The latest Fed minutes re-highlighted the action that the Fed has undertaken to quell any agitation in the repo market. During September 2019, the repo market was struck with a significant shortage in money supply, in a period when demand for money was high. This resulted in a spike in overnight rates that at one point reached 10 per cent from the normal two per cent average. This sent panic waves into the interbank market which was reminiscent from the historic credit crunch a decade ago. Policy makers swiftly investigated the matter in order to understand whether this was an isolated case or a wider problem which might have significant repercussions.
The abnormally high overnight interest rates meant that large US banks pressured the Fed for it to provide capital at a more reasonable rate. After the initial hesitation by the Fed, it injected circa $50 billion to calm down the repo market. The cause for this upheaval in the overnight market has been attributed to the fact that large US banks are restricted to undertake specific investment opportunities following the credit crisis in 2008.
This was mentioned by Jamie Dimon, CEO of JP Morgan Chase on the reasons for the debacle. This should raise concerns on potential ramifications should the liquidity in the interbank market face the same challenges it faced in crisis times. Potentially, the Ted spread (difference between the three-month T-bill and three-month Libor Rate) could spike to unprecedented levels in the wake of a recession as the normal functioning of banks servicing short term liquidity needs is prohibited given the current regulatory framework in the US. The secured overnight financing rate which measures the cost of borrowing cash overnight collateralised by treasury securities shot up over 5 per cent, when now it’s trading at around 1.55 per cent.
The improving conditions was not possible without the intervention by the Fed.
In last December’s press conference, it was highlighted that the Bank of International Settlements concluded that the spike was due to structural and regulatory issues that could reoccur. Fed chairman Jerome Powell countered this argument by saying that the current adjustment to the repo market is sufficient, even though adjustments need to be carried out. Investors need to understand the magnitude and repercussions of the Fed’s current action.
In order to maintain short term rates within the Federal Funds rate range of 1.50 per cent and 1.75 per cent, the Fed is having to inject capital into the economy. The size of such injection has resulted in an expansion in the Fed’s balance sheet to the tune of $256 billion. Economists and investors alike have dubbed this as a ‘mini’ stimulus to the US economy at a time were the Fed has constantly stressed that there is no need for such a measure given the rate cuts as well as the economic trajectory for the US.
In conclusion, the Fed as the lender of last resort has acted responsibly during the month of September. However, it must be kept in mind that if this interventionist manoeuvres by the Fed persists; it would be tantamount to artificially managing short term rates rather than letting the market’s invisible hand act freely. As a result, investors would expect that marked changes are carried out for the normal functioning of the money market which will enable the Fed to cut back on its balance sheet expansion and restore normal market operations.
Disclaimer: This article was issued by Jesmar Halliday, investment manager at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.