On Tuesday the Federal Reserve bought $53.2 billion of short-term securities to stabilize the market for money market securities.
A funding shortage on Monday and Tuesday had led rates on overnight general collateral repurchase agreements to climb as high as 10% and pushed the effective Fed Funds rate, the interest rate that the Fed sets to control the economy and the money supply, to 2.25%, the very top of the 2% to 2.25% current range.
The causes of the liquidity shortage look to be structural but also circumstantial. On the structural end, after the Fed greatly expanded its balance sheet to head off the worst effects of the Great Recession, it stopped injecting cash (which used to be a common occurrence) into the market to ensure adequate short-term liquidity because there was so much money sloshing around financial markets. But now that the Fed has stopped expanding its balance sheet (and had begun running it down by selling assets, which has the effect of reducing the money supply) and now that the Federal government is selling so many bills, notes, and bonds to fund a ballooning Federal budget deficit, it looks like the very short end of the market is having liquidity problems. On the circumstantial side, it looks like the coincidence of a payment date for corporate taxes, the settlement date for last week’s Treasury auctions, and last week’s sell off in bonds, all combined to take cash reserves out of the banking system just when there was a need for more liquidity.
The Fed moved so quickly to inject cash into the money market markets because in the Fed meeting on Wednesday the central bank is expected to lower its benchmark short-term rate by another 25 basis points. It would not install confidence in the financial markets if the Fed declared an interest rate cut but the real-life marks refused to follow the script and pushed rates up instead.
The action in the overnight repurchase market allows primary Treasury dealers to borrow cash from the Fed against Treasury securities or other collateral.
I wouldn’t look for any immediate market consequences from this cash injection. But I do think it is one more sign that the financial markets are under stress–even if that’s not showing up, at the moment, in asset prices or volatility indexes.