders can lead to rapid swings by creating imbalances between supply and demand.
Fed interventions in the repo market, like the ones deployed Tuesday and Wednesday, were commonplace for decades before the crisis. Then they stopped when the central bank changed how it enacted policy by expanding its balance sheet and using a target rate band.
The tumult seen Monday and Tuesday doesn’t mean another global funding crisis, even though trouble getting funds through repo a decade ago doomed Lehman Brothers and almost snuffed out the global financial system.
But, many experts say, these wild few days show that there’s not enough reserves -- or excess money that banks park at the Fed -- in the banking system. That means traders are this week having to pay up to get these funds, even as bank reserves total more than $1 trillion. And it suggests the Fed may again have to grow its $3.8 trillion balance sheet through quantitative easing, or debt purchases that create fresh reserves.
Read More: Fed May Expand Balance Sheet After Repo Squeeze, Gundlach Says
There are other remedies. The Fed has considered introducing a new tool, an overnight repo facility, that could be used to reduce pressure in money markets. And some strategists predict it may make another technical tweak to IOER, something that’s already been done three times since last year in an attempt to keep markets in line.
“There were a confluence of factors that triggered the issues this week,” said Darrell Duffie, a Stanford University finance professor who’s co-authored research on repos with Fed staffers. “But the fact that it’s happening means something at the Fed should be done. For the Fed to be really confident in ending the issues, they will have to grow the balance sheet.”
The U.S. government has made matters worse over the past year by adding a record amount of new debt, and that will likely only increase as the deficit swells past $1 trillion. That has buoyed the amount of debt that dealers have on their balance sheets, and the repo market is one way they finance those positions. That said, their Treasury holdings are down from a peak in May, so that’s not necessarily behind this week’s big moves.
“Supply is a backdrop contributor to the issues, as there is just that much more collateral that needs to be financed,” said Seth Carpenter, a former adviser to the Fed Board of Governors who is now chief U.S. economist at UBS Securities LLC. “The market is still trying to deal with tight balance sheets from dealers. Overall this is all part of the market shifting through time to a new set of realities.”