One wouldn’t know the Federal Reserve has done nothing but add to its record monetary stimulus from looking at short-term funding markets.
The federal funds effective rate on overnight loans between banks was 0.16% on Nov. 21, up from 0.06% at the end of September 2011, the month Fed officials announced they would begin swapping short-term securities in their portfolio for long-term debt under Operation Twist. The rate for borrowing and lending Treasuries for one day through repurchase agreements also has surged.
Higher overnight interest costs are a side effect of Operation Twist that has persisted despite new accommodation, including a third round of quantitative easing and extending the horizon for near-zero borrowing costs through mid-2015. When the program ends in December, the Fed will have shrunk its portfolio of short-term securities by $667 billion U.S. through Twist sales and redemptions, designed to lower long-term interest rates while keeping the size of the Fed’s balance sheet constant.
The Fed’s sale of short-term Treasuries has put record amounts of these securities on primary dealers’ balance sheets, increasing their financing costs. As of Nov. 14, the 21 primary dealers that trade directly with the Fed held $69 billion U.S. of Treasury coupon securities due in three years or less, compared with $1.8 billion U.S. on Oct. 5, 2011, Fed data show. That’s down from a record $76.9 billion U.S. on July 25.
The glut has helped drive repo rates higher, as the firms typically use the securities as collateral for temporary loans through the overnight lending market as a way to help finance their holdings. A repo typically involves the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender.
When the amount of debt dealers need to finance through the repo market increases, rates typically rise to attract more lenders, which are primarily money-market mutual funds. During the height of the global financial crisis in 2008, when Treasuries were in short supply amid global demand for the debt as a haven, repo rates collapsed to nearly zero given the supply shortage.
The overnight repo rate for Treasuries climbed to 0.288% as of Nov. 23 from minus 0.001% on Dec. 30, a Depository Trust & Clearing Corp. general-collateral finance repo index shows. The index has averaged 0.258% in the last month, compared with 0.096% in 2011.
Distorted repo rates increasingly matter because the money- market metric has gained stature as bankers and investors seek alternatives to the London interbank offered rate, known as Libor. Regulators across the globe are investigating claims that banks altered submissions used to set Libor to appear financially healthier or benefit traders.
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