Wall Street's worst fears of a year-end funding squeeze never materialized thanks in large part to the quarter-trillion dollars the Federal Reserve stuffed into the market to ensure nothing became gummed up.
The question now, though, is what it will take for the U.S. central bank to withdraw from its daily liquidity operations in the $2.2 trillion market for repurchase agreements, or repos - after it became a dominant player in a short three months.
"The repo operations are a band-aid, but the wound isn't healed fully," said Gennadiy Goldberg, an interest rate strategist at TD Securities.
The New York Fed began injecting billions of dollars of liquidity into the repo market in mid-September, when a confluence of events sent the cost of overnight loans as high as 10%, more than four times the Fed's rate at the time. A month later, the Fed moved to expand its balance sheet - and boost the level of reserves - by snapping up $60 billion a month in U.S. Treasury bills.
The Fed will continue pumping tens of billions a day into the repo market through at least the end of January. Its ability to exit from the repo market after that time will depend on how long it takes the central bank to make the balance sheet large enough so there are adequate reserves in the banking system - and the repo operations are no longer needed.
"It seems implausible to me that the Fed will be able to stop their repo operations by the end of January," said Mark Cabana, head of U.S. rates strategy at Bank of America Merrill Lynch.
Minutes from the Fed's December policy meeting released on Friday showed its staffers expected repo operations to be "gradually" reduced after mid-January. However, staff members also said the central bank may need to continue offering some repo operations until at least April, when tax payments could reduce the level of reserves.
Another challenge for Fed officials: Deciding just how big the central bank's balance sheet, which is currently about $4 trillion, should be.
"There are people at the Fed who have a preference for the smallest possible balance sheet, and we just don't know how much their views have evolved," said Lou Crandall, chief economist at Wrightson ICAP, a research firm.
Fed policymakers have said they will continue purchasing Treasury bills into the second quarter of 2020 with the goal of bringing reserves back above the level seen in mid-September, when they fell below $1.5 trillion.
Bringing reserves to $1.7 trillion would provide a cushion of about $200 billion to absorb shocks during periods of tight liquidity, said Joseph Abate, a short rate strategist for Barclays. Holding up to $2 trillion in reserves could offer a bigger cushion and reduce the likelihood of volatility in short-term borrowing markets, depending on what the demand is for reserves, he said.
'LONG-TERM
CONVERSATIONS'
Some financial firms are urging the Fed to stay involved permanently through a standing repo facility, which would allow firms to trade Treasury holdings for cash. But Fed officials are still working out the details and plan to keep discussing the issue at future meetings, the minutes from Friday showed.
Richmond Fed President Thomas Barkin said on Friday that in addition to a standing repo facility, long-term fixes for providing more liquidity in money markets could include adjusting liquidity regulations and setting restrictions on other programs that can affect reserves, such as the foreign repo pool.
"All those are legitimate long-term conversations to have now that we're through the short term," Barkin told reporters after a speech to the Maryland Bankers Association in Baltimore.
In the meantime, Fed officials could make changes to the repo offerings to help wean markets off the temporary support. Officials could reduce the frequency or the size of the repo offerings after January and bring them back during times of expected stress, Abate said.
One issue is that the Fed is allowing dealers to borrow cash at a cheaper rate than is available from other market participants, which discourages firms from borrowing in the private market they used before the Fed began to intervene, Goldberg said.
Figuring out the right structure could take some time. "What they want to do is incentivize the market to go to fellow market participants first and the Fed second, and I don't think we're there yet," Goldberg said.
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