As the Fed was meeting to consider cutting interest rates, it lost control of the very benchmark rate that it manages.
It's been a rough week in the overnight funding market, where interest rates temporarily spiked to as high as 10% for some transactions Monday and Tuesday. The market is considered the basic plumbing for financial markets, where banks who have a short-term need for cash come to fund themselves.
The odd spike in rates forced the Fed to jump in with money market operations aimed at reining them in, and after the second operation Wednesday morning, it seemed to have calmed the market. The Fed announced a third operation for Thursday morning.
In a rare move, the Fed's own benchmark fed funds target rate rose to 2.3% on Tuesday, above the target range set when it cut rates at its last meeting in July. The target range was since cut by a quarter point Wednesday to 1.75% to 2% from 2 to 2.25%.
"This just doesn't look good. You set your target. You're the all-powerful Fed. You're supposed to control it and you can't on Fed day. It looks bad. This has been a tough run for Powell," said Michael Schumacher, director, rate strategy, at Wells Fargo.
Fed Chairman Jerome Powell, in addressing the run up in short-term funding rates, said the Fed had been expecting extra demand because of Treasury settlements and a need for cash by corporations who were paying taxes. But he said it was surprised by the volatile market.
"For the foreseeable future, we're going to be looking at it, if needed, doing the sorts of things we did the last two days, these temporary open market operations That'll be the tool we use," the chairman told reporters after the Fed announced a quarter point rate cut Wednesday afternoon.
Schumacher and other strategists said the Fed's two operations Tuesday and Wednesday morning seem to have calmed the market for now, but the question is why did the wild swing in rates happen in the first place. Strategists say it seems to be the result of a cash crunch, not, for now, the makings of a credit crisis.
Powell said the Fed would be looking at the situation and over the next six weeks the Fed will take stock of what's happening in the market before deciding what steps to take to deal with volatility spikes.
Drew Matus, chief market strategist at MetLife Investment Management said funding markets could be volatile for the next couple of weeks.
"I can't pinpoint what happened. And I'm not sure anyone can. I'm not sure the Fed knows because he said he's going to learn over the next six weeks. I'm taking away from that that the funding markets are going to be more volatile over the next six weeks." Matus said. "They don't have a solution because in part, they're still learning. The market is very different than it was before the crisis. When we began the restart of normalizing policy, this is one of the things that was going to be a learning experience."
A second rate the Fed watches, the secured overnight financing rate, or SOFR, shot up to 5.25% on Tuesday from 2.43%. That is the median rate for $1.2 trillion in short-term funding transactions that occurred Tuesday. SOFR affects floating rates on about $285 billion outstanding in corporate and other loans.
What is a repo?
But the concern is if it persists, it could give the appearance of an underlying problem in the financial system. Strategists pin the problem on a number of factors, including the Fed's reduction in its own balance sheet, which removed some liquidity from the market, as well as changes in rules after the financial crisis, which required banks to hold more capital, reducing their ability to offer repos, or repurchase agreements. A repo is an exchange of collateral, such as Treasury securities, for cash.
On Monday, there seems to have been a perfect storm in the market, causing a cash shortage. Corporations were seeking dollars for quarterly tax payments, and the Treasury had also issued a large amount of bills, which reduces liquidity. There was also speculation that the attack on Saudi Aramco, which took half its production off line, may have spurred demand as oil spiked and investors feared a Middle East conflict.
The Fed on Tuesday accepted $75 billion of $80.5 billion in bids submitted in its overnight repo operation, after accepting $53 billion on Monday. The repo rate was quoted at 2.25% to 2.60% after Tuesday's operation from a range that was up to above it at 3%, just before it. That rate on Tuesday temporarily hit a high of 9%.
"They're working on this repo problem. It's a work in progress. They're doing very well. They pretty much got it under control," said Ralph Axel, rates strategist at Bank of America Merrill Lynch.
The Fed also trimmed the interest rate on excess reserves at its meeting Wednesday, in an effort to better control its fed funds rate. It trimmed it to 1.8%, a 30 basis point cut compared with the 25 basis point reduction for the benchmark funds rate, now at 1.75 to 2%.
"Generally this whole repo spike is declining, too. So you would expect fed funds to probably print a little bit lower tomorrow, but it may not be enough to be within the band," said Axel.
Matus said the short-term funding squeeze was probably the result of a number of events, including tax payment day, but he and others noted that it does not normally happen on tax day. "The repo market that we're thinking of, the pre-crisis repo market of 2008 doesn't exist any more. It's a different market with different rules for banks and primary dealers," he said.
Matus added that the staffing at the New York Fed is different. There is currently no permanent head of its markets group since Simon Potter left in June. Potter had served in that role since 2012. The markets group oversees implementation of domestic open market and foreign exchange trading operations for the Federal Open Market Committee.
Fed must address Wednesday
Axel said the market will be looking for answers from the Fed on how it will solve the problem permanently, particularly with the approach of the end of the quarter on Sept. 30, when there is more funding pressure as alternate financing is typically reduced at quarter end and repo is in high demand. There have been other incidents where rates in the repo market shot up including in December when markets were selling off.
"Does the Fed continue to roll over the $75 billion facility for the rest of the month? Or does it shift over to permanent operations?" said Axel. "Sept. 30 is another potential hot spot for funding rates. It's a big issue to make sure they control rates on Sept. 30 to make sure they stay within their band."
Axel said he believes the quick crunch came just as the Treasury Department moved to shore up its own cash reserves, which grew from $183 billion a week ago Wednesday to $298 billion by Monday.
"Since the 2011 debt ceiling crisis, Treasury has decided to maintain a very large cash balance," said Axel, adding the Treasury previously did not find it necessary. He said the Treasury decided that it is in the public interest to have a large cash balance should it ever need to absorb any problems in the Treasury funding market.
Axel said the funds are drawn from excess reserves which the Fed controls, and that lowers the money supply. "That's why to offset this, and to solve the problems that were in the financing markets, the Fed added money to the money supply through open market operations which is the traditional role of the New York Fed," he said.
