Fed loses control of its own interest rate on day of big decision — ‘This just doesn’t look good’

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Jerome Powell, chairman of the U.S. Federal Reserve, waits for the start of a House Financial Services Committee hearing in Washington, D.C., on Wednesday, July 10, 2019.Andrew Harrer | Bloomberg | Getty ImagesAs the Fed was meeting to consider cutting interest rates, it lost control of the very benchmark rate that it manages.It’s been a rough week in the overnight funding market, where interest rates temporarily spiked to as high as 10% for some transactions Monday and Tuesday. The market is considered the basic plumbing for financial markets, where banks who have a short-term need for cash come to fund themselves.The odd spike in rates forced the Fed to jump in with money market operations aimed at reining them in, and after the second operation Wednesday morning, it seemed to have calmed the market.In a rare move, the Fed’s own benchmark fed funds target rate rose to 2.3% on Tuesday, above the target range set when it cut rates at its last meeting in July. The target range is 2% to 2.25%, and the funds rate was at 2.25% on Monday.A second rate the Fed watches, the secured overnight financing rate, or SOFR, shot up to 5.25% on Tuesday from 2.43%. That is the median rate for $1.2 trillion in short-term funding transactions that occurred Tuesday. SOFR affects floating rates on about $285 billion outstanding in corporate and other loans.Fed Chairman Jerome Powell is expected to face questions on the issue when he briefs the press, after the central bank’s 2 p.m. rate decision Wednesday afternoon. The Fed is projected to cut the fed funds target rate by a quarter point to 1.75% to 2%.”This just doesn’t look good. You set your target. You’re the all-powerful Fed. You’re supposed to control it and you can’t on Fed day. It looks bad. This has been a tough run for Powell,” said Michael Schumacher, director, rate strategy, at Wells Fargo.Schumacher and other strategists said the Fed’s two operations Tuesday and Wednesday seem to have calmed the market for now, but the question is why did the wild swing in rates happen in the first place. Strategists say it seems to be the result of a cash crunch, not, for now, the makings of a credit crisis.What is a repo?But the concern is if it persists, it could give the appearance of an underlying problem in the financial system. Strategists pin the problem on a number of factors, including the Fed’s reduction in its own balance sheet, which removed some liquidity from the market, as well as changes in rules after the financial crisis, which required banks to hold more capital, reducing their ability to offer repos, or repurchase agreements. A repo is an exchange of collateral, such as Treasury securities, for cash.On Monday, there seems to have been a perfect storm in the market, causing a cash shortage. Corporations were seeking dollars for quarterly tax payments, and the Treasury had also issued a large amount of bills, which reduces liquidity. There was also speculation that the attack on Saudi Aramco, which took half its production off line, may have spurred demand as oil spiked and investors feared a Middle East conflict.The Fed on Tuesday accepted $75 billion of $80.5 billion in bids submitted in its overnight repo operation, after accepting $53 billion on Monday. The repo rate was quoted at 2.25% to 2.60% after Tuesday’s operation from a range that was up to above it at 3%, just before it. That rate on Tuesday temporarily hit a high of 9%.”They’re working on this repo problem. It’s a work in progress. They’re doing very well. They pretty much got it under control,” said Ralph Axel, rates strategist at Bank of America Merrill Lynch.Strategists said the Fed is likely to trim the interest on excess reserves at its meeting Wednesday. That rate is currently at 2.10%, and Schumacher said it could be lowered by the Fed to 1.80% when it cuts rates Wednesday.That could help the central bank keep better control of fed funds.”Generally this whole repo spike is declining, too. So you would expect fed funds to probably print a little bit lower tomorrow, but it may not be enough to be within the band,” said Axel.Drew Matus, chief market strategist at MetLife Investment Management, said Powell’s briefing could be especially difficult.”He’s going to have to respond to questions coherently, and repo is not the most easy topic for most people to understand, even for the Fed chair. It’s really a specialist area on Wall Street,” Matus said. “He’s going to have to respond in a way that’s reassuring to people. It could be a challenging press conference.”Matus said the short-term funding squeeze was probably the result of a number of events, including tax payment day, but he and others noted that it does not normally happen on tax day. “The repo market that we’re thinking of, the pre-crisis repo market of 2008 doesn’t exist any more. It’s a different market with different rules for banks and primary dealers,” he said.Matus added that the staffing at the New York Fed is different. There is currently no permanent head of its markets group since Simon Potter left in June. Potter had served in that role since 2012. The markets group ovesees implementation of domestic open market and foreign exchange trading operations for the Federal Open Market Committee.Fed must address WednesdayAxel said the market will be looking for answers from the Fed on how it will solve the problem permanently, particularly with the approach of the end of the quarter on Sept. 30, when there is more funding pressure as alternate financing is typically reduced at quarter end and repo is in high demand. There have been other incidents where rates in the repo market shot up including in December when markets were selling off.”Does the Fed continue to roll over the $75 billion facility for the rest of the month? Or does it shift over to permanent operations?” said Axel. “Sept. 30 is another potential hot spot for funding rates. It’s a big issue to make sure they control rates on Sept. 30 to make sure they stay within their band.”Axel said he believes the quick crunch came just as the Treasury Department moved to shore up its own cash reserves, which went from $183 billion a week ago Wednesday to $298 billion on Monday.”Since the 2011 debt ceiling crisis, Treasury has decided to maintain a very large cash balance,” said Axel, adding the Treasury previously did not find it necessary. He said the Treasury decided that it is in the public interest to have a large cash balance to absorb any problems in the Treasury funding market.Axel said the funds are drawn from excess reserves which the Fed controls, and that lowers the money supply. “That’s why to offset this, and to solve the problems that were in the financing markets, the Fed added money to the money supply through open market operations which is the traditional role of the New York Fed,” he said.

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