Fed Intervenes to Curb Soaring Short-Term Borrowing Costs

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For first time since 2008 the central bank injects funds into money markets after a sudden shortage of cash

9-17-19 12:51 PM EDT
By Nick Timiraos and Daniel Kruger

For the first time in over a decade, the Federal Reserve Bank of New York took steps Tuesday to relieve pressures that were pushing short-term interest rates higher than the central bank wanted Monday.

Strains developed Monday in short-term financing markets that suggested the central bank could lose control of its federal-funds rate, a benchmark that influences borrowing costs throughout the financial system.

Bids in the fed-funds market on Tuesday morning reached as high as 5%, according to traders, well beyond the central bank’s target range, which is 2% to 2.25%.

The Fed moved Tuesday morning to put $53 billion of funds back into the banking system through transactions known as repurchase agreements. After the moves, the New York Fed said the effective fed-funds rate, or the midpoint of transactions in that overnight market, stood at 2.25%, up from 2.14% on Friday.

The pressures that had sent the fed-funds rate higher were related to shortages of funds for banks, stemming from rising government deficits and the central bank’s decision to shrink its securities holdings in recent years. Its reduced holdings have soaked up funds in the financial system, crimping liquidity.

The Fed is likely to continue to provide funding to ensure the smooth operation of the repo market for some time to come, although it isn’t clear how long that might be, said Gennadiy Goldberg, a fixed-income strategist at TD Securities.

“I think they’re going to be playing this one by ear,” he said. “This is in every way, shape and form an emergency measure.”

The Federal Reserve’s rate-setting committee began a two-day policy meeting on Tuesday at which officials are likely to lower the fed-funds range by a quarter-percentage point to cushion the economy from a broader global slowdown, a decision unrelated to recent funding-market strains.

The New York Fed hasn’t had to conduct such a transaction since 2008 because during and after the financial crisis, the Fed flooded the banking system with reserves when it purchased hundreds of billions of dollars of Treasurys and mortgage-backed securities in an effort to spur growth after cutting interest rates to near zero.

It has been draining reserves from the banking system since 2014, when it stopped increasing its securities holdings. The declines accelerated after the Fed began shrinking its holdings in 2017. Reserves have declined from $2.8 trillion to less than $1.5 trillion last week.

The Fed stopped shrinking its asset holdings last month, but because other Fed liabilities such as currency in circulation and the Treasury’s general financing account are rising, reserves are likely to grind lower in the weeks and months ahead.

The Fed hasn’t announced when it will begin allowing its balance sheet to increase, which would stop reducing reserves.

The strains in funding markets this week have been driven by several factors.

First, reserves have been declining. Second, brokers who buy and sell Treasurys have more securities on their balance sheets due to increased government bond sales to finance rising government deficits.

Then on Monday, these strains were aggravated by a series of technical factors. Corporate tax payments were due to the U.S. Treasury and Treasury debt auctions settled, leading to large transfers of cash from the banking system.

Meantime, postcrisis financial regulations have made short-term money markets less nimble than they used to be. This didn’t matter as much when the banking sector was awash in reserves and could absorb the kind of seasonal swings witnessed this week.

“The issue here is not that the level of reserves is structurally too low. We’ve reached the level where the market doesn’t respond to temporary deposit flows as efficiently or fluidly,” said Lou Crandall, chief economist at financial-research firm Wrightson ICAP.

Monday’s tax payments and debt settlements “drained money from the system, and there was no cash sitting on the side waiting to come in,” said Mr. Crandall.

Banks are holding on to reserves because they don’t think they can part with them and still continue to conduct the normal operations of a bank, such as cashing checks, approving mortgages and allowing companies to draw on letters of credit, Mr. Goldberg said. “Even small confluences of events will start to have outsized effects,” he said.

What happens in this narrow sector of the financial market can be important because funding spikes create the risk of sudden and disorderly efforts by market participants to reduce debts given the lack of cheap and predictable short-term financing.

“This sort of thing can lead to substantial pullbacks, and that can create very unpredictable dynamics in markets,” said Mr. Crandall.

Scott Skyrm, a repo trader at Curvature Securities LLC, said he had seen cash trade in the fed-funds rate as high as 9.25% Tuesday.

“It’s just crazy that rates could go so high so easily,” he said.

On his trading screens, Mr. Skyrm said he could see traders with collateral securities that they were trying to exchange for cash. The rates they were offering would start to rise until an investor with cash available to trade would start to accept their bids, gradually driving repo rates down until investors had exhausted their cash, he said. Then rates would resume their climb.

While there are technical factors to explain why cash would be in high demand this week, including corporate tax payments, the settlement of recently issued Treasury securities and the approach of quarter-end, they didn’t seem to explain the “crazy market volatility,” Mr. Skyrm said.

“It seems like there’s something underlying out there that we don’t know about,” Mr. Skyrm said.

Write to Nick Timiraos at [email protected] and Daniel Kruger at [email protected]

Dow Jones Newswire

September 17, 2019 12:51 ET (16:51 GMT)

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