Analyst view: Fed’s day two of cash injection into U.S. banking system

(Reuters) – As if the U.S. Federal Reserve didn’t already have enough on its plate heading into its meeting on interest rates this week, chaos deep inside the plumbing of the U.S. financial system has thrown policymakers an unexpected curve ball.

Cash available to banks for their short-term funding needs all but dried up on Monday and Tuesday, and interest rates in U.S. money markets shot up to as high as 10% for some overnight loans, more than four times the Fed’s rate.

On Wednesday, the New York Fed accepted $75.0 billion in bids from primary dealers at a repurchase agreement (repo) operation “in order to help maintain the federal funds rate within the target range” of 2.00-2.25%.

The award total was higher than the $53.15 billion on Tuesday, which was the first such operation the central bank conducted in more than decade.

COMMENTS:

ROBERT PAVLIK, CHIEF INVESTMENT STRATEGIST AND SENIOR PORTFOLIO MANAGER, SLATESTONE WEALTH LLC, NEW YORK

“It contradicts the last policy statement. They (the Fed) didn’t really indicate further rate cuts would come, and then they do the overnight repos. Adding liquidity to the market means there might be, at least I’m thinking, a shift in policy. The market may start to anticipate that this is the beginning of the shift in policy.”

CLIFF TAN, EAST ASIAN HEAD OF GLOBAL MARKETS RESEARCH, MUFG

“This is largely an incident that is isolated to U.S. money markets…Ultimately, there’s enough dollars around the world that there won’t be a contagion effect coming over to Asia. In the theoretical world, it should affect everywhere, but (in reality) those trading Treasuries are not suddenly going to go to Hong Kong to see if they can get dollars out here.”

NICK TWIDALE, DIRECTOR AND CO-FOUNDER, X-CHAINGE, SYDNEY

“I was a bit surprised when I read the Fed had stepped in. Markets are not very worried at this point because they are confident the Fed is backing the market. If it happens more in the next few weeks and months then it will become worrying.

“According to me this is another red flag from the market that all is not well and that we’ll probably we subjected to more volatility and downside risks in the coming months.

“Hopefully it’s a one-off.”

“I think there is a risk of contagion from a liquidity fallout where we see a flight to safety, selling pressure across risk assets and a spike in bond prices. It won’t necessarily be the move but the speed of the move that will do it. It will lead to panic and everybody will try to get out the door at the same time.

MASAHIKO LOO, PORTFOLIO MANAGER, ALLIANCE BERNSTEIN

“While rates have calmed down a bit after the Fed has injected funds, we need to stay cautious.

“Dollar/yen basis swap spreads have widened a bit, so for Japanese investors, that means currency-hedged investment in dollar bonds become more difficult.

“Because the spikes in rates is considered to be driven by technical factors, I don’t think there’s much to worry in the near-term. But this has showed that there is a shortage of U.S. dollar in markets so the Fed may have to take some steps.”

AKIRA TAKEI, A GLOBAL FIXED INCOME FUND MANAGER, ASSET MANAGEMENT ONE, TOKYO

“I don’t think the FOMC will mention this in its statement, but I am paying very close attention to how Powell addresses the money market problem. If the Fed doesn’t tackle this now it will come up again in the future.

“Domestically in the United States, the corporate tax payment season is driving the spike in repo rates. There is also reduction in liquidity for dollars overseas. It is partly because of the trade war. It is becoming more difficult for some people to get dollar funding. However, the reality is that eventually people will try to get away from holding the dollar, like the Chinese or Russian authorities. They don’t want to hold the dollar as a key currency in their FX reserves, because what will they do if they face U.S. sanctions?

“I’m looking at euro/dollar and dollar/yen basis swaps. If they widen further this shows it is getting harder to do funding in dollars.

“This problem will come up again in a week or two because there will be strong demand for dollars at the end of September, which is the end of the third quarter. This is when companies and investors close their books.

“We better prepare for a rainy day. Difficulty in funding dollars could lead to another sell-off in Treasuries. After August, I fell the market is on the fence whether Treasury yields will rise or fall. This could push us off the fence.”