The Federal Reserve may have succeeded in thwarting major year-end turmoil in funding markets, but 2020 is likely to bring a whole new set of concerns.
The U.S. central bank has been injecting liquidity into markets through repurchase-agreement operations since mid-September in a bid to keep control of short-end rates. Earlier this month ramped up its offerings to help smooth the market’s path into January. It has also been bolstering system reserves through Treasury bill purchases.
The results of the most recent repo actions, which were undersubscribed, suggest that there is now ample funding for the year-end turn. That means the kind of spike seen in September — when overnight repo rates surged to 10% from around 2% — is unlikely to be repeated for now. Whether the Fed can end its interventions without chaos re-emerging, though, is less clear.
“Stopping operations will be difficult since the market is still short of reserves when excluding repo operations,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. “If the Fed were to pare back liquidity too quickly, they could risk sparking another shortage.”
Chairman Jerome Powell said during his press conference following the Dec. 11 Federal Open Market Committee meeting that there would come a time when it’s appropriate for overnight and term repo operations to “gradually decline.” He did not, however, offer any indication as to when that would be and officials have so far said they would conduct the repo operations through January. The release of the minutes from that meeting on Friday could provide more hints as to how policy makers are thinking about removing temporary liquidity from the system.
The Fed has provided roughly $230 billion of liquidity for the end of the year to avoid a cash crunch. There is also a further $150 billion of overnight money available at its final overnight operation of 2019 on Tuesday, although close to $31 billion in existing overnight funding will also be rolling off that day.
Mark Cabana, head of U.S. interest rates strategy at Bank of America, expects the Fed’s repo offerings to continue beyond January, but reckons officials will adjust the interest rate on operations rather than the size of them, when the time comes.
“If they boost the rate, the dealers will likely naturally decrease reliance on the Fed for funding,” he said. “This is especially true since bill purchases keep adding reserves.”
On top of the temporary liquidity that’s been added via repo operations, the Fed has also bolstered permanent reserves by around $157 billion through its bill-purchase program, and that is set to continue at a pace of $60 billion per month until some time in the second quarter at least.
Powell has also said the Fed would be willing to extend its reserve-management purchases of Treasuries to coupon-bearing securities, if needed, although such a move could add fuel to the debate about whether the program can be considered quantitative easing.
TD’s Goldberg said the Fed won’t begin weaning the market off of repo operations until the end of the first quarter or the beginning of the second, once the central bank has had a chance to increase the reserves in the system. Any earlier risks upending the repo market once again.
“The Fed will not want to exit repo operations until they are absolutely certain the market can stand on its own two feet,” he said.