Tuesday 22 October 2019

US Fed forced to steady markets after cash squeeze

The US central bank, the Federal Reserve (Fed), has been forced to make repeated interventions in the markets this week after a spike in prices in the arcane but important repo (repurchase) market in which big banks manage cash supplies. (stock picture)
The US central bank, the Federal Reserve (Fed), has been forced to make repeated interventions in the markets this week after a spike in prices in the arcane but important repo (repurchase) market in which big banks manage cash supplies. (stock picture)

Richard Leong

The US central bank, the Federal Reserve (Fed), has been forced to make repeated interventions in the markets this week after a spike in prices in the arcane but important repo (repurchase) market in which big banks manage cash supplies.

Traders at the Fed intervened after the level of cash available to banks for short-term funding needs all but dried up on Monday and Tuesday.

It meant interest rates in US money markets shot up to as high as 10pc for some overnight loans, more than four times the Fed's rate.

That sent a chill through markets because it recalled events during the financial crisis.

The Fed made an emergency injection of more than $50bn to steady the market, its first since the financial crisis more than a decade ago, preventing borrowing costs from spiralling even higher.

The exact cause of the squeeze is a matter of some debate, but most market participants agree two coincidental events on Monday were at least partly to blame.

First, US corporations had to withdraw funds from money market accounts to pay for quarterly tax bills, and then, on the same day, the banks and investors who bought the $78bn of US Treasury notes and bonds last week had to settle up.

It all hoovered cash out of the financial system.

On top of that, the reserves which banks park with the Fed and are often made available to other banks on an overnight basis are at their lowest since 2011, thanks to the central bank's culling of its vast portfolio of bonds over the past few years.

Added together, these factors are testing the limits of the $2.2 trillion repurchase agreement - or repo - market, a grey but essential component of the US financial system.

Whatever the cause, the episode has added fuel to the argument that the Fed needs to take steps to avoid more disruptions in the repo market further down the road.

The repo market underpins much of the US financial system, helping to ensure banks have the liquidity to meet their daily operational needs and maintain sufficient reserves.

In a repo trade, Wall Street firms and banks offer US Treasuries and other high-quality securities as collateral to raise cash, often overnight, to finance their trading and lending activities.

The next day, borrowers repay their loans plus what is typically a nominal rate of interest and get their bonds back. In other words, they repurchase, or repo, the bonds.

The system typically hums along with the interest rate charged on repo deals hovering close to the Fed's benchmark overnight rate, currently set in a range of 2pc to 2.25pc. That rate was expected to be cut by a quarter percentage point yesterday.

But sometimes investors get fearful of lending, as seen during the global credit crisis, or at other times there are just not enough reserves or cash in the system to lend out, as appeared to be the case this week. And that can cause a squeeze on the market and send borrowing costs zooming higher.

Trading in stocks and bonds can become difficult. It can also pinch lending to businesses and consumers and, if the disruption is prolonged, it can become a drag on a US economy that relies heavily on the flow of credit.

Coming out of the financial crisis, after the Fed cut interest rates to near zero and bought more than $3.5 trillion of bonds, banks built up massive reserves held at the Fed.

But that level of bank reserves, which peaked at nearly $2.8 trillion, began falling when the Fed started raising interest rates in late 2015. They fell even faster when the Fed started to cut the size of its bond portfolio about two years later.

The Fed stopped raising interest rates last year and cut them in July and was expected to do so again yesterday. It has also now ceased allowing bonds to roll off its balance sheet.

The question vexing policymakers now is whether those actions are enough to stop the downward drift in reserves, which are a main source of liquidity in funding markets like repo.

Reuters

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