Investors take for granted that the Federal Reserve controls interest rates. Rarely do they have to think about how.
But a surprisingly lively couple of days in short-term money markets has meant that the “how” became nearly as important as the “why.”
The stress started on Monday in the market for repurchase agreements, or repos. The repo market channels more than $1 trillion in funds through Wall Street every day, usually without fanfare. That money is used to pay for the day-to-day operations of big banks and hedge funds.
Then the Fed’s key interest rate, known as the federal funds rate, hit 2.3 percent on Tuesday. That’s above the central bank’s target, and the rise reflected unexpected strains.
The central bank on Wednesday cut interest rates by a quarter percentage point as part of its effort to ensure that the economic expansion continues. In addition, it took a series of steps to make sure short-term interest rates do what it wants. The Fed poured new money into markets for a second straight day and said that it would cut what it pays banks to keep excess reserves parked with it.
In the past, when the repo markets managed to make headlines, it was in exceptional episodes of market stress — for instance, in the early days of the financial crisis.
This time, there is little reason to worry that an economic catastrophe is in the offing. But the movement highlighted the importance of a market that usually operates in the background.
The repo market is a critical to a functioning Wall Street.
Repos are short-term loans mainly used by banks and hedge funds in their daily bond trading and brokerage businesses.
These firms typically pay for their investments with borrowed money, and the repo market provides those large sums of money on a daily basis. The money comes from other financial institutions like money market mutual funds that lend it out
for very short periods. A borrower in the repo market could take that cash for a single night, for example, to cover purchases made the day before.
But something went awry this week: The cost of taking out a loan in the repo market shot sharply higher starting on Monday, which caught people off guard.
Interest rates on overnight loans, which have averaged roughly 2.2 percent since early August, jumped to 2.88 percent on Monday. Then on Tuesday, they rose to as high as 6 percent.
Repo rates are meant to reflect the federal funds rate, and that’s falling as the central bank lowers its interest rate target to bolster the economy.
The surge in rates may have been coming for a while.
When there is a lot of money available for the big banks to borrow each night, rates stay low.
But in recent days, a number of factors had drained funds out of the market. Monday was a tax payment deadline for big companies and a holiday in Japan, which meant a large source of funds was shut off. And after a recent auction of government bonds, people had to divert cash to pay for those.
Those were the likely trigger events for this week’s surge. But the amount of money pooled in this market has been declining for a while. And that’s because of the Fed.
Since 2018, the Fed has been shrinking its holdings of bonds and reversing its crisis-era policy of pushing money into the financial system.
The change has effectively reduced the supply of money available in the short-term lending markets. The surge in short-term rates suggests that the Fed might have removed a bit too much, making reserves too scarce.
“The problem is, we don’t know what that minimum level is and we just smacked right into it,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities USA.
The repurchase market is just one of the short-term money markets where short-term cash and bank reserves are channeled to borrowers, and rate increases in one can influence others.
In the market for commercial paper — unsecured loans to banks and other large corporations — rates for overnight borrow also surged.
In the past, strange moves in the repo market were a sign of trouble.
The good news is, a brief increase in short-term interest rates will probably not mean much to the broader economy.
It could briefly raise the cost of trading at financial firms, hurting their profits. And if it persists, it could undermine the belief of those in the financial markets that the Federal Reserve can effectively apply monetary policy as it intends.
The main reason that the surge in the repo market has received attention is because it reminds people of the last time the market went haywire.
In August 2007, the repo markets suddenly tightened, in what turned out to be one of the earliest indications that there were deep problems in the financial system.
Then, the problems in the market were centered around the market for mortgage-backed securities, which were often labeled AAA, and were used by borrowers as collateral in the repurchase markets.
As investors began to become aware of the deep troubles of the American mortgage market, the began to avoid lending against mortgage collateral. Repo rates surged, reflecting the realization of increased credit risk in these kinds of bonds that were often built out of poorly made home loans.
This time is different. No, really.
The surge in repo rates does not mean that investors now think Treasury bonds are risky. If that were the case, interest rates in the bond market would be higher. In fact, they’re quite low. The yield on the 10-year note was roughly 1.78 percent on Wednesday.
“While these issues are important for market functioning and market participants, they have no implications for the economy or the stance of monetary policy,” the Fed chair, Jerome H. Powell, said a news conference on Wednesday.
Basically, the story of the repo market this week is essentially a hiccup for the technocrats at the central bank, leaving the markets without enough cash to go around.
That’s not great to see, but there is no reason to think this is the leading indicator of another financial crisis.
Jeanna Smialek contributed reporting.