By Karen Brettell
(Reuters) - The Federal Reserve averted a year-end funding squeeze on Tuesday as large banks took only a small portion of $150 billion on offer in its last overnight repo operation of 2019, and the cost of borrowing fell to its lowest level since March 2018.
The New York Federal Reserve has been injecting liquidity into the repo market to reduce the chance of funding stress after a flare-up in September sent the cost of overnight loans as high as 10%, more than four times the Fed’s rate at the time. That had caused particular concern about the year-end.
"It looks like what the Fed did worked," said Tom Simons, a money market economist at Jefferies in New York. "The Fed acted out of an abundance of caution, and fortunately the result was a very calm year-end here so far."
Banks took $25.60 billion in the Fed's overnight repurchase agreement, or repo, operation, which offers funding over the crucial year-end period. The banks also took only a small share of three liquidity operations on Monday.
Banks and investors borrow in the repo market to finance asset purchases and other business expenses, but the availability of loans over year-end can dry up as banks pare their risk-taking.
"There really are not any signs of dollar funding pressure across markets," said Mark Cabana, head of U.S. rates strategy at Bank of America Merrill Lynch (NYSE:BAC). He said the smooth year-end was partly due to the Fed's actions, as well as pre-planning by banks.
The Fed has thrown $255.6 billion into the funding market through early January to ensure the financial system operates smoothly over the choppy year-end period. It will continue pumping tens of billions a day into the repo market through the end of January at least, including up to another $185 billion in one-day and term deals on Thursday, when the market kicks off the new year.
Cabana said he anticipated the Fed would extend support through the end of the first quarter, but noted that the market wants to know "What's the end game?"
(GRAPHIC: The Fed dives into the repo market - https://fingfx.thomsonreuters.com/gfx/mkt/13/415/415/Pasted%20Image.jpg)
Markets have absorbed a lot of funding provided by the central bank, which suggests the Fed is providing needed liquidity, said Joseph Abate, a short rate strategist for Barclays (LON:BARC).
"You could definitely imagine that rates would be higher" without that support, he said.
The overnight repo rate jumped to 1.90% on Tuesday before dropping to 1.40%, which is below the Fed's target fed funds range of 1.50% to 1.75%.
High demand for Treasuries for year-end was the likely factor behind the fall. The Fed saw the strongest demand for Treasuries in its reverse repo operation on Tuesday since June 2018.
In a reverse repo operation the Fed borrows money from market participants in exchange for Treasury collateral.
The rate is far lower than previously predicted.
Forward repo markets were pricing overnight loans for year-end at 2.50% early on Monday and at around 4% a few weeks ago, according to analysts.
(GRAPHIC: Repo and Fed balance sheet - https://fingfx.thomsonreuters.com/gfx/mkt/13/417/417/Pasted%20Image.jpg)