Federal Reserve intervention in repo market a step towards more QE

Federal Reserve intervention in repo market a step towards more QE

The Federal Reserve Bank of New York has a well-earned reputation for fighting fires in financial markets, particularly in the arcane and crucial realm of short-term funding for banks and investors.For the second day running, the New York Fed has turned on its fire hose and pumped money into the financial system. There are signs that the $75bn it made available on Wednesday will help calm funding pressure in a geeky but important part of the bond market’s plumbing, the repurchase or repo sector.Many will recall that troubles in the repo market, where banks and investors borrow cash overnight using Treasuries as collateral, were a symptom of funding problems for investment banks in 2008. But that is not the current situation. Instead, this week’s sharp rise in overnight interest rates is a symptom of an issue that has been bubbling away for a couple of years. It ultimately means the US Federal Reserve will have to resume buying more Treasury debt, expanding its balance sheet.During the era of quantitative easing, the Fed injected money into the financial system by buying Treasury and mortgage bonds from banks, which then held that cash as excess reserves with the central bank. Those reserves peaked at $2.9tn in July 2014, and then began to fall. That is because the Fed began shrinking its balance sheet — by ceasing its bond purchases. At the same time, the amount of Treasury debt in circulation has expanded to fund the increasing US budget deficit.When repo rates spike, as they did this week, that is a sign that the financial system does not have enough cash on hand. Such an outcome was foreseen a couple of years ago, when Lorie Logan, head of market operations and market analysis at the New York Fed, said in May 2017: “Upward pressure on overnight interest rates is the most direct indicator that reserves are becoming scarce.”The current figure of $1.4tn in bank reserves held at the Fed appears large, but much of it is tied up because of regulatory and liquidity requirements, according to analysts.That leaves little spare cash for banks to deploy when it becomes more difficult to borrow money in the repo market. This week’s spike in rates reflects two forces. Companies have pulled cash from money market accounts to pay corporates taxes for their September 15 deadline. Meanwhile, banks have been flooded with recent sales of Treasury debt that they need cash to pay for. The end result has been a spike in the overnight repo rate from about 2.25 per cent to a peak of 10 per cent. Joe LaVorgna at Natixis says: “Rising financing needs effectively drain reserves from the banking system because primary dealers need to [absorb] the Treasury auctions. The ensuing shortfall in reserves leads to a bidding up in the cost of overnight financing.”After the New York Fed’s temporary injections of money into the financial system, many in the market think a lasting solution will require the central bank to start expanding its balance sheet once more, albeit on a modest scale. Thomas Costerg, senior economist at Pictet argues: “The Fed needs to leave a cushion of bank reserves and they will need to resume [Treasury] purchases.”Analysts at Bank of America Merrill Lynch estimate the Fed will purchase a total of $400bn in Treasuries over the next year. This reflects $250bn that restores “an ‘abundant’ reserve level plus a buffer” of $150bn a year “to maintain this reserve level”.Financial plumbing is technical, but it matters. The resumption of quantitative easing, in at least the form of baby steps, appears closer than many think. michael.mackenzie@ft.com


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