The Federal Reserve is heading into a tricky period as the end of the year approaches and potentially brings back volatility in money markets.
The Fed is attuned to the issue and has injected hundreds of billions of dollars in liquidity into the banking system since mid-September, when short-term borrowing rates moved up sharply in large part because liquidity in the system did not flow properly.
Analysts say the Fed's actions will have a calming effect on the overnight repurchase, or repo, market — where banks, hedge funds and other financial firms borrow and lend cash overnight in exchange for collateral such as U.S. Treasury securities.
But analysts also see a risk that rates for overnight lending may jump again, partly because large banks often take a step back from lending in the repo market near the end of the year. Doing so helps them avoid higher capital requirements for the coming year that regulators put in place if they deem a big bank has gotten somewhat more risky.
"I don't think there's any doubt that repo rates are going to spike on year-end. The question is how much are they going to spike," said Jonathan Hill, vice president of U.S. rates strategy at BMO Capital Markets.
Powell: Pressures 'appear manageable,' but Fed ready to act as needed
The New York Fed is upping its planned repo operations through January 2020 to try to mitigate those year-end pressures, as elevated repo rates influence other short-term rates like the Fed's benchmark federal funds rate. In mid-September, for example, the Fed's benchmark rate breached its 25-point target range as a result of the turmoil.
The Fed's repo purchases are temporary injections of liquidity, but the Fed has also been making permanent purchases of $60 billion in Treasury bills each month, a move that boosts banks' reserve levels and ensures there is more cash sloshing around in the system.
The Fed's actions have "gone well so far," with money market pressures remaining subdued since their initial jump in mid-September, Fed Chairman Jerome Powell told reporters Dec. 11.
"We think that the pressures appear manageable, and we stand ready to adjust the details of our operations as necessary to keep the federal funds rate in that target range," Powell said.
The Fed's goal is not to eliminate all volatility in the repo market but to limit the risk that a spike in rates will move the Fed's benchmark rate too much, Powell added.
How much volatility the Fed is willing to tolerate is an "open question that everyone is trying to figure out," said Michael Pugliese, an economist at Wells Fargo Securities.
First test coming Dec. 16
The first hurdle that the Fed and market participants will have to clear comes Dec. 16, when both a settlement date for U.S. Treasury securities and a corporate tax payment deadline occur.
That combination proved to be a spark that drove repo rates higher in mid-September, and it is expected to provide some upward pressure on rates again.
Those two factors will essentially lead companies and investors to pull cash from banks and make payments to the Treasury, depleting banks' reserve levels and locking up some cash at Treasury that banks might otherwise use to lend in the repo market.
Hill, of BMO Capital Markets, said he expects Dec. 16 to be relatively smooth given the Fed's ongoing liquidity injections but that substantial rate volatility would suggest the Fed's actions have "only been a band-aid and not sufficient to really calm the market."
'Forensic work' examining repo market continues
Three months after the mid-September flareup in the repo markets, its causes are still the source of debate and subject to what Powell has described as "forensic work" inside and outside the Fed.
One factor seems clear to the Fed: that it may have gone too far in slimming down its balance sheet, a process that gradually reduced bank reserves since it began in late 2017. The Fed has been working to get the level of bank reserves back to or above its early September levels by purchasing $60 billion in Treasury bills each month. Although the details may change later on, the Fed has said its bill-buying program will continue "at least into the second quarter of 2020."
Other liabilities on the Fed balance sheet also gradually ate into reserves heading into September: continued steady growth in currency demand; a rise in a foreign repo pool that the Fed offers to other central banks and official international bodies; and a deposit account that the Treasury Department holds at the Fed. The Treasury account has experienced substantial volatility this year. It dwindled earlier in 2019 after Treasury officials took so-called extraordinary measures to avoid a debt limit breach, and then in August, the Treasury began rapidly rebuilding the account after Congress approved a two-year debt ceiling increase.
But the broader questions on recent repo turmoil revolve around bank regulation and why large banks opted against lending cash in the repo market even though the spike in rates meant they would get a substantial return for lending short-term cash.
Regulations implemented after the financial crisis likely played a role. Banks are now required to hold a much larger stock of "liquid" assets to ensure they can stay afloat in stress scenarios. The reserves that banks hold at the Fed are an attractive way of meeting those rules, since reserves are essentially cash that can easily be moved around. Treasury securities, considered to be virtually risk-free, also count as top-tier liquid assets.
But reserves appear to be slightly more attractive than Treasurys, as the latter would need to be sold to turn them into cash.
That preference for reserves tends to show up through two avenues: resolution plans, which require large banks to plot out how they would be unwound during a hypothetical bankruptcy, and internal liquidity stress tests. The latter "can create a preference at some institutions for central bank reserves over other liquid assets," Fed Vice Chairman for Supervision Randal Quarles said at a House hearing Dec. 4.
Longer-term decisions will have to wait
The Fed is reviewing potential tweaks to its regulations that would get liquidity flowing more freely "in ways that don't undermine [the] safety and soundness" of the banking system, Powell said Dec. 11. But any formal changes would take time and would need to go through a public comment period, he added.
Fed officials are also weighing whether they should launch a standing repo facility, which would give firms a way to easily trade their stock of Treasury securities for reserves at the Fed at a certain price. One key goal of the facility would be to reduce banks' demand for reserves, as they would have an easy way to access reserves on an ongoing basis.
But it is unclear whether the Fed will opt for launching a standing repo facility, and officials would first have to agree on several key details, including what kinds of firms would be eligible to participate and the price of the Treasury-to-reserve trades.
"I think the standing repo facility is something that'll take some time to evaluate and create the parameters of and put into place," Powell told reporters. "At the moment what we're focused on [is] year-end."