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Prolonged funding stress boosts call for permanent Fed fix

Bloomberg logoBloomberg 9/19/2019 Liz Capo McCormick and Alexandra Harris

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Signs that stress in U.S. funding markets is rebuilding ramped up pressure on the Federal Reserve to permanently increase reserves by boosting Treasury holdings, even as it was preparing a temporary liquidity injection for the fourth straight day.

The New York Fed said Thursday that it will once again do a $75 billion overnight repo operation on Friday. It follows liquidity doses of the same size Thursday and Wednesday and $53.2 billion on Tuesday. The central bank is deploying this remedy for the first time in a decade.

QuickTake: The Repo Market’s a Mess. (What’s the Repo Market?)

This week’s actions have helped calm the funding market, with repo rates declining to more normal levels after soaring to 10% Tuesday, four times last week’s levels. However, swap spreads tumbled to record lows Thursday amid concern Fed policy makers, following their two-day meeting that ended Wednesday, didn’t announce more aggressive steps to keep rates from spiking. Swaps are signaling less appetite for Treasuries, driven by concern traders won’t be able to fund purchases of U.S. debt through the repo market.

“The Fed needs to do at least double what they offered now and maybe even be more vigilant and do something even more significant,” Thomas Simons, senior economist at Jefferies LLC, said after Thursday’s repo operation. “This attitude of trying to kind-of fix the problem is not great.”

The effective fed funds rate was set at 2.25% as of Wednesday. It was at 2.30% Tuesday, above the top of the Fed’s target range of 2% to 2.25% before policy makers lowered their benchmark rate Wednesday.

Overnight general collateral repurchase agreement rates continued to retreat Thursday, trading around 1.725%. Still, experts say the Fed needs to reveal a permanent fix, rather than these ad-hoc overnight operations.

“We expect these episodes of funding stresses to become more frequent with demand for funding and U.S. Treasury supply forecast to increase heading into year-end and the Fed’s reserve levels likely to drop further,” Jerome Schneider, head of short-term bond portfolios at Pacific Investment Management Co., wrote in a note Wednesday with his colleagues.

The operations, once common before the 2008 financial crisis, temporarily add cash as the Fed takes government securities as collateral. Wall Street bond dealers submitted about $84 billion of securities for Thursday’s Fed action, the most in the three days.

a large brick building: The Federal Reserve Bank of New York© Photographer: Bloomberg/Bloomberg The Federal Reserve Bank of New York

The latest addition of liquidity follows the Federal Open Market Committee’s move Wednesday to reduce the interest rate on excess reserves, or IOER, by more than their main interest rate, an attempt to quell money-market stresses.

Given the added supply, banks’ holdings of Treasuries have risen and are increasingly being financed by money-market funds investing in repo, which leaves “U.S. funding markets more fragile,” Schneider wrote. He said this adds to other reasons why the Fed needs to do more to engineer a long-term fix.

After policy makers wrapped up the two-day meeting Wednesday, Fed Chairman Jerome Powell said the central bank will keep doing these repo operations if that’s what it takes to get markets back on track. He spoke hours after the effective fed funds rate busted through the central bank’s cap, evidence Powell and his colleagues were losing their grip on one of their most important levers for controlling the financial system.

Powell also said the Fed would provide a sufficient supply of bank reserves so that frequent operations like the ones they’ve done this week aren’t required.

The only way “to permanently alleviate the funding stress is to rebuild the buffer of reserves in the system,“ according to Morgan Stanley strategist Matthew Hornbach.

Relying on repo operations doesn’t resolve the issue of reserves declining as the Treasury rebuilds balances, Hornbach wrote in a note. Having regular operations will also increase market uncertainty as the Fed could halt purchases at any time, while the size of its buying will have to expand over time as reserves drop, he said.

“It is certainly possible that we’ll need to resume the organic growth of the balance sheet sooner than we thought,” Powell said, referring to the central bank potentially buying securities again to permanently increase reserves and ensure liquidity in the banking sector.

Read More: Powell Stresses Solid U.S. Outlook After Fed Cuts Rates Again

Many strategists had predicted the Fed would take even more aggressive measures to reduce the pressures. One idea that’s gotten a fair amount of attention is something called a standing fixed-rate repo facility -- a permanent way to ease funding pressures. Many analysts even predicted a Wednesday announcement that the Fed would start expanding its balance sheet.

That didn’t happen. However, with the Fed apparently ready to keep injecting liquidity whenever it’s needed, “it’s enough for now,” said Jon Hill of BMO Capital Markets.

“This week’s dramatic moves in the short-term funding markets serve as a case in point for the need to carefully consider liquidity in the financial system,” Rick Rieder, global chief investment officer of fixed income at BlackRock Inc., wrote in a note.

“All of this funding market gyration points to the increasingly obvious fact that the end of Fed reserve draining is insufficient to stabilize these markets,” he said.

--With assistance from Edward Bolingbroke.

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