In the Market: How Trump's and Harris's pledges could exacerbate the market's Fed addiction

The Federal Reserve risks expanding its role beyond that of a lender of last resort, moving to prop up markets even during stable conditions, especially as pressures mount from U.S. presidential candidates aiming to add trillions to the national deficit.

A recent indicator of this mission creep occurred on September 30, when typical quarter-end strains on Treasury markets led to a $2.6 billion drawdown from the Fed's Standing Repo Facility (SRF). This facility, established in 2021 following a market disruption, allows certain lenders to borrow against collateral like Treasuries to address cash shortfalls in the market and prevent sudden spikes in short-term interest rates that could threaten financial stability.

However, two banking sources, who requested anonymity for candid discussion, along with a market expert, indicated there was no liquidity crisis on that day, and signs of financial stress were actually below normal levels. Instead, they pointed to a significant structural issue: the Treasury market, now approximately $28 trillion in size, has grown too large for banks to facilitate these trades effectively. Regulatory changes following the 2008 financial crisis have made these transactions less profitable, leading banks to either lack sufficient balance sheet capacity or choose not to engage.

This issue is likely to worsen as U.S. fiscal deficits continue to rise. A budget-focused think tank recently estimated that Republican candidate Donald Trump’s tax and spending proposals could add $7.5 trillion to the deficit over the next decade, while his Democratic counterpart, Kamala Harris, could add $3.5 trillion. Both campaigns have faced criticism regarding these projections.

In response, the Fed and market participants are considering various measures that could deepen its involvement in the markets, such as centrally clearing some transactions, expanding access to borrowing from the Fed, and offering the SRF earlier in the day.

While ensuring the smooth functioning of Treasury markets is crucial for global financial stability, the Fed's increasing role could lead to unintended consequences, such as crowding out other investors and creating asset bubbles, similar to what occurred after the COVID-19 pandemic.

Stanford University finance professor Darrell Duffie expressed concern about this trend, stating, "We must redesign the financial system and regulations so that the market can effectively manage liquidity demands, even during stressful periods, and we have not achieved that yet."

The Fed declined to provide comments on the matter.

It is important to acknowledge the Fed's vital role in this context. The central bank faces difficult choices, constrained by the actions of fiscal authorities. Viral Acharya, a former deputy governor of the Reserve Bank of India, noted that the situation is increasingly resembling an emerging-market crisis, characterized by soaring deficits, an aggressive borrowing calendar, and mismatches—particularly frictions—in private liquidity demand and supply.

Acharya, now an economics professor at NYU Stern School of Business, remarked, "Central banks are constantly battling multiple crises simultaneously."

Lender of Last Resort
The concept of a central bank serving as a lender of last resort was first proposed by 19th-century economist Walter Bagehot, who argued that such a role is essential to avert bank panics. Since its inception in 1913, the Federal Reserve has intervened numerous times to fulfill this function.

However, the Fed's presence in the market has significantly increased since the 2008 financial crisis, resulting in an expanded balance sheet and the creation of new facilities to support various markets. This growth in the Treasury market—more than doubling in the last decade—has not been matched by an increase in intermediation capacity.

The SRF was introduced after a crisis moment in September 2019, triggered by a sudden interest rate spike in the repurchase agreement (repo) market, where institutions borrow short-term funds using Treasuries and other collateral. For several years, the SRF remained largely unused, serving primarily as a testing ground for banks.

One source revealed that some foreign banks typically withdraw from the market at quarter-end to reduce their balance sheets, a practice informally known as "window dressing" to lower capital charges.

Moral Hazard
The reduced capacity in the market resulted in insufficient funding on September 30 when many participants sought to borrow. Consequently, a key repo interest rate—the Treasury GCF Repo Index—spiked by 33 basis points to 5.22%. Based on trades informing another benchmark rate, known as SOFR, Duffie estimated that about $600 billion in trades were executed at significantly higher rates.

The reluctance of banks to borrow more from the SRF, even at these elevated rates, pointed to balance sheet limitations rather than a liquidity crisis within the financial system, as noted by Duffie and the banking source.

Concerns are mounting about what might transpire at year-end when U.S. banks typically withdraw from the market, leading to reduced intermediation capacity in repo markets. The banking source indicated that borrowers might seek repo loans for several days instead of the standard overnight terms to navigate these challenges.

Acharya warned of the risk of creating moral hazard through the Fed's interventions. "If market participants believe the Fed will always step in, why would they effectively manage their liquidity risks?" he questioned.

 

 

 

 

 

 

 

 

 

Paraphrasing text from "Reuters" all rights reserved by the original author.