By Nick Timiraos
WASHINGTON -- The Federal Reserve over the last three months has
flooded money markets with hundreds of billions of dollars in cash
to avoid a repeat of volatility that roiled cash markets in
September.
The success of the moves -- which reversed roughly half of the
Fed's shrinkage of its asset portfolio over the prior two years --
will encounter a test around Dec. 31. That is when some financial
institutions could face incentives from regulations to limit their
lending, which could cause supply and demand imbalances for
cash.
Fed officials have said they believe deposits by banks held at
the Fed, called reserves, grew scarce enough in mid-September to
put pressure on an obscure but important lending rate in the market
for repurchase agreements, or repos. Banks and other firms use
repos as a way to borrow cash for short periods, pledging
government securities as collateral.
"You can flood the markets with reserves but are the reserves
going to be redistributed to the corners of the markets that need
it? That's the big question," said Ward McCarthy, chief financial
economist at financial-services company Jefferies LLC.
To prevent a squeeze from happening again, Fed officials have
been buying short-term Treasury bills from financial institutions
to put more reserves back into the financial system. They also have
conducted daily injections of liquidity into markets.
Altogether, those operations could add nearly $500 billion in
net liquidity to markets around Dec. 31.
The end of the year is an important date because large banks
could limit lending activities in derivatives and repo markets to
guard against extra regulatory burdens. For these banks, their
lending profile on Dec. 31 is used to determine how much equity
capital they must raise against their liabilities.
In the last few years, repo rates have typically been no more
than a 10th of a percentage point above or below the Fed's
benchmark rate, but on Dec. 31, 2018, they widened by 2.75
percentage points.
This spread grew again on Sept. 17 after large payments of
corporate taxes and Treasury auction settlements the day before
resulted in a major transfer to the government of cash held in the
banking system. This flow of payments reduced reserves.
"The markets acted as though reserves had become scarce," Fed
Chairman Jerome Powell said at a Dec. 11 news conference.
The September episode prompted the Fed to intervene in markets
to prevent reserves from declining further. The central bank
announced plans to provide overnight and 14-day loans in the repo
market, and by mid-October had agreed on a scheme to keep reserves
from declining further by purchasing $60 billion a month in
Treasury bills.
"Their response has been very effective," said Priya Misra, head
of interest-rate strategy at TD Securities. "They were quick to
acknowledge reserves dropped too low. They were very humble, and
that level of humility is good to see."
The September market stress may have also focused financial
institutions that rely on repo funding to lock in financing ahead
of the end of the year.
"There is some evidence that people are getting their ducks in a
row," said Seth Carpenter, chief U.S. economist at UBS Group AG and
a former official at the Fed and the Treasury Department. He said
he sees a one-in-three chance of repo-market issues at
year-end.
If there were going to be destabilizing money-market pressures
on Dec. 31 they should be cropping up now, said Mark Cabana, head
of short-term interest-rate strategy research at Bank of America.
"The concerns in my own mind have cooled significantly," he
said.
The Fed added hundreds of billions of dollars in reserves to the
banking system earlier this decade when it purchased Treasury and
mortgage securities to stimulate the economy when short-term
interest rates were near zero. It began draining these reserves in
2017 by allowing more of those assets to mature without replacing
them.
It stopped doing so in July, after cutting short-term rates in
response to worries about the global growth outlook.
Reserves are a liability against assets on the Fed's balance
sheet, and they can decline when the Fed holds its balance sheet
steady if other liabilities rise.
This is precisely what happened in August and early September,
after the Treasury Department began rebuilding its general account
-- maintained at the Fed -- after Congress suspended the federal
borrowing limit. This cash balance is one of several liabilities on
the Fed's balance sheet that had been growing, further squeezing
reserves out of the system.
Fed officials are also trying to determine whether postcrisis
rules meant to assure major banks have a sufficient cash cushion to
weather a crisis have led banks to hoard reserves, aggravating the
September market tumult.
The episode caught Fed officials by surprise in part because
they didn't think reserves had grown especially scarce.
As the Fed fine-tunes its response to money-market volatility,
its officials face a broader tension. They want to avoid spikes in
the repo market -- such as those related to the year-end funding
pressures -- that could interfere with their ability to set
short-term interest rates.
But they don't necessarily see their job as to eliminate
volatility entirely from short-term lending markets. One risk:
Stamping out volatility during normal times could yield more
volatility when shocks hit.
"You do want to create room for repo rates to vary again, and
create a margin where normal market forces can play out," said Lou
Crandall, chief economist at financial-research firm Wrightson
ICAP.
What the Fed is doing right now, he said, appears designed to
provide a guardrail for markets as the central bank and Wall Street
learn more about any unexpected side effects from changes in market
structure and regulation after years in which the Fed maintained a
larger asset portfolio.
"We are going to be in an era for the next couple of years in
which...money markets can experience severe distortions that are
just inefficient," Mr. Crandall said.
Write to Nick Timiraos at nick.timiraos@wsj.com
(END) Dow Jones Newswires
December 26, 2019 09:59 ET (14:59 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.