While most people would point to the Federal Reserve’s decision to lower its policy interest rate this week as an indication that monetary conditions will gradually soften, we believe the central bank’s involvement in a lesser-known corner of financial markets a day earlier could portend a more significant action in order to restore easy monetary settings.
On Wednesday this week the Federal Reserve lowered its target interest rate for the second time this year, and reiterated commitment to act further should the US economy falter or global geopolitical risks threaten the outlook. This was widely anticipated by the market and did not come as a surprise to us as the central bank continues to gradually reverse the course of raising rates that it had pursued for the three years prior.
Upper bound of the Fed Funds Target Rate
Rather it was an earlier shock in an unfamiliar market for short-term funding that caught the market unaware and is likely to have deep and lasting implications for the monetary environment going forward.
On Monday the interest rate being charged in the overnight market for repurchase agreements, or repos, had risen from just over 2% up to 6%. Then on Tuesday the rate spiked higher to 10% before the New York branch of the Fed moved to inject $53 billion of liquidity into the repo market to bring those borrowing costs down. On Wednesday and Thursday, the NY Fed again provided $75 billion each morning to ensure rates did not flare up.
Cost of borrowing in the overnight repo market
In the repo market, banks, dealers and money market funds borrow and lend trillions of dollars each day on an overnight basis using fixed income securities like US Treasuries as collateral. Typically, banks borrow to satisfy their needs for short term funds, money market funds lend to earn additional return, and the interest rate they transact at is close to the fed funds rate. But that didn’t happen this week and market participants have pointed to two key reasons for the disruption.
On one hand, companies were required to make federal tax payments on Monday, which meant withdrawing cash from money market funds and reducing the supply of liquidity in the repo market by up to $100 billion. On the other hand, Monday was also the settlement date for almost $80 billion in debt issued by the US Treasury Department, which also drained cash from the banking system. With less money available for lending the cost of borrowing jumped. This would not likely have been the case before.
Banks use reserves to meet regulatory requirements and facilitate interbank payments. When reserves are readily available banks are less likely to hoard cash with the Fed and a more willing to be active in funding markets which promotes liquidity and free flow of money. However, bank reserves have fallen from a peak near $2.8 trillion in 2014 to $1.4 trillion today. The decline is reflective of the Fed reducing its holding of Treasuries and other bonds to reverse the quantitative easing it undertook for a decade following the financial crisis.
At the same time, the US Government’s borrowing requirement has increased – the budget deficit crossed the $1 trillion mark for the fiscal year-to-date in August – and greater Treasury issuance also saps bank reserves. In this case primary dealers are forced to buy bonds from the government by relinquishing reserves or funding them through short-term lending markets.
Excess reserves held by US banks at the Fed
When the Fed stepped in to calm the repo market this week it acted to create bank reserves in exchange for Treasury collateral. This fix is only temporary, however, as the arrangements expire every 24 hours. The Fed might decide to continue to roll this emergency support, thereby increasing the balance of Treasuries on its own balance sheet to maintain a higher level of reserves in the system. Alternatively, the Fed could decide to resume its bond purchase program to more permanently lift reserves. Either way the result is the same and it would signal that a meaningful level of quantitative easing will be necessary once more to ensure the proper functioning of the US financial system.
Christopher Demasi is a Portfolio Manager with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.