Why is the Federal Reserve injecting money into the financial system?

A perfect storm this week hit one of the most important sources of lubrication in the financial markets, highlighting the fear that the Federal Reserve's attempt to relax after a financial crisis has failed.

Repurchase agreements are the fat that allows the financial system to continue to run, allowing different market participants to borrow and lend themselves to cover short-term cash needs.

In fact, it is short-term loans that banks and investors contract between themselves, exchanging cash for collateral, often overnight.

On Tuesday, the wheels stopped turning. The so-called pension rate has reached a high of 10%, while it is generally trading at the Federal Reserve's target interest rate of between 2% and 2.25%. The New York branch of the Fed had to intervene to restore order.

But what exactly is happening? The answer lies both in the short-term problems and in the major structural changes in the financial markets in recent years, when the Fed had ended the huge bond purchases it had made to stimulate the economy. after the financial crisis.

Why now?

In the United States, tax day is September 15th. Some companies are getting ready by pooling the liquidity they need and putting it into money market funds – short-term investments that use the repo market to lend cash for a short period of time, while getting a poor return. . Now that tax day has passed, this money has been pulled off the market, reducing the supply of dollars.

At the same time, about $ 54 billion of Treasury securities have flocked to the market due to the settlement of a multitude of previously auctioned debts. This has created a wave of requests from people wishing to borrow money to finance the purchase of these treasury bills.

In simple terms, the demand for liquidity is higher while the supply of liquidity is lower.

In the longer term, the Fed's bank reserves have decreased

Analysts believe that these two factors alone should not cause the deep cracks in the pension market that we saw this week. The underlying problem is more structural.

The Fed has reduced the size of its balance sheet, leaving Treasury bills and mortgage bonds bought after the financial crisis. In return, this reduces the amount of cash reserves held by banks with the Fed. In 2014, banks held $ 2.9 billion in "excess reserves" with the central bank. Since then, that number has fallen to about $ 1.3 billion, where it has rocked all summer.

Less cash reserves means less money available in banks to cover the stress of short-term financing.

"We have had tax payments in the past. What's different this time is that it's been in a period of quantitative tightening, "said Jon Hill, interest rate strategist at BMO Capital Markets. "The companies that make their money from the market are only the trigger for bankruptcy."

Reserves can now be too weak

The Fed does not know exactly the minimum level of reserves that banks must maintain to operate effectively. In June, an article published by the New York Fed indicated that the minimum level could be about $ 1 billion.

Lorie Logan, head of operations and market analysis at the New York Fed, said in a speech in 2017 that we will know this level when we see it.

"The upward pressure on day-to-day interest rates is the most direct indicator of the scarcity of reserves," she said. "Even if brief rate hikes may not be materially adverse, a more sustainable rate hike would be a sign that reserves have already become scarcer than necessary to maintain interest rate control."

The latest rise in the repo markets thus shows that banks' reserves may be too scarce, which increases the supply of liquidity on the financial markets.

That is, we might have reached the level that Ms. Logan was talking about.

Could it get worse?

Yes. Since Ms. Logan's speech, the Fed has stopped the downsizing of its balance sheet and is maintaining it now.

Indeed, its assets are now at a stable level. On the other side of the balance sheet of the central bank are some big articles. Bank reserves are one, but the amount of cash held by the US Treasury is another.

Previously, the US Treasury had only $ 5 billion in its cash account at the Fed. But since 2015, the Treasury has enough cash to cover a week of exits – about 400 billion dollars. On September 11, the Treasury Secretary, Steven Mnuchin, had only $ 184 billion, which means that he is currently facing pressure to recover the balance of his current account.

Another factor is the simple growth of circulating cash in circulation, which tends to grow at about the same rate as GDP, said BMO Capital Markets' Hill.

As these two factors evolve, something has to break down in order for the liability to match the asset. This puts downward pressure on the level of banks' reserves, draining even more liquidity from the market.

What can be done about this?

Some things. The Fed could lower the interest rate it pays on banks' reserves when it closes its monetary policy meeting on Wednesday, trying to keep other short-term interest rates – like repos – in its target range.

The Fed could also begin to increase its balance sheet faster than expected in order to keep pace with the currency's growth and cash flow increases in the US Treasury.

Finally, the Fed could put in place a permanent takeover procedure.

It would essentially be a permanent pressure valve able to evacuate some of the air from the market to prevent any explosion. The New York Fed took drastic action on Tuesday to relieve the pressure and promised to do the same when trading resumes on Wednesday. This would be a permanent pension facility, but on a scheduled basis more regularly.

"Obviously, it's a tool they need in the toolbox," said Janaki Rao, portfolio manager at AllianceBernstein. "These are somewhat unknown territories. Monetary policy was developed at any time during the crisis and we are dealing with a modified paradigm in which the Fed must strive to understand and propose new solutions to deal with it. "

Additional report by Colby Smith in New York