Borrowing rates skyrocketed on Tuesday in a corner of the markets the public rarely notices but that is critical to the functioning of the global financial system.
The spike in overnight borrowing rates forced the New York Federal Reserve to come to the rescue with a special operation aimed at easing stress in financial markets.
It was the NY Fed’s first such rescue operation in a decade, the last occurring in late 2008.
“It’s unprecedented, at least in the post-crisis era,” said Mark Cabana, rates strategist at Bank of America Merrill Lynch.
On Tuesday morning, the NY Fed launched what’s called an “overnight repo operation,” during which the central bank attempts to ease pressure in markets by purchasing Treasuries and other securities. The goal is to pump money into the system to keep borrowing costs from creeping above the Fed’s target range.
The episode demonstrates evidence of emerging strains in financial markets and raises concern that the Federal Reserve could be losing its grip on short-term rates.
“The funding markets are clearly stressed,” said Guy LeBas, managing director of fixed income strategy at Janney Capital Markets. “It’s going to require Fed action.”
The NY Fed announced plans late Tuesday to hold another repurchase agreement operation on Wednesday that would aim to repurchase up to an additional $75 billion.
The rate on overnight repurchase agreements hit 5% on Monday, according to Refinitiv data. That’s up from 2.29% late last week and well above the target range set in July by the Federal Reserve, which is 2% to 2.25%. The surge continued Tuesday, with the overnight rate hitting a high of 10% before the NY Fed stepped in.
Although it doesn’t get as much attention as the Dow or the 10-year Treasury rate, this overnight market plays a central role in modern finance. It allows banks to quickly and cheaply borrow money, for short periods of time, often to buy bonds like Treasuries. This market broke down during the 2008 financial crisis.
However, analysts drew a distinction between the current period of stress and what happened during the crisis. Back then, investors were deeply worried about the financial health of banks. Today, banks are hauling in record profits and balance sheets look sturdy.
It’s unclear what exactly is causing the stress in the overnight market, or how long it will last.
“No one knows why this is happening,” Jim Bianco CEO of Bianco Research, said on Twitter. “If it persists more than another day or two, it will be a problem.”
$1 trillion deficits and paying Uncle Sam
There are some theories.
Cabana, the Bank of America analyst, blamed the spike in overnight lending rates on the Fed badly underestimating the amount of cash needed to keep the financial system operating smoothly.
“The Fed just made a policy mistake,” Cabana said. “There is not enough cash in the banking system for the banks to meet all of their liquidity and regulatory needs. I’m not that worried, because the Fed will fix it.”
The catalyst for the stress, according to Cabana, was the fact that US companies withdrew vast sums of money from banks to make quarterly tax payments to the US Treasury Department. That forced banks to draw down their reserves at the Fed.
The rate spike may also be a symptom of the sharp increase in Treasury bonds being issued to fund the federal government. The federal deficit has spiked to $1 trillion this fiscal year because of the tax cuts and surge in government spending.
Banks typically buy Treasuries by borrowing in the overnight market. The jump in Treasury issuance caused a large increase in demand for short-term financing.
“The fundamental issue is there are just too many darn Treasuries out there,” Cabana said. “Both parties are to blame. The $1 trillion deficit will keep this an issue.”
The return of QE?
No matter the cause, more Fed action may be needed, including additional temporary NY Fed operations.
“They may have to do the same thing tomorrow morning,” said LeBas.
The Fed may also need to lower the interest it pays on excess bank reserves, or IOER. Bank of America Merrill Lynch predicted the Fed will cut this rate slightly on Wednesday.
“That’s like a Band-Aid,” Cabana said.
As a longer-term solution, Barclays and Bank of America expect the Fed to begin expanding its balance sheet again by purchasing Treasuries. The Fed’s bond buying program, known as quantitative easing, or QE, was launched during the financial crisis to keep borrowing costs extremely low. As the economy healed, the Fed reversed course and started to shrink its balance sheet.
Cabana doesn’t think the Fed will call this QE, though he said it will work the same way. The central bank will grow its balance sheet by purchasing Treasuries.
“The Fed won’t admit this,” Cabana said, “but it looks and smells an awful lot like the monetary authority is financing the fiscal authority.”