By Saqib Iqbal Ahmed
NEW YORK (Reuters) - Investors were jolted last week when rates in an obscure part of the U.S. lending market spiked, prompting fears of bigger problems for the financial market and broader economy.
Cash available to banks for their short-term funding needs all but dried up early last week, and borrowing costs in the $2.2 trillion repurchase agreement - or repo - market soared as high as 10% at one point on Tuesday, about four times the Federal Reserve's policy rate.
(Graphic: U.S. repo rate, https://fingfx.thomsonreuters.com/gfx/mkt/12/6324/6255/Repo%201.png)
On Tuesday, in a first since 2008, the "effective" or average interest rate in the federal funds market, which the Fed aims to influence, settled above the top-end of the Fed's current range of 2.25%, at 2.30%. Investors worried that the Fed may be losing control of its own interest rate.
(Graphic: Fed funds rate vs Fed's target range, https://fingfx.thomsonreuters.com/gfx/mkt/12/6330/6261/Repo%202%20Fed%20fund%20vs%20target%20range.png)
That forced the Fed to inject hundreds of billions of dollars in temporary cash into the banking system the past few days, its first major market intervention since the financial crisis more than a decade ago, to prevent borrowing costs from spiraling even higher.
It has also revived memories of how ructions in the repo market were a symptom of funding problems for investment banks in 2008.
Much has changed, however, since the last time the repo rate was the buzz of Wall Street.
SECURED VS UNSECURED RATES:
A key difference between now and 2008 is the reason for the spike in the repo rate. In 2008 it was mostly about rising counter-party risk, effectively the fear among banks that they would not be paid back, that upended the market.
This latest jump in the repo rate, though, is likely due to a confluence of more technical factors, including quarterly corporate tax payments and settlement on $78 billion in Treasury notes and bonds on Sept. 16 that led to a severe drop in cash for wholesale lending, analysts said.
While the repo rate - which uses Treasuries as collateral - seized up this week, the three month U.S. Dollar LIBOR interest rate - the average interest rate at which a bank can get unsecured funding from another bank - has stayed in check.
(Graphic: U.S. repo rate & dollar 3-month LIBOR, https://fingfx.thomsonreuters.com/gfx/mkt/12/6325/6256/Pasted%20Image.jpg)
THE TED SPREAD
The TED spread, which warns investors of potential market downturns and volatility, is not flashing caution. The spread, which measures the difference between the rates on 3-month Treasury bills (US3MT=RR) and 3-month LIBOR, widens in periods of financial stress, as it did in 2008.
Right now, though, the spread is the narrowest it has been in nearly a decade, pointing to investor confidence in the U.S. financial system.
(Graphic: TED spread, https://fingfx.thomsonreuters.com/gfx/mkt/12/6332/6263/Pasted%20Image.jpg)
BANK RESERVES
Part of the reason why the repo rate exploded higher last week was due to the scarcity of bank reserves - deposits that commercial banks park at the Fed, analysts said.
When banks reserves are low they have less to lend out to liquidity-starved investors.
(Graphic: Bank reserves at the Fed, https://fingfx.thomsonreuters.com/gfx/mkt/12/6328/6259/Pasted%20Image.jpg)
Banks have seen their reserves fall due to the U.S. central bank shrinking its balance sheet over the last two years. This means they have less to lend to other banks as liquidity dries up.
(Graphic: The Federal Reserve's balance sheet, https://fingfx.thomsonreuters.com/gfx/mkt/12/6329/6260/Repo%203%20Fed%20balance%20sheet.png)
DEALERS' HOLDINGS
Primary dealers' Treasury holdings have grown from nearly nothing in 2008 to about $200 billion as government borrowings ballooned over the last decade. Dealers need to fund these inventories, which may be putting pressure on the repo market.
(Graphic: U.S. primary dealers' Treasury holdings, https://fingfx.thomsonreuters.com/gfx/mkt/12/6380/6311/Pasted%20Image.jpg)