A hiccup, a tremor or an earthquake, whatever just happened and whichever superlative you use to describe it, it definitely had the Federal Reserve on edge. For the first time since 2008, the central bank was forced to make an emergency intervention in money markets on only hours notice. It was so impromptu and rushed, in fact, that the first attempt to set up the emergency lending facility actually failed for technical reasons. The Fed eventually got the hang of what it was doing, but not before money market interest rates briefly spiked to 10%.
A decent proxy for these difficult to understand markets is the Invesco Ultra Short Duration Exchange-Traded Fund (GSY, Financial), which invests much of its funds in repurchase agreements and money market funds. How this normally ultra-stable ETF performs over the next several days could be telling.
This has happened once before, almost 11 years ago to the day. According to data from the New York Fed, on Sept. 30, 2008, overnight interest rates skyrocketed to the same high of 10%, pushing the effective federal funds rate up 95 basis points in two days. For a tense period of about a month, the Fed had to struggle to keep these overnight interest rates within target range. By mid-October, it seemed that then Chair Ben Bernanke had finally tamed the wild horse and brought them back in range.
That previous episode was clearly linked to bank failures at the time. This time, it’s something else, but nobody knows what exactly. The prevailing theory is a combination of heavy short-term Treasury issuance coinciding with corporate tax payment deadlines sucking liquidity out of the banking system from two directions. If these were the only reasons, however, then money market rates would have fallen down close to the target range of 2.00% to 2.25% by now. The problem is, while they have come down substantially from their 10% peak, they have not returned to the Fed’s target range and are still stuck around 4% as of Wednesday morning, according to Jefferies. That's why the Fed ran its repo facility again on Sept. 18, to the tune of $75 billion.
If the Fed cannot get overnight rates back down to target, then it doesn’t really matter what the interest rate decision is today. Whatever the target, if the central bank cannot actually get them there, then the target is irrelevant.
That would be a doomsday scenario very unlikely to happen at this point. What is more likely is the Fed could at first struggle to push rates back down to within their desired range, being forced to directly inject lots more liquidity into the banking system than they otherwise planned in order to re-establish control of short-term funding. If overnight borrowers tap all of the $75 billion the Fed is planning to provide, then they will have injected over $125 billion into the banking system over only two days, a fairly hefty amount for such a short period of time. Think of it as quantitative easing on demand.
Yesterday’s rate spike does reveal one thing clearly though. While there may be over $1.3 trillion in excess reserves in the banking system, those reserves are being held on to white-knuckled as even 10% interest rates could not coax them out of the hands of their holders until the Fed stepped in and provided the needed liquidity itself.
The bottom line here is it now looks like reserve scarcity has been reached in the banking system, and that more money will have to be pumped in over the longer term in order to keep rates under control. At the very least, this is probably going to nudge the Fed into lowering the interest it pays on excess reserves, currently sitting at 2.1%, in order to coax holders of reserves to lend them out more. This probably won’t fix the problem, however, because whoever is holding on to those excess reserves wouldn’t even give them up for 10% yesterday.
That’s why a more permanent form of quantitative easing looks more likely. However the Fed may decide to add liquidity from a technical perspective, we should see a strong jump in the amount of dollars in the U.S. banking system over the next several weeks and months. For stocks, this is almost never a bad thing.
Disclosure: No positions.
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