By Richard Leong
NEW YORK (Reuters) - The U.S. Federal Reserve on Tuesday injected billions of dollars into the financial system with a move it has not used in more than a decade to calm money markets, as lending dwindled partly due to huge payments for taxes and bond supply.
The central bank said it conducted an overnight repo operation, resulting in a $53.15 billion boost in cash into the banking system.
The Fed will hold another repo operation early Wednesday.
In an overnight repo operation, banks borrow cash from the Fed using Treasuries and other securities as collateral. Repo operations have been rare in recent years because banks have had ample supply of available cash for daily operations.
The temporary shortage of cash was due to quarterly corporate tax payments and the settlement of $78 billion in supply of Treasuries sold last week, analysts said.
The chaos in money markets since Monday added to Fed policymakers' list of concerns that is already heavy on risks from U.S.-China trade tensions, a weakening global economy and sluggish domestic inflation.
Fed officials began a two-day policy meeting on Tuesday and are widely expected to cut the central bank's policy rate by a quarter of a percentage point.
The surge in borrowing costs, which banks and Wall Street pay to raise cash to fund their trades and loans, also exposed cracks in money markets left by the Fed's normalization of its massive balance sheet that ended in July, analysts said.
The central bank amassed holdings of Treasuries and mortgage-backed securities during three rounds of quantitative easing (QE) after the financial crisis. Reduction of those holdings was at least partly responsible for a nearly $900 billion decline in bank reserves since 2017.
"The root cause is the shortage of reserves," said Gennadiy Goldberg, senior interest rates strategist at TD Securities in New York. "This is a funding squeeze."
(GRAPHIC: Bank excess reserves held at the Fed - https://fingfx.thomsonreuters.com/gfx/mkt/8/2036/2021/Fed%20excess%20reserves.PNG)
SURGING MONEY RATES
At one point on Tuesday, overnight borrowing costs in the $2.2 trillion repurchase agreement market spiked to as high as 10%.
In the repo market, banks and Wall Street dealers use securities as collateral to obtain cash from money market funds and other cash investors.
Another alarming signal was a jump in the average federal funds rate, which the central bank aims to influence. It reached 2.25% on Monday, which matched the upper end of the Fed's current target range and was a move not seen since the height of global credit crisis more than a decade ago.
Analysts attributed for the spike on Monday in repo rates.
Compounding this precarious backdrop was likely a flood of Treasuries dumped on dealers due to last week's dramatic global bond market sell-off, analysts said.
FED TO THE RESCUE
By early Tuesday, there were no signs cash had returned to money markets.
"This increased the pressure on the Fed to doing something," Goldberg said.
The Fed embarked on a move it last deployed on a large-scale since 2008 during the height of the global credit crisis. Repo rates dropped to zero after the Fed announcement before ending the day at about 2.0%, analysts said.
Now, analysts expect the Fed to do more to calm money markets including a standing repo facility, a decrease on what it pays on excessive reserves and/or an increase of its purchases of Treasuries.
Jeffrey Gundlach, chief executive of DoubleLine Capital, told Reuters that the Fed will embark "pretty soon" on "QE lite," in order to increase the money supply and spur lending and investment.
(GRAPHIC: U.S. repo rate - https://fingfx.thomsonreuters.com/gfx/mkt/12/6165/6096/U.S.%20repo%20rate.png)