On September 18 the Federal Reserve cut fed funds by 25 basis points to 1.75%-2.00%. Fed Chairman Jerome Powell read a very boring statement and seemed to ignore the recent spike in repo rates. The big elephant in the room is that there is not enough liquidity in the banking system and the Fed had to inject $204 billion into the markets this week. Repo rates hit as high as 10% as the Fed lost control, which made a quarter point reduction in Fed Funds irrelevant.
The Fed has reduced the level of banking reserve too much and will need to start growing its balance sheet again. Mark Cabana, an analyst for Bank of America blamed the spike in overnight lending rates on the Fed badly underestimating the amount of cash needed to keep the financial system operating smoothly. According to Cabana, US companies withdrew vast sums of money from banks to make quarterly tax payments to the US Treasury. That forced banks to draw down their reserves. B of A has concluded the Fed will need to issue $200 billion in T-bills in the next two months which will further drain liquidity.
The surge in Treasury repo rates poses a threat to the market because traders will not take new positions without confidence in their ability to obtain funding at consistent rates. If the plumbing does not work everything starts to break down. The Fed is losing control of the Fed Funds Rate at the short end because US. Deficits are growing and the primary treasury dealers are holding too much inventory. Foreign investors are not buying US Treasuries as much because carry costs have risen.
The Fed's instant reaction so far has been to use Temporary Open Market Operations (TOMO) to inject cash into the repo market. The loans to the overnight repurchase markets enable dealers to finance and carry growing levels of Treasury inventory they have been forced to carry because of the deficit. The rates on some commercial paper jumped from 2.3% to 4.5%. Secured overnight financing rate (SOFR) jumped from 2.43% to 5.25% this past week.
At the next Fed meeting October 29-30, analysts at Goldman Sachs and B of A, believe the Fed will be forced to launch a Permanent Open Market Operations (POMO) and expand the Fed balance sheet by buying treasuries. Analysts at B of A Merrill Lynch estimate the Fed will need to purchase a total of $400 in Treasuries over the next year. This will restore $250 billion in banking reserves and a $150 billion buffer to avoid spikes in the repo rate. This POMO program is expected to start in November 2019. Annalists are careful to call it a POMO and not Quantitative Easing. Regardless of what it is called, it will be a monetization of the deficit, and will cause a spike in monetary assets such as gold.