Fed's repo stress will ease but not disappear by year-end

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© Reuters. Fed’s repo stress will ease but not disappear by year-end

By Karen Brettell

NEW YORK (Reuters) – A cash shortage that has plagued crucial overnight lending markets during the past few weeks is likely to flare back up heading into year-end, although measures taken by the Federal Reserve to provide liquidity means the worst of the strains are probably over.

The Fed began daily repurchase agreements in mid-September, after the repo rate for overnight loans surged to 10%, the highest since the financial crisis and far above the Fed’s then maximum fed funds target rate of 2.25%.

The operations inject cash into the banking system, after demand for overnight loans from companies, banks and other borrowers overwhelmed supply.

Analysts said the need to settle large amounts of Treasury issuance and cash needs from companies to pay taxes were factors behind the cash crunch.

A reduction in excess bank reserves, cash held at the Fed that can be made available for loans, was also a large contributor, with JPMorgan (NYSE:) in particular having cut the cash it holds on deposit at the Fed by 57% this year.

The Fed’s repo operations will run until at least January.

Last week it also began purchasing Treasury bills, which will increase reserves in the system. When the Fed buys securities from a bank, it credits the bank’s reserve account.

Analysts and market participants say these moves helped stabilize the market, where there are around $2.2 trillion in outstanding loans.

But a jump in funding costs last week show that further bouts of volatility are likely to re-emerge. Banks and other large investors typically reduce risk-taking as they close their books for year-end, with fewer funds being made available for loans.

“It’s a step in the right direction and it really does help to fundamentally address some of these issues of there being too few reserves in the banking system,” said Mark Cabana, head of U.S. short rates strategy at Bank of America Merrill Lynch (NYSE:) in New York.

That said, “I just don’t think that year-end is going to be particularly clean. I think that we will see some additional repo volatility.”

The Fed began reducing its bond holdings in late 2017. Purchases after the financial crisis, known as quantitative easing, were designed to boost investment and economic growth.

GRAPHIC: U.S. Fed balance sheet – https://fingfx.thomsonreuters.com/gfx/mkt/12/7722/7653/BalanceSheet.png

MORE STEPS NEEDED

To reduce the risk of further disruptions, market participants say they expect more interventions from the Fed.

One issue with the Fed’s purchases of Treasury bills is that money market funds are a major holder of the debt and will be reluctant to give it up, knowing that new purchases will come with lower returns.

“Money funds just happen to be the largest owner and probably are not looking to sell, because whatever we reinvest would needless to say be lower than when we purchased it originally,” said Deborah Cunningham, chief investment officer for global liquidity markets at Federated Investors in Pittsburgh.

Money market funds hold around 20% of the $2.25 trillion in outstanding Treasury bills, according to Fed data.

Dealers own few bills compared to Fed demand. On average they have owned $22 billion in bills year-to-date, below the $60 billion the Fed plans to purchase each month, Cabana said.

If the Fed’s purchases disrupt liquidity in the bill market, which could occur in the coming months, the Fed may expand purchases to short-dated Treasury notes, which would be easier to source, Cabana said.

Dealers held $83 billion in notes with maturities up to three years this year, on average.

GRAPHIC: U.S. primary dealers’ Treasury holdings – https://fingfx.thomsonreuters.com/gfx/mkt/12/7723/7654/PrimaryDealerHoldings.png

The most important fix to ensure there is not a repeat of September, however, would be for the Fed to introduce a standing repo facility.

The Fed has said it is looking at a permanent repo facility but has not yet committed to such a move.