By Paul J. Davies and Sam Goldfarb
Banks on Wednesday snapped up $75 billion on offer from the Federal Reserve Bank of New York in a second day of intervention meant to ease a crunch in overnight funding markets.
Banks asked for $80.05 billion in funding in the auction, $5 billion more than the amount offered by the Fed. At Tuesday's auction, the first in a decade, banks took $53 billion of the $75 billion on offer.
Overnight loan rates remained elevated before Wednesday's auction at about 2.8%. Soon after, they dropped to 2.6% and by midmorning were down to 2.25%, according to Refinitiv data.
The tumult in U.S. overnight money markets is adding to investors' hopes that the Federal Reserve might cut rates faster than expected in coming months or restart buying bonds to boost the amount of money in the financial system. A loosening of monetary policy could alleviate strains that caused overnight lending rates to spike as high as 10% Tuesday.
The Fed on Wednesday cut its key interest rate by a quarter-percentage point and reiterated it would "act as appropriate" to sustain the economic expansion. At a press conference, Fed Chairman Jerome Powell said the central bank would consider further interventions in money markets as needed for the foreseeable future, though he said the gyrations in those markets had no implications for the broader economy or the Fed's monetary policy.
Soon after, the New York Fed said it would conduct its third operation of the week on Thursday morning, in which it will again offer up to $75 billion of short-term cash loans.
The high short-term U.S. rates and lower rates elsewhere have put foreign investors off buying U.S. Treasurys as it becomes increasingly less profitable to fund longer-term U.S. government bonds with short-term borrowing.
"A series of sharper than priced-in rate cuts from the Fed will bring down the front end of the yield curve [cut short-term yields] and encourage foreign buyers back in," said Guy LeBas, chief fixed-income strategist at Janney Capital Management, in Philadelphia.
Foreign buyers with lots of dollars at hand, such as non-U.S. lenders and central banks, have also stopped buying Treasurys because they can put unlimited amounts of cash into the Federal Reserve's foreign repo program. This facility is an ultrasafe haven for funds -- paying the same as overnight repo -- and has been absorbing foreign-owned dollars like "a supermassive black hole," Zoltan Pozsar, a money-market strategist at Credit Suisse Group, said in August.
Cutting interest rates more rapidly so that longer-term Treasurys yield more than short-term money would help to reverse this trend.
The spike in overnight rates has already had some impact on the real economy.
By Tuesday morning, the rate of borrowing money in the repurchase-agreement, or repo, market reached as high as 10%, compared with just over 2% in the days prior. The Fed's effective benchmark rate traded at 2.3% on Tuesday, according to the New York Fed, above the 2% to 2.25% target set by the central bank's rate-setting committee. This hasn't occurred since the Fed moved to a target range after the 2008 financial crisis.
Trying to ensure the federal-funds rate remains within its target range, the Fed on Wednesday reduced the interest rate it pays banks for holding excess reserves at the central bank by a little more than a quarter-percentage point. That creates a buffer if the federal-funds rate rises above the excess reserve rate, which has long served as its ceiling.
Evergy Inc., the holding company for several utilities in Kansas and Missouri, saw overnight rates for its commercial paper almost double, according to the company's assistant treasurer, James Gilligan. The rates rose from 2.3% to 4.5% and from 2.34% to 4.05%, while rates for six-day commercial paper increased from 2.3% to 2.6%, Mr. Gilligan said.
The company's entities usually borrow $20 million to $100 million each through commercial paper each day. Mr. Gilligan said he is expecting more rate spikes going forward.
A reference rate created by the Fed as a potential benchmark for variable-rate lending, the secured overnight financing rate, or SOFR, also climbed to a record 5.25% Tuesday from 2.43% Monday. SOFR, which is derived from repo rates, has been chosen by a group of banks and regulators in the U.S. as a preferred replacement for the still widely used but much criticized London interbank offered rate.
But the bigger problem is in the balance sheets of U.S. banks, particularly those that act as primary dealers, the institutions that buy Treasurys from the government and sell them on to investors.
The spike in overnight repo rates was caused by a string of coincidental events, including corporate tax payments and Treasury sales, according to analysts and investors. But those events only had such a startling effect because banks were already operating close to the minimum level of reserves they want to hold.
After the 2008 crisis, the Fed's massive bond-buying programs led to a huge increase in reserves in the system. But that has gone into reverse as the central bank tightened monetary policy in the past couple of years.
The Fed's reversal has forced the U.S. Treasury to sell more bonds to banks and investors. That reduces the amount of money in the financial system because primary dealers buy the bonds using reserves.
The Fed believed there was still spare capacity of $200 billion to $300 billion in reserves before money would get too tight and overnight funding problems would appear, according to Morgan Stanley analysts. However, the combination in recent days of corporate tax payments and Treasury issuance showed that cushion may not have existed.
"Ultimately, the only way for the Fed to alleviate reserve scarcity and funding stress is to inject liquidity and increase the amount of reserves in the system," the analysts wrote in a note published overnight Tuesday.
This is why the New York Fed poured billions in overnight funding into the repo market on Tuesday and again on Wednesday.
But a longer-term solution will be needed. One problem for the Fed is that it has become more difficult to know just how much reserves banks want to hold. This is due to changes in regulations designed to ensure banks can meet waves of deposit withdrawals in times of extreme stress.
Mr. Powell on Wednesday noted that the level of reserves in the banking system is uncertain, and that it's possible the Fed would resume the growth of its balance sheet sooner than expected.
"Market participants are now asking: 'Is the Fed up to the task of estimating the quantity of reserves required by banks and whether it has the tools to supply them when needed,'" said Mark Cabana, head of U.S. short rates strategy at Bank of America Merrill Lynch in New York.
"They [the Fed] don't understand the impact of some of the second-order effects of regulations they've put in place since the crisis," he said.
--Nina Trentmann, Justin Baer and Patricia Minczeski contributed to this article.
Write to Paul J. Davies at email@example.com and Sam Goldfarb at firstname.lastname@example.org