US Federal Reserve acts to curb soaring borrowing costs

For the first time in more than a decade, the US Fed has injected cash into money markets to pull down interest rates.

The Fed will probably continue to provide funding to ensure the smooth operation of the repo market for some time. Picture: Bloomberg

For the first time in more than a decade, the Federal Reserve injected cash into money markets this week to pull down interest rates after technical factors led to a sudden shortfall of cash.

The pressures relate to shortages of funds banks face resulting from an increase in federal borrowing and the central bank’s decision to shrink the size of its securities holdings in recent years. It reduced these holdings by not buying new ones when they matured, effectively taking money out of the financial system.

Separately, the Fed’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 global slowdown, a decision unrelated to the strains in the funding market.

The Fed funds rate, a benchmark that influences borrowing costs throughout the financial system, rose to 2.25 per cent on Monday, from 2.14 per cent on Friday. The Fed seeks to keep the rate in a target range of 2-2.25 per cent. Bids in the Fed funds market reached as high as 5 per cent early on Tuesday, according to traders, well above the band.

The New York Fed moved on Tuesday morning to inject $US53bn ($77bn) into the banking system through transactions known as repurchase agreements, or repos. The NY Fed said it would inject up to $US75bn more on Wednesday, but many in the market were looking beyond that decision. “The market will be waiting to see if the Fed makes this a more permanent part of the playbook,” said Beth Hammack, the Goldman Sachs treasurer.

Fed policymakers set their target range to influence a suite of short-term rates at which banks lend to each other in overnight markets — but those rates are ultimately determined by the markets. If various operations in the markets fail, the Fed funds rate can deviate significantly from the target.

Cost of borrowing money overnight using repurchase agreements

In the short run this probably affects only market participants who borrow in the overnight markets, but if the strains last long enough it can affect the rates other businesses and consumers pay.

Such deviations also undercut the Fed’s ability to keep the economic expansion on track through monetary policy, such as by lowering rates to provide a boost and raising them to prevent the economy from overheating.

Rising rates in overnight lending markets “are clearly not desirable because they impede the transmission of monetary policy decisions to the rest of the economy”, said Roberto Perli, an analyst at Cornerstone Macro.

The Fed will probably continue to provide funding to ensure the smooth operation of the repo market for some time, although it isn’t clear how long that might be. “This is in every way, shape and form an emergency measure,” said TD Securities fixed-income strategist Gennadiy Goldberg.

There wasn’t evidence on Tuesday of credit market dislocations or other transactions that have followed past periods of distress. Instead, the pressures that sent the funds rate higher were related to monetary and regulatory changes that created shortages of funds for banks.

The New York Fed hasn’t had to intervene in money markets since 2008 because during and after the global financial crisis, the Fed flooded the financial system with reserves — the money banks hold at the Fed.

It did this by buying hundreds of billions of dollars of Treasuries and mortgage-backed securities to spur growth after cutting interest rates to nearly zero.

Reserves over the last five years have been declining, after the Fed stopped increasing its securities holdings and later, in 2017, after the Fed began shrinking the holdings. Reserves have fallen to less than $US1.5 trillion last week, from a peak of $US2.8 trillion.

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 months ahead.

In addition, brokers who buy and sell Treasuries have more ­securities on their balance sheets due to increased government-bond sales to finance rising government deficits.

Then on Monday, corporate tax payments were due to the Treasury, and Treasury debt auctions settled, leading to large transfers of cash from the banking system.

Meanwhile, post-crisis regulations have made short-term money markets less nimble. This didn’t matter as much when the banking industry was awash in reserves and could absorb the kind of swings witnessed this week.

The surge in repo rates began on Monday afternoon, well after most trading in the market for overnight loans typically takes place. The origin of the demand for cash was unclear, as traders seeking cash could have been acting on their own behalf or as intermediaries for other parties.

Unexpected bids seeking cash entered the market at a time traders said was uncomfortably close to the 3pm deadline for settling trades.

Scott Skyrm, a repo trader at Curvature Securities, said he had seen cash trade in the repo rate as high as 9.25 per cent on 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 begin accepting bids, gradually driving repo rates down until investors had exhausted their cash. Then rates would resume their climb.

While temporary technical factors could explain why cash would be in high demand this week, they didn’t explain the market volatility. “It seems like there’s something underlying out there that we don’t know about,” Mr Skyrm said.

Bank executives have warned that regulatory changes, such as a rule that requires banks to hold enough high-quality liquid assets to fund cash outflows for 30 days, could lead to funding strains.

“Watch out when times get bad and people are getting stressed a little bit,” JPMorgan chief James Dimon said.

The Wall Street Journal