The Federal Reserve has used open market operations to soothe the short-term funding market, and now its temporary fix faces a test as the third quarter ends.
The Fed has used overnight and 14-day market operations to stabilize the repo market, used by financial institutions to fund themselves on a short term basis. The Fed was reacting to a sudden spike in rates Sept. 16 and 17, and it is under pressure to permanently resolve the issue, which seems to stem from a cash crunch in the overnight borrowing market, rather than a credit crisis.
During the temporary panic in the overnight funds market, rates spiked to as high as 10%, and the Fed's own benchmark federal funds rate briefly traded at 2.30%, 0.05 above the Fed's target range on Sept. 17. The weighted average Treasury repo rate in the Fed's operation was at a subdued 1.80% Friday. In the past several days, the Fed expanded its facilities, as they met high demand, but by Friday, both its $100 billion overnight repo and its $60 billion 14-day were undersubscribed.
"Clearly things are calmer than they were last week, but there are still definite questions and concerns. We still do have relatively elevated rates whether it's in Treasurys or mortgages [this week]," said Ralph Axel, U.S. rates strategist at Bank of America Merrill Lynch. "It's still up for debate whether or not adding additional reserves at this point will matter for funding issues through the end of the year."
Repo is a corner of the financial markets that is obscure to most people. It is where institutions go when they need short term cash, exchanging some collateral, like Treasurys or mortgage securities, for a short term loan. It is considered the plumbing of Wall Street, and the worry is if it doesn't work or shows stress, then it could lead to real stress in the financial system.
The third quarter winds down on Monday, and the overnight, repo market as it's known, could face strong demand as banks pull back on lending to spruce up their balance sheets to closeout the quarter. Market pros will be watching how much the Fed facility is used and whether interest rates become elevated again. There should be also be high demand due cash needs related to the settlement of $113 billion in Treasurys, auctioned Tuesday, Wednesday and Thursday.
"If things get messy, the Fed will bump it up...If the Fed is getting this worked up about the end of Q3, it seems the Fed will take aggressive measures to make sure year end is okay," said Michael Schumacher, director, rate strategy at Wells Fargo. High yields in repo make it difficult for borrowers to maintain the types of margins they need on certain types of investments. Hedge funds are one customer for the repo market. "They need repo...if repo becomes tougher to gets to be more expensive, that makes it more difficult for a hedge fund to put on a position."
Major banks who are the primary dealers are the only institutions that can use the Fed facility, and they then would be lenders to other institutions that need capital. but they could also serve as a bottleneck since they are not required to report how the short term funds are being used.
"The banks do a lot of work to make their balance sheets look particularly safe when they're going to publish their quarterly statements. That means they don't want to show a tremendous amount of short-term liabilities on their balance sheet. It is a normal end of quarter phenomena," said Odeon Capital Group bank analyst Richard Bove.
There was also a big improvement in another important rate, the secured overnight funding rate. SOFR, as it is known, was at 1.85% Thursday, down from 5.25% on Sept. 17 and 2.01% on Wednesday. That means on Sept. 17, 5.25% was the median rate for $1.2 trillion in short-term funding transactions. SOFR affects floating rates on about $285 billion outstanding in corporate and other loans.
Bove said it appears the issues in the market were possibly seasonal, but for some reason the demand and supply were imbalanced and it's still not clear why there was such high demand for cash. That has led for calls for the Fed to address the situation, which popped up unexpectedly mid-September, not at quarter end or during a period of financial market volatility. There have been other brief periods of stress, most particularly last December when there was a violent sell off in the stock market.
"There's always been this problem between the Fed's monetary policy and the Fed's bank supervision policy. The banks supervision policy since 2012 have been fairly clear about repos," said Bove. "The Fed didn't want the banks to be involved in that market. It set up rules...what the rules did was to force the banks to lengthen the maturities on their debt and reduce the amount of funds they make available in the repo market." That resulted in less support from banks than in the past.
Strategists said the regulatory changes are part of the issue. The repo operations of banks now show up against their capital ratio and could affect the amount of capital versus leverage they would be expected to hold by regulators. In the fourth quarter, that becomes especially acute as banks seek to improve year end capital ratios.
The Fed changed the rules when the Dodd Frank legislation for bank reform was adopted after the financial crisis, which was the last time the Fed had to intervene in the repo market.
The Fed is expected to address the issue of the cash crunch when it meets Oct. 29 and 30, and it should discuss some of the solutions it has considered in the past, like a standing repo facility where it would be prepared to intervene every day. Another solution would be to expand its balance sheet, and the talk is that it would consider some short-term quantitative easing to expand its holdings of Treasurys.
The New York Fed runs market operations for the Federal Open Market Committee, and it was able to steady the market once it began operations on Sept. 17. Strategists say Monday's outcome will be important to watch to see how much demand there is for capital, plus at what rate it is being accepted. A sharp move up in rates would be a warning that the Fed needs to keep its hand in the market into the fourth quarter, as it works up a long term solution.
"I think it will be fine because the New York Fed has its eye on the issue. I'm not worried," said Joseph Gagnon, senior fellow at Peterson Institute for International Economics. "I wouldn't want to overstate the problem, as long as they're responding, they're able to keep it under control...Our point is they should have a system in place that is more automatic so these issues don't come back, and they don't have to keep responding. The key one is a standing repo facility, where people who want to borrow can borrow at a rate the Fed sets...They should also increase reserves and the balance sheet."
Strategists, trying to get to the bottom of the period of stress, blame the spike last week on a perfect storm of events. There was a surge in demand from companies making tax payments as well as investors that had to make settlement on a large amount of Treasurys. But one unexpected event was the attack on Saudi Aramco, which knocked out half of its energy production. That is believed to have triggered some investors to seek the safety of cash, and it also prompted speculation that Saudi Arabia itself was seeking cash, as a temporary precaution.