The Federal Reserve is closing out 2019 seemingly in control, at least for the moment, of a problem that only a few months ago threatened to spiral into a crisis.
Issues in the overnight lending market, where banks go to fund their operations, caused short-term borrowing rates to spike briefly in mid-September. More importantly, they raised concerns over whether the Fed’s attempts to stage manage its escape from the extraordinary measures it took during and after the financial crisis were running awry.
Despite concerns that those earlier issues would crop up again as the year came to a close and a liquidity crunch would erupt again, the funding market, known as repo, seems to be running smoothly.
“They’ve managed to inject enough liquidity to provide a strong signal that they’re going to be flexible and provide further assistance to see themselves through what was going to be a very tight period,” said James McCann, global economist at Aberdeen Standard Investments. “It looks like they’re going to catch up with a problem that had quite embarrassingly gotten out of control.”
Credit Suisse analyst Zoltan Pozsar notably predicted that unless the Fed before year’s end initiated a fourth round of bond buying — quantitative easing — it could face a severe funding crisis. Market concerns focused on a cash crunch stemming from Treasury settlements, as well as big banks concerned about meeting end-of-year capital requirements being reluctant to provide funding to institutions that need it.
To address the issues, the Fed has conducted daily operations thus far totaling more than $234 billion to dampen market volatility and keep the central bank’s overnight funds level, which is used as a benchmark for multiple other short-term interest rates, within a range of 1.5%-1.75%.
On Monday alone, the Fed injected another $18.65 billion for a two-day repo operation — exchanging high-quality capital for cash — and $30.8 billion in a one-day offering. However, both issues were undersubscribed, having offered $75 billion and $35 billion respectively. That means there was less demand and thus lower funding pressures.
While there’s still one trading day left in the year, it appears that the Fed will close 2019 in control of the banking industry’s vital plumbing system.
A test for the market
Whether that state of affairs will continue as the central bank’s repo operations continue into the new year remains an open question. The Fed in October stated that the injections will run “at least into the second quarter,” with the question unclear of just how long they will continue beyond that.
“The real test is when it stops,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “You can cure any problem in the short term by just throwing money at it. The test is when the Fed starts walking away, whether this market can now behave on its own.”
The Fed has been walking a tightrope through the process, particularly since the announcement that it would resume the expansion of its balance sheet just two years after it started reducing the holdings on what had then been a $4.5 trillion level. The balance sheet is composed mostly of Treasurys and mortgage-backed securities the Fed had acquired during and after the financial crisis.
Since the repo problem erupted on Sept. 16, the balance sheet has grown 10.4% to more than $4.2 trillion. At this pace, it could eclipse its previous high in the first quarter of 2020.
Fed officials have sought to differentiate the expansion from the three rounds of quantitative easing that were aimed at reducing long-term interest rates, rescuing the housing market and pushing investors into riskier assets like stocks and corporate bonds.
Pozsar had said in a note that the Fed would need to go a full-blown QE, buying coupon-bearing notes rather then short-term Treasury bills. Fed Chairman Jerome Powell said earlier this month that he didn’t see a need to buy coupons, but added that the central bank “would be prepared to do that” if the need arose.
Good for banks
Banking analyst Dick Bove at Odeon Capital Group points out that the balance sheet expansion has coincided with a 7.6% year-over-year growth of the monetary base, compared to 3.2% a year ago. That in turn has happened alongside a violent rally on Wall Street as companies buy back stock and reduce share count.
“Money supply is expanding at above average rates and share growth is not. Consequently, share values are expanding — not likely to stop soon,” Bove said in a note.
Indeed, financials have been a market leader this year, and particularly in the fourth quarter, during which the sector has risen nearly 10%.
So long as the Fed keeps the spigot open, banks are widely expected to continue to rally. But when that changes, or when the next hiccup comes in the repo market, the sector could face a challenge.
“The repo market, in a nutshell, is brittle,” said John Lekas, founder of Leader Capital and manager of its low-duration bond fund. “The next risk is if the Fed steps away for some reason. The [repo] market could be in trouble.”