The Fed can't keep rates down!
EDITOR'S NOTE
There's a delicious irony to the drama playing out in repo markets right now.
Repo is short for "repurchase," and it simply refers to the overnight markets where financial players borrow to fund their day-to-day activities. They can also lend to these markets and pick up some short-term yield.
Everyone's buzzing about the spike in repo rates yesterday, which jumped by about a quarter-point to nearly 2.5%, per BMO. The catalyst seems to have been the fact that, per Brian Reynolds, yesterday was a quarterly corporate tax payment day; those cash payments tend to drain money from money markets and thus push up yields. (By the way, Mr. Reynolds says this is also a bullish sign for next earnings season, if this spike reflects a bigger-than-usual corporate America tax bill.)
The spike in repo rates is dragging up other short-term rates (because rates compete for lending dollars), so now you've got the fed funds rate--the benchmark interest rate which the Fed sets at each policy meeting--popping too! It's right around 2.25%, the very top of the Fed's range which, recall, they cut at their last meeting in late July.
Now, anytime "repo spike" makes the headlines, people get understandably panicky because they remember the credit crunch of '07 that preceded the Great Recession of '08-09. Back then, markets seized up because participants lost faith in each other's creditworthiness as the economy began to shut down.
That's not the dynamic playing out right now. As Mr. Reynolds jokes, this spike is about "positive chaos." But it is still chaos in one very significant way: it suggests the Fed is losing and maybe has already lost control of setting short-term interest rates.
"The chance of the Fed being forced to intervene in funding markets today just increased substantially," said BMO's Jon Hill before the open, "in order to make sure [the] effective funds [rate] remains within the target range." He'd heard it had surged up to 6% for some borrowers! And sure enough, the New York Fed came out and said it would carry out up to $75 billion of repo this morning to help boost liquidity and bring rates back down. They reportedly took up about $53 billion.
What else might the Fed need to do now, to keep rates down? Cut the interest paid on excess reserves, says Mr. Hill, announce a standing repo facility, and/or begin to grow assets (a.k.a. bank reserves) again. Keep in mind the Fed is meeting right now and is expected to announce another quarter-point rate cut tomorrow afternoon.
The larger problem is that Fed policymakers have arguably focused too much on the macro debate over rates to the detriment of their actual ability to set rates. (One additional consequence of all this, says Mr. Reynolds, is that it will make people even less likely to want to give up on Libor funding, which policymakers have been trying to phase out for years.)
It may not be quite the way pundits warned about, but the Fed's loss of control over short-term rates still could cause major headaches if it's not corrected quickly from here.
See you at 1 p.m.!!
Kelly
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