Market Insider

The Fed may have to do more to calm the stress in the short-term lending market

Key Points
  • The Fed this week is expected to discuss the recent stress in the short-term lending markets, and Fed Chairman Powell will likely say Wednesday that policymakers are ready to do whatever it takes to keep things calm.
  • But the Fed is unlikely to have any long-term solutions yet, although it has taken steps to increase liquidity and expand its balance sheet.
  • Analysts say the Fed may ultimately do more quantitative easing and provide a permanent market operations facility, but for now it is not likely to address banking regulations, which some say are behind the problem.
McCulley: Powell did a fantastic job
McCulley: Powell did a fantastic job

Federal Reserve Chairman Jerome Powell is expected to say the Fed will do whatever it takes to keep short-term funding markets calm, but he is not yet likely to have a longer-term solution for recent stress in the market.

Market pros say it's possible the Fed may ultimately have to expand its balance sheet even more through a new quantitative easing program, in addition to steps it's already taken. It also is expected to make a permanent, standing repo operation, instead of just temporary ones.

Powell speaks to the press at the end of the Fed's two-day meeting Wednesday afternoon, and it's unclear whether the Fed will mention the short-term funding market in its statement or whether Powell will be the source for any new information on the Fed's thinking.

The short-term funding market, or 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 it shows stress, then it could lead to real problems in the financial system.

The repo market became a hot topic after the market showed signs of strain in September, and the Fed intervened with open market operations. A cash crunch of sorts was blamed for the wild spike in short-term rates to about 10% on Sept. 15.

The Fed is responding by expanding its balance sheet by more than $400 billion through the purchase of Treasury bills. It also immediately started open market operations and has since expanded them. It increased its overnight operations to $120 billion last week and is doing longer-term 14-day operations to assure the markets are liquid ahead of the end of the month and end of the year.

'Assure the markets'

"Ultimately the funding pressures are not gone, but they are not in the acute phase," said Ralph Axel, interest rate strategist at Bank of America Merrill Lynch. Axel expects Powell to be asked about the Fed's response to the pressures in the repo market.

"I think this is the moment where he's got to assure markets that the Fed has the tools to control the fed funds rate in their range, and that they are still evolving in their approach to this new abundant reserve regime. At the last FOMC meeting, they were just one day into it," he said.

As the central bank met in September, the fed funds rate actually moved temporarily above the range set by the Fed, due to pressures in the short-term funding market.

Gregory Faranello, executive director and head of U.S. rates at AmeriVet Securities, said the Fed still does not have a long-term solution to the problem. Some market pros blame the change in banking regulations for the strains on repo because banks are required to hold more reserves and face more scrutiny particularly at year-end on the mix of their holdings.

"He's going to have to speak to it. Everything that I have heard really from the Fed in the last month to five weeks has really been all about reserves. They're being pressed about the liquidity ratios," said Faranello. "Jamie Dimon mentioned it on the earnings call. The banks are complaining they have these reserves, but the Fed has restricted how they apply the reserves."

Faranello believes it's politically sensitive for the Fed to make changes in the regulations just now, but it ultimately will change them. Last week, Sen. Elizabeth Warren sent a letter to Treasury Secretary Steven Mnuchin about her concerns that banks will try to use the stress in the market as an excuse to get regulators to ease rules on the industry.

Another QE?

Axel also said a solution may be for the Fed to expand its balance sheet even more than it now plans. He expects Powell to say the Fed's current efforts are working.

"He will say the Fed is effective. There's some chance he acknowledges the end of the year balance sheet dynamics are less controllable by the Fed but also less important as an indicator of abundant reserves. He can make a case while year-end repo rates might rise, they are not related to the total level of reserves the Fed keeps in the system," Axel said. "While it is important to talk about year-end funding pressures, it's more about bank deleveraging."

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. Banks also try to lower their risk profile at year-end.