Pedestrians walk past the New York Federal Reserve Bank building in lower Manhattan.
Pressure in money markets that has led the Federal Reserve to step in to provide short-term liquidity may be the result of financial troubles in the so-called shadow banking system, said Joseph LaVorgna, chief economist for the Americas, at Natixis.
LaVorgna, on Twitter, said the magnitude and persistence of the Fed’s aid to the repo market was troubling.
Asked for more details, LaVorgna on Thursday told MarketWatch that he thought some firms may have been caught on the wrong side of the “massive, violent sell-off” in the bond market earlier this month. Shadow banking refers to a range of non-bank credit-market participants, including hedge funds.
“There was a massive dislocation in the markets” this month if you look at momentum trading, said LaVorgna, who began his career at the New York Fed. In addition to a selloff that sent Treasury yields higher, a heavy rotation out of previously favored growth and momentum stocks in to value was also thought to have caused pain for traders.
Borrowers, including banks, securities firms and hedge funds, use the repo market to borrow cash over the short term in return for collateral, including securities such as U.S. Treasurys.
Last week, overnight repurchasing rates soared to three times their usual rate, pushing the effective fed funds rate briefly beyond its target range. This lending rate reflects how much investors and banks have to pay to borrow cash over a short period, in return for highly rated collateral like Treasurys.
The pressure in a key part of the U.S. financial system’s plumbing forced the New York Fed to step in on Sept. 17 and begin offering daily overnight repo operations. In its operations, the Fed lends funds in return for collateral with a small group of banks or securities dealers known as primary dealers, who, in turn, work as intermediaries between the Fed and other investors. The volatility sparked a search for explanations and prompted criticism of the New York Fed’s handling of the market.
When the market moves that violently there are always some entities that are caught offside, LaVorgna said, speculating that it’s possible “someone got caught on a trade and had to liquidate.” If so, the identities of those firms might become known after the end of the quarter, he said.
LaVorgna said he didn’t think the turmoil was tied to problems with the banking sector because the fed funds rate, which is the rate at which banks provide overnight loans to each other, didn’t spike.
Analysts have been divided about the root causes of the market turmoil. Some blame the Federal Reserve for being slow to react and letting its balance sheet shrink too far as its bond buying program begun after the 2008 financial crisis was slowly unwound . Critics said the Fed should have been aware that factors cited for the funding squeeze, including quarterly tax payments and Treasury auction settlements, could cause dislocations.
New York Fed President John Williams said his bank was investigating the recent market dynamics. The New York Fed has said it would continue to offer daily repo operations of at least $75 billion through Oct. 10 and has instituted other measures.
Market participants say the moves have brought some measure of calm back to the market.
“In the short-term, the Fed has worked it out. But there will need to be a longer-term solution. Increasing the balance sheet is one,” said Gregory Faranello, head of U.S. rates at AmeriVet Securities, in an interview with MarketWatch.
In a Thursday blog post, Brian Sack of hedge fund D.E. Shaw, and Joseph Gagnon of the Peterson Institute for International Economics said one way to prevent another seizure in funding markets would be for the central bank to expand its portfolio of securities by $250 billion over the next two quarters. Sack is a former head of the New York Fed’s Markets Group, while Gagnon is a former Fed official.
They also urged the Fed to implement a standing fixed-rate repo facility and said the Fed should be explicit in its desire to control the repo rate rather than prioritizing the fed funds rate. They said the Fed should consider targeting the repo rate instead of the fed funds rate when setting policy.
Others have pointed the finger at post-crisis regulations stipulating banks carry ample reserves which in turn constrained their ability to lend out short-term funds to money markets and bring down overnight borrowing costs when they got out of hand.
Under those rules, U.S. lenders with more than $250 billion of assets have to keep highly liquid assets on their balance sheet in order to deal with cash outflows.
“In another time, this type of dislocation would have been something banks could have arbitraged away,” said Dave Leduc, head of Mellon’s actively managed fixed-income arm.
“Banks were unable to get involved to provide liquidity,” Leduc noted. “Has there been some unintended consequences in that the stricter regulatory environment where it’s creating dislocation problems in the market?” asked Leduc.
Ultimately, LaVorgna said he didn’t think the Fed bank was to blame.
Instead, he said it’s more likely to a “micro architectural” problem with the financial system. “There are some clogs in the financial plumbing,” he said. It is hard to know who is feeling pain now because the Fed’s daily moves to add liquidity to the system has the effect of masking where the problem lies, he said.