Wall Street is getting worried that the Federal Reserve's aggressive efforts to control short-term borrowing rates have run into some potholes, with more danger ahead.
The central bank has been working feverishly to address issues that popped up more than a month ago in the repo market, the overnight lending place where banks go to borrow money from each other. A cash crunch led to a spike in several rates, leading the Fed to institute programs to maintain proper liquidity levels.
While the effort has worked fairly well so far — rates rose last week, though not nearly as much as in mid-September — finance professionals fear that the market problems are not fixed and funding issues can happen again.
"The repo market has been drugged into submission by the Fed," said Jim Bianco, head of Bianco Research. "That's fine for a while. But what I am getting concerned about is that they're not figuring a way to get it off the drug and get it back to normal, and that will be a problem longer term for them."
Investors have long complained about the Fed hand-holding the market, injecting trillions of dollars in liquidity and keeping interest rates artificially low during and after the financial crisis.
This is a different situation, though.
Rather than looking to goose the economy back to health, the Fed is now using its balance sheet to make sure banks have enough reserves and an adequate amount of capital is flowing through the system to keep things running efficiently. The effort also is aimed at keeping the Fed's own overnight funds rate within the 25 basis point target range it employs.
To do so, the central bank earlier this month announced a new bond-buying program that initially will target about $60 billion a month of short-term Treasury bills. The program began last week with about $20 billion worth of purchases.
As the balance sheet expansion kicked off, the funds rate pushed to the upper end of its target range, hitting 1.9% for a few days, or 10 basis points above the interest on excess bank reserves, which is supposed to serve as a guardrail for the funds rate. The repo rate similarly rose, eclipsing 2% at one point.
Market pros worry that a confluence of factors will make the Fed's market balancing act difficult.
Bianco insists that the Fed is not being discerning enough about credit quality in providing cash in exchange for collateral; others are concerned with what happens as the year draws to a close and banks are more focused on shoring up their liquidity mandates than keeping cash flowing in the overnight markets.
"With year-end coming up, this is all likely to get much worse, in our view, before it gets better," J.P. Morgan Chase fixed income analysts led by Joshua Younger said in a note.
Younger pointed to last week's rate bump as indications that all is not settled in the repo markets.
The Fed has said that large settlements of Treasury auctions were at the root of September's disturbance — along with payment of corporate income taxes — that sapped money out of the system. But Younger said such events, rather than serving as excuses, "look much more like warnings."
"Given the benefits of our newfound perspective, we recommend viewing these moves as highlighting the limitations of the Fed's chosen solution to their operational issues," he wrote.
In addition to buying T-bills, the Fed has been conducting a series of temporary operations to keep the overnight markets humming.
At the heart of the issue is how much bank cash, or reserves, the Fed should be holding. The central bank had cut the reserves level by more than $600 billion by allowing a capped level of maturing bond proceeds to roll off each month. However, the operation, nicknamed "quantitative tightening," seemed to go too far, shaking confidence in whether the Fed indeed was operating in an "ample reserves" regime.
Bianco said one way the Fed can help the market is by showing it is taking the reserves situation seriously.
Former Fed Chair Janet Yellen, who presided when the balance sheet reduction operation began in October 2017, remarked that the process would "run in the background" and be "like watching paint dry," remarks that are now widely derided in the finance community. Similarly, current Chairman Jerome Powell said in December that the process was on "autopilot," another characterization that rankled markets as it signaled more tightening to come.
"We're learning it's a much bigger deal that what the Federal Reserve stated it was," Bianco said. "They should acknowledge that movements in their balance sheet matter a lot more than they say."
In that light, Bianco said the Fed should probe deeper into whether its own liquidity and capital requirements for banks are gumming up the lending portals. Fed officials so far have mentioned regulations in passing but have not made a commitment to review the rules.
For their part, Fed officials have been stressing a couple of points: that the measures taken during September's repo market stress have worked, and that investors should not confuse the current balance sheet expansion with the quantitative easing measures taken to address the crisis.
"Our open market operations have succeeded at keeping the federal funds rate within the target range and have stabilized conditions in short-term funding markets," New York Fed President John Williams said in a speech Friday. "At the same time, recent experience has provided important lessons for the successful operation of the ample reserves framework."
Williams added that the Fed will continue to monitor the reserves situation "and may adjust the specifics of the plan as appropriate."
Still, others on Wall Street, including Goldman Sachs and Bank of America Merrill Lynch, have warned about possible disruptions in the overnight funding markets, though BofAML said the year-end issues could be classified as "typical."
The balance sheet expansion "represents a necessary step that serves to fix the reserve hole the Fed dug itself into by continuing QT for too long, should firmly place the Fed back into an 'abundant reserve regime,' and represents a rapid shift away from repo operations to permanent balance sheet growth,'" wrote Athanasios Vamvakidis, a forex strategist at BofAML.