Fed Intervenes to Curb Soaring Short-Term Borrowing Costs - WSJ

For the first time in more than a decade, the Federal Reserve injected cash into money markets Tuesday to pull down interest rates and said it would do so again Wednesday 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 Tuesday at which officials are likely to lower the federal-funds range by a quarter-percentage point to cushion the economy from a global slowdown, a decision unrelated to the funding-market strains.

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

The New York Fed moved Tuesday morning to inject $53 billion into the banking system through transactions known as repurchase agreements, or repos. The bank said Tuesday afternoon it would inject up to $75 billion more on Wednesday morning, 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 Group Inc. treasurer.

Fed policy makers 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.

In the short run this likely 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 likely will 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, analysts said Tuesday. “This is in every way, shape and form an emergency measure,” said Gennadiy Goldberg, a fixed-income strategist at TD Securities.

There wasn’t evidence Tuesday of credit-market dislocations or other transactions that have followed past periods of distress. Instead, the pressures that sent the fed-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 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 Treasurys 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 $1.5 trillion last week from a peak of $2.8 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 weeks and months ahead.

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

Meanwhile, postcrisis financial 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. These days, “the market doesn’t respond to temporary deposit flows as efficiently or fluidly,” said Lou Crandall, chief economist at financial-research firm Wrightson ICAP.

The surge in repo rates began Monday afternoon, well after the vast majority of trading in the market for overnight loans typically takes place, investors, traders and analysts said. 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, one trader said.

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

Scott Skyrm, a repo trader at Curvature Securities LLC, said he had seen cash trade in the repo 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 begin accepting bids, gradually driving repo rates down until investors had exhausted their cash, he said. 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, Mr. Skyrm said. “It seems like there’s something underlying out there that we don’t know about,” he 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.

“If you all are selling corporate bonds one day, and you want JPMorgan to take on—finance $1 billion—I can’t, because it’ll just immediately affect these ratios,” said JPMorgan Chase Chief Executive James Dimon at a banking conference this month. “It won’t hurt you very much in good times. Watch out when times get bad and people are getting stressed a little bit.”

One question is what steps the Fed’s rate-setting committee might take to improve its control of the crucial plumbing that transmits its policy decisions to the broader economy.

Over the past year, the committee has occasionally lowered a separate interest rate paid to banks on reserves held at the Fed, which could reduce banks’ desire to place reserves with the Fed and thereby increase liquidity in other short-term lending markets. The Fed could consider another such tweak on Wednesday, though analysts said it would amount to a temporary patch.

This week’s funding strains create new urgency to take two other steps that have been under consideration this year.

In June, officials debated becoming more involved in supporting the repo market by creating a new standing facility that would reduce volatility in its participants’ demand for cash. Officials didn’t reach a final decision.

Eventually, Fed officials will allow the central bank’s balance sheet to grow again by purchasing Treasury securities to offset growth in liabilities, which would prevent reserves from falling further.

Write to Nick Timiraos at nick.timiraos@wsj.com and Daniel Kruger at Daniel.Kruger@wsj.com

https://www.wsj.com/amp/articles/fed-to-conduct-first-overnight-repo-transactions-in-several-years-11568729757