The New York Federal Reserve has vowed to ease the turmoil that erupted last month in the overnight lending market. Keeping that promise is proving to be a very heavy lift.
Borrowing costs in this critical corner of Wall Street have gotten back to normal. But that’s only because–behind the scenes–the NY Fed is pumping in vast amounts of money to ease the cash crunch before it spills over into the real economy or dents consumer and business confidence.
For instance, the NY Fed pumped in $99.9 billion of cash into the financial system on Tuesday alone. It topped that by injecting $134.2 billion on Thursday. In addition to that short-term liquidity, which gets paid back quickly, the NY Fed purchased $26 billion of Treasury bills this week. Those T-bill purchases drew enormous demand, with banks requesting nearly four times as much cash from the Fed.
These aggressive steps from the Fed, along with the strong demand from banks, shows that the overnight lending market is not back to normal. Banks are still clamoring for cash — and the Fed is rushing to fill the vacuum.
“There is something wrong with the plumbing of the financial system. The stress is still there,” said Philip Marey, senior US strategist at Rabobank.
Precisely why a cash shortage exists is up for debate, with everything from post-crisis regulations to the $1 trillion deficit being blamed.
And the Fed is still trying to figure out how much cash is needed to ease the stress.
Earlier this week, the NY Fed announced it increased the size of its overnight repurchase agreement (repo) operations to at least $120 billion. That’s up from $75 billion previously. And the NY Fed lifted the size of its term repo operations, which span multiple days, to at least $45 billion.
All that is on top of the $60 billion in Treasury bills the Fed has promised to outright purchase each month. That permanent liquidity will boost the size of the central bank’s massive balance sheet, reversing recent efforts to shrink it.
“Without the Fed, the repo market just wouldn’t function anymore. That’s the sad conclusion of what we’ve seen since September,” Marey said.
‘Fiddling with the dials’
The overnight lending market gets little attention when it is functioning smoothly. Banks, hedge funds and other financial institutions quickly and easily borrow money. This dull but critical market hums along in silence.
But that changed in September. Borrowing costs suddenly spiked well above the range set by the Fed, raising fears that the Fed was losing its grip on short-term borrowing costs — the central way it speeds up and slows down the economy.
The NY Fed eased the stress by injecting tons of cash, marking its first rescue in the overnight lending market since 2008. By pumping in cash, the Fed was essentially acting like the plumber.
Continued pressure has forced the Fed to repeatedly step up its response, suggesting that officials are struggling to determine how much cash is required to get the market operating smoothly again.
“They are basically fiddling with the dials,” said Nicholas Colas, co-founder of DataTrek Research. “That’s not a comfortable feeling, because this is an important market.”
Why the market stress matters
So far, this market stress hasn’t had an impact on the real economy. Borrowing costs for mortgages and other loans remain low. But the risk is that there could be is a spillover, either through a severe cash crunch or a blow to confidence.
Colas compared the situation with going to the ATM and finding out there is no cash and customers must go into the branch. It’s more of an annoyance than a real problem.
“But if it happens enough times, you start to wonder: What the hell is wrong with the ATMs at the bank?” Colas said.
If it lasts long enough or gets out of hand, the pressure in the overnight lending market could raise questions about the Fed’s ability to influence short-term borrowing costs.
“The Fed lives and dies by confidence. And this does not inspire confidence,” said Colas.
Although it seems unlikely, it’s also possible that the Fed badly underestimated how much cash is needed in the system.
“A financial institution could get into trouble. If it falls over, that could have repurcussions for other institutions,” said Marey. “Accidents can happen, as we saw in 2007 and 2008.”
No one can agree on what’s causing it
Even though the overnight lending market stress first emerged in mid-September, its cause remains a mystery.
Fed officials initially blamed one-off events: The withdrawal of cash by US companies to make quarterly tax payments to the Treasury Department and the settlement of a large amount of Treasury purchases. Both those factors have since passed, and they should have been anticipated by investors.
Some analysts and bankers blamed post-crisis rules that limit the ability of banks to provide cash to short-term borrowers when needed. For instance, big banks must comply with the liquidity coverage ratio, or LCR, which requires them to keep a large amount of easily tradeable assets on their balance sheets.
Earlier this month, Senator Elizabeth Warren warned against the overnight lending market stress being used as a catalyst to push for deregulation.
“It would be painfully ironic if unexplained chaos in a small corner of the banking market became an excuse to further loosen rules that protect the economy from these types of risks,” Warren wrote in a letter to Treasury Secretary Steven Mnuchin.
Peter Boockvar, chief investment officer at Bleakley Advisory Group, argued that the overnight lending market problems show that the system is having trouble swallowing the record amount of Treasuries being issued to finance America’s $1 trillion budget deficit. He says it’s creating a cash shortage.
“What has become crystal clear is that the massive US budget deficit and funding needs has finally overwhelmed the system,” Boockvar said.
Others don’t buy that argument, because Treasury rates remain low and the massive budget deficit has been well anticipated.
No matter the cause, it’s clear the Fed will be forced to continue pumping tens of billions of dollars into the system daily for the foreseeable future..
“It is worrisome that these numbers continue to rise, and we don’t yet have a very clear explanation,” said Colas.