Let’s all calm down.
This week’s crunch in short-term borrowing markets in the United States has created widespread worry that deeper problems are lurking under the surface of the financial system. Over the space of a few hours on Monday, rates for some overnight loans shot up fourfold, touching 10 per cent. The U.S. Federal Reserve had to make an emergency injection of more than US$125-billion on Tuesday and Wednesday to restore normality to the system.
It was the Fed’s first major intervention since the financial crisis and awakens fears that a new crisis is looming. But such fears seem implausible to folks who know the system well.
“What you’ve seen in the market this week is hard to explain, but fairly easy for the Fed to correct,” says Stephen Williamson, central banking chair at the University of Western Ontario in London, Ont.
Mr. Williamson, a former vice-president of the Federal Reserve Bank of St. Louis, acknowledges the rate spike indicates there are “frictions” in the system that are not well understood. However, the turmoil doesn’t show any sign of spiralling into the far deeper and more pervasive loss of confidence that hit the banking system during the 2008 crisis, he says.
The stock market concurs. This week’s madness barely dented the S&P 500 index, which continued to hover near record highs. The share prices of major U.S. banks, such as JPMorgan Chase & Co. and Citigroup Inc., also went unscathed. Judging from their performance, investors are still confident in the wider financial system.
Most commentators agree a couple of factors played a role in the sudden spike in rates on the repo, or repurchase market, where large borrowers put up Treasuries and other high-quality securities as security for overnight loans. One was the US$78-billion offering of U.S. Treasury bonds and bills last week. Investors who bought into the bond offering had to settle up on Monday. On the same day, U.S. corporations had to pay their quarterly tax bills.
Both deadlines probably sapped the supply of cash available for overnight loans, making the repo market vulnerable to a rate spike. To make matters worse, the supply of reserves that banks maintain within the Fed system has been falling for years. These reserves are often made available to other banks through overnight loans, and their increasing scarcity may have contributed to the upward pressure on repo rates as well.
“While there were one-off triggers to the repo surge, we believe that the outsized reaction in rates is a function of reserve scarcity among some banks and the regulatory restraints on banks from trading reserves,” Priya Misra, head of global rates strategy at TD Securities, wrote in a note.
Both Mr. Williamson and Ms. Misra agree the Fed has tools it can use to solve the problem. Mr. Williamson points out that it could simply choose to intervene directly in repo markets to maintain rates in its comfort range. Ms. Misra says the Fed may have to resume growing its balance sheet – that is, buying Treasuries from commercial banks – to reverse the decline in bank reserves. (Reserves are like chequing accounts for banks. They are held at the Fed and are useful when banks have to make large payments to one another.)
The Fed seems to be mulling its options for now. As its two-day meeting wrapped up on Wednesday, the U.S. central bank made only minor adjustments to its tools for managing interest rates. That may indicate its own bafflement on the issue.
The repo market has been acting oddly for a while, Mr. Williamson notes. Since the middle of last year, repo rates have demonstrated a tendency to briefly shoot up at month ends. The latest spike is much larger but seems similar in kind to the earlier episodes. They all seem to be driven by frictions within the system that are not well understood, but pass quickly. Unlike the mayhem of the financial crisis, the spikes appear unrelated to any fundamental doubts about bank solvency or collateral quality.
“It’s not a crisis, but it does make the Fed look bad because they should be able to do this [manage short-term rates] seamlessly,” he says. “What’s worse is that they don’t seem to be able to explain exactly why the system isn’t working as it should.” That should concern investors, no doubt. But it doesn’t seem like a good reason to panic.