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Prolonged Funding Stress Boosts Calls for Permanent Fed Fix

Liz Capo McCormick and Alexandra Harris
Prolonged Funding Stress Boosts Calls for Permanent Fed Fix

(Bloomberg) -- Signs that stress in U.S. funding markets is rebuilding ramped up pressure on the Federal Reserve to permanently increase reserves by boosting Treasury holdings, even as it was preparing a temporary liquidity injection for a fourth straight day.

The New York Fed plans to do another $75 billion overnight repo operation on Friday. It follows liquidity doses of the same size Thursday and Wednesday, and $53.2 billion on Tuesday. The central bank is deploying this remedy for the first time in a decade.

The Repo Market’s a Mess. (What’s the Repo Market?)

This week’s actions have helped calm the funding market, with repo rates declining to more normal levels after soaring to 10% Tuesday, four times last week’s levels. However, swap spreads tumbled to record lows Thursday amid concern Fed policy makers haven’t announced more aggressive steps. Swaps are signaling less appetite for Treasuries, driven by concern traders won’t be able to fund purchases through the repo market.

“The Fed needs to do at least double what they offered now and maybe even be more vigilant and do something even more significant,” said Thomas Simons, senior economist at Jefferies LLC. “This attitude of trying to kind-of fix the problem is not great.”

There are others signs of investor apprehension about future funding levels, which is manifesting in different ways.

Treasury bill sales on Thursday were met with a poor reception, as investors demanded to be compensated via higher yields for locking up cash. Meanwhile, in cross currency basis -- which show floating-rate payments in different currencies -- the premium for the Australian dollar over its U.S. counterpart collapsed by the most in eight years during Asian trading hours.

So while overnight general collateral repurchase agreement rates have retreated, trading around 1.95% Friday, around Thursday’s levels, market participants say the Fed needs to reveal a permanent fix, rather than these ad-hoc overnight operations.

“We expect these episodes of funding stresses to become more frequent with demand for funding and U.S. Treasury supply forecast to increase heading into year-end and the Fed’s reserve levels likely to drop further,” Jerome Schneider, head of short-term bond portfolios at Pacific Investment Management Co., wrote in a note Wednesday with his colleagues.

The operations, once common before the 2008 financial crisis, temporarily add cash as the Fed takes government securities as collateral. Wall Street bond dealers submitted about $84 billion of securities for Thursday’s Fed action, the most in the three days.

The latest addition of liquidity follows the Federal Open Market Committee’s move Wednesday to reduce the interest rate on excess reserves, or IOER, by more than their main interest rate, an attempt to quell money-market stresses.

Given the added supply, banks’ holdings of Treasuries have risen and are increasingly being financed by money-market funds investing in repo, which leaves “U.S. funding markets more fragile,” Schneider wrote. He said this adds to other reasons why the Fed needs to do more to engineer a long-term fix.

Cap Busted

After policy makers wrapped up the two-day meeting Wednesday, Fed Chairman Jerome Powell said the central bank will keep doing these repo operations if that’s what it takes to get markets back on track. He spoke hours after the effective fed funds rate busted through the central bank’s cap.

Powell also said the Fed would provide a sufficient supply of bank reserves so that frequent operations like the ones they’ve done this week aren’t required.

The only way “to permanently alleviate the funding stress is to rebuild the buffer of reserves in the system,“ according to Morgan Stanley strategist Matthew Hornbach.

Relying on repo operations doesn’t resolve the issue of reserves declining as the Treasury rebuilds balances, Hornbach wrote in a note. Having regular operations will also increase market uncertainty as the Fed could halt purchases at any time, while the size of its buying will have to expand over time as reserves drop, he said.

“It is certainly possible that we’ll need to resume the organic growth of the balance sheet sooner than we thought,” Powell said, referring to the central bank potentially buying securities again to permanently increase reserves and ensure liquidity in the banking sector.

Read: Fed Should Be Worried About ‘Collateral Damage,’ BofA Says

Many strategists had predicted the Fed would take even more aggressive measures to reduce the pressures. One idea that’s gotten a fair amount of attention is something called a standing fixed-rate repo facility -- a permanent way to ease funding pressures. Many analysts even predicted a Wednesday announcement that the Fed would start expanding its balance sheet.

That didn’t happen. However, with the Fed apparently ready to keep injecting liquidity whenever it’s needed, “it’s enough for now,” said Jon Hill of BMO Capital Markets.

“This week’s dramatic moves in the short-term funding markets serve as a case in point for the need to carefully consider liquidity in the financial system,” Rick Rieder, global chief investment officer of fixed income at BlackRock Inc., wrote in a note.

“All of this funding market gyration points to the increasingly obvious fact that the end of Fed reserve draining is insufficient to stabilize these markets,” he said.

(Updates with Friday repo levels.)

--With assistance from Edward Bolingbroke and Stephen Spratt.

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net;Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Nick Baker, Mark Tannenbaum

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