Investors and policy makers are bracing for new disruptions to short-term cash markets going into the end of the year.
Federal Reserve officials have so far committed about $350 billion to efforts aimed at calming the market for overnight repurchase agreements, or repos, where banks and other firms borrow cash for short periods in exchange for collateral, such as supersafe government securities. That includes injecting cash into money markets for the first time since the financial crisis and buying Treasury bills, a move some investors have compared to the postcrisis quantitative easing.
Fed officials—who are scheduled to meet Tuesday and Wednesday—want to avoid a repeat of September’s surge in volatility, when an unexpected shortage of cash sent rates climbing as high as 10%.
Investors are making their own preparations, hoarding cash to ensure they have enough available to lend if rates spike again at the end of the year. It is an educated guess. The cost of borrowing overnight using repo has spiked at the end of recent quarters and at the end of 2018, when rates climbed as high as 6%.
Disruptions in the money markets concern investors and banks because repo is a crucial part of how financial firms fund trading and investment. Some worry the volatility will make it more expensive for dealers to underwrite bond sales and participate in government debt auctions, while investors say it can increase the difficulty of trading some assets.
Investors say today’s repo-market turbulence is significantly different than the disruption that preceded the financial crisis. Back then, overnight lending rates soared before freezing as investors questioned the quality of assets pledged as collateral and ultimately the solvency of large investment banks such as Lehman Brothers and Bear Stearns. While the recent disruptions instead stem from a scarcity of cash, the magnitude and urgency of the Fed’s response highlights the importance of maintaining a smoothly functioning market.
Behind the recent swings, analysts point to a shortage of reserves. In September, rates spiked after a confluence of events that drained liquidity from the financial system, with investors sending funds to the Treasury Department to settle purchases at government debt auctions at the same time corporations sent quarterly tax payments, according to Fed officials, investors and economists.
The Federal Reserve Bank of New York responded by offering billions of dollars of overnight loans in the repo market. It has since added repo loans with longer terms and increased the amount of these offerings as demand for them has mounted. It is also buying $60 billion a month in Treasury bills.
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After their meeting this coming week, Fed officials are expected to emphasize their willingness to provide funds to maintain liquidity in the financial system. Those efforts face a test in the middle of this month. That is when corporate tax payments are due and investors must settle purchases made at this week’s Treasury debt auctions—a repeat of the circumstances that led to the September rate spike.
Balance-sheet constraints at the largest banks will also play a key role, impacting year-end liquidity in repo markets, according to J.P. Morgan research analysts. Several of the world’s largest banks will limit repo and derivatives activity headed into year-end to protect against a possible 50-basis-point capital increase on account of regulations.
Treasury Secretary Steven Mnuchin said Thursday he is working closely with Fed officials to ensure there are ample reserves, or deposits banks keep at the Fed.
Mr. Mnuchin said the Treasury is also working with bank regulators to review whether regulatory issues contributed to the interest-rate spike, and considering the timing of corporate tax payments.
“The Fed wants to fix the problem at any cost,” said Gennadiy Goldberg, a government bond strategist at TD Securities. “We’re still in emergency mode.”
Policy makers and market participants disagree about whether postcrisis regulations are to blame for the September spike in repo markets. Some contend that capital requirements such as the leverage ratio—a rule stipulating banks hold a certain amount of investor equity compared to debt—distort lender incentives to trade low-risk assets. Others said that opportunists are using the turmoil in the repo markets to soften regulations that have been in place for years.
Daniel Tarullo, a former Fed official, said Thursday at a Brookings Institution conference that the stress in the repo market raises broader issues in postcrisis rules, notably whether regulations require banks to hold too much cash, keeping it out of circulation.
The Fed is expected to release its repo market lending schedule Thursday. Analysts expect that policy makers will increase the amount of cash they plan to lend, particularly with loans that mature after the new year, to reduce the risk of a cash shortage.
Fed officials are also debating whether to create a permanent facility that would unlock excess reserves for banks to deploy to boost liquidity and contain repo-market volatility. While analysts and investors expect such a solution by next year, policy makers have yet to resolve key questions about the potential program, such as who could borrow from it and at which interest rates.
Some investors and analysts said repo rates could still climb at year-end, even with a dramatic increase in Fed lending. That is because big banks, which are assessed year-end regulatory capital fees based on the amount of risky loans on their books, could raise what they charge for overnight loans to offset the higher regulatory costs they would face from any additional repo lending.
Nick Maroutsos, co-head of global bonds at Janus Henderson, said the firm is preparing to lend in the repo market if a shortage of cash at year-end leads to the expected spike in overnight and short-term rates.
“We’re waiting to pounce,” Mr. Maroutsos said.
Write to Daniel Kruger at Daniel.Kruger@wsj.com
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Investors Gird for Year-End Turmoil in Cash Markets - The Wall Street Journal
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