THE FEDERAL RESERVE HAS BEEN QUIETLY INCREASING THE SIZE OF ITS MONEY-MARKET INTERVENTIONS / BARRON´S MAGAZINE

The Federal Reserve Has Been Quietly Increasing the Size of Its Money-Market Interventions

By Alexandra Scaggs




The Federal Reserve is offering a larger amount of short-term cash loans.

The Federal Reserve has been intervening more aggressively in money markets as it attempts to keep interest rates from rising around the end of the year.

On Monday, the central bank again increased the amount of short-term cash loans it plans to offer banks to ensure U.S. interest rates remain stable later this month.

It now plans to offer $25 billion in cash loans for the 28-day period ended Jan. 6, up from $15 billion previously.

Last week, it increased the size of a 42-day facility for the period ended Jan. 13 by $10 billion as well.

That extra $20 billion doesn’t substantially change the total amount of cash loans made by the New York Fed, which is tasked with keeping interest rates within the policy band targeted by the Fed.

It does, however, illuminate the challenge the central bank faces in the corner of money markets where trading desks lend cash to one another, known as the repo market.

In repo transactions, traders sell government securities for cash on a short-term basis, agreeing to buy back the securities at a premium on a predetermined future date, usually one to 90 days later. (“Repo” is short for repurchase agreement.)

The central bank has been active in that market since mid-September. Around Sept. 17, a series of events tied up cash on banks’ balance sheets in government securities, and drove short-term interest rates sharply higher. The Fed intervened with repo transactions, easing some of the pressure.

It isn’t unusual for the Fed to participate in repo markets. Before the financial crisis, the central bank implemented its monetary policy by lending out cash in repo markets, albeit in smaller amounts.

But the end of the year could bring more upward pressure on interest rates, and once again challenge the Fed’s ability to maintain rates within its targeted band. Strategists say that is true even though the Fed is buying $60 billion of Treasuries a month—purchases that ordinarily would tend to pull rates lower.

Here’s why: Year-end is an especially tricky time for banks and their bond-dealer subsidiaries.

Global regulators measure banks’ importance to the financial system, and their requirements for those lenders, based on a snapshot of their balance sheets at the end of the year.

Requirements for the biggest banks are the most stringent,

The effect is that global banks will have an incentive to substantially reduce the size of their balance sheets as the end of the year approaches. That could make them less willing to lend cash in the repo market, driving rates higher.

To address that pressure, the central bank could offer more cash loans for up to six weeks to tide banks over until January.

Repo deals in themselves don’t shrink bank balance sheets, according to Mark Cabana, strategist with Bank of America Merrill Lynch. But longer-term repo transactions should give banks confidence that they will have sufficient cash at the end of the year, he wrote in a recent note. That would allow them to plan ahead and shrink their balance sheets in other ways.

That means more bank trading desks will likely want to borrow from the Fed for a several-week period ending in January. That trend has already started, according to Fed data.

Not only has the central bank has increased the size of repo transactions that end in January, but demand was unusually high for past 42-day transactions.

Take, for example, the $25 billion facility that the Fed opened on Nov. 25, essentially agreeing to lend cash until Jan. 6. There were $49 billion of bids for that facility—almost twice the volume of repo transactions on offer.

The Fed also offered a $25 billion facility on Monday, which will provide a cash loan until Jan. 13. Banks’ trading desks submitted $42 billion of bids for that facility.

None of the Fed’s other repo transactions in the past two weeks had demand that outpaced the amount on offer.  

All of this raises the question of why banks are short on cash reserves in the first place. That has to do with both the central bank’s recent efforts to shrink its balance sheet and the global response to the financial crisis.

Global regulators require banks to hold on to a large store of reserves and high-quality assets thanks to rule changes meant to eliminate the need for bailouts. Some banking functions can only be done in cash, however, so banks often need to pledge their high-quality assets—government securities—in exchange for cash.

Until recently, banks had more than enough reserves to fulfill their needs for cash and regulatory requirements.

But then the Fed started to shrink its bond portfolio. Cash reserves at banks diminished as the lenders bought debt securities the central bank once would have snapped up.

Their excess reserves have declined by more than 35% since the end of 2017. That was apparently too much of a drop; the mid-September funding crunch indicated some scarcity of reserves.

The Fed has started purchasing bonds again since then. It is doing so to boost reserves enough to relieve funding pressures, not to ease monetary policy outright. It is considering other options to ease funding pressures as well, but it probably won’t implement any of them until next year.

So those $60 billion in monthly Treasury purchases don’t quite count as quantitative easing.

According to Cabana, they may not even be sufficient to ease upward pressure on rates at the end of the year.