Wall Street, Fed prep to avoid year end disruption in repo markets

With memories of September's historic spike in short-term funding costs still raw, Wall Street and the Federal Reserve are gearing up for another potential cash crunch at year end.

Liquidity levels will be tested as early as Monday, when Wall Street firms have to shell over cash to the U.S. Treasury for this week's government bond sales and businesses draw down reserves to make quarterly tax payments - events that could drain more than $100 billion in liquidity from the banking system. Those factors were identified as two of the main culprits in the mid-September episode, when interest rates in the overnight repurchase agreement - or repo - market shot to as high as 10%, more than four times the Fed's benchmark overnight lending rate.

And a new wild card may come into play this month. Some large banks may scale back lending in the repo market in an effort to shrink their balance sheets to avoid regulatory penalties, which would add to the funding stress.

"The market is still quite fragile," said Blake Gwinn, head of front-end rates strategies for NatWest Markets.

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The Fed's recent efforts to boost liquidity in cash lending markets - which were not in place in September - could ease some of the pressure.

The U.S. central bank has been injecting tens of billions of dollars of cash into overnight lending markets through daily and longer-term operations in the repo market since mid-September. And in mid-October, it began purchasing $60 billion a month in Treasury bills to raise the level of reserves in the banking system.

"The Fed is now increasing the balance sheet," said Zachary Griffiths, a rate strategist for Wells Fargo Securities. "That's a major differentiator between now and the middle of September."

Last month, the Fed also began offering longer repo operations of up to 42 days - compared to the more typical term of about 14 days - to help firms shore up their cash levels through the end of the year.

Investors snapped them up, with bids for all three of the longer repo operations exceeding supply. The Fed upped the size of the second and third offerings by $10 billion each and officials have said they are willing to adjust the repo operations as needed to keep markets running smoothly. The central bank is scheduled to issue an update on the balance sheet program on Thursday.

The strong demand for repo could be a sign that dealers and other financial firms are being proactive about securing access to reserves to avoid a shortage at the end of the year. But there is no guarantee that the liquidity being provided by the Fed is going to reach the hedge funds and other firms in need of liquidity, said Gwinn. The dealers accessing the liquidity from the Fed could choose to hold onto that cash or to use it for other purposes beyond the repo market, he said.

Fed officials are still discussing the merits of a potential standing repo facility, which could reduce demand for reserves by making it easier for banks to trade their Treasury holdings for cash. However, that fix likely would not come until next year, since policymakers are still debating the details of how such a facility should be structured.

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Money markets will be tested again on Dec. 31, when some large banks may reduce their repo lending to shrink their balance sheets and avoid higher capital surcharges, said Teresa Ho, U.S. short-term fixed income strategist for JPMorgan Chase. Some banks that are not subject to the same requirements may help to spread liquidity by lending in repo markets, Ho said, but it is difficult to know how heavily they will participate. "That doesn't mean they're going to go all in," she said.

In perhaps the most extreme forecast, Zoltan Pozsar, a Credit Suisse analyst who has been watching the repo market closely for more than a year, warned this week that any potential disruption at year-end could be so severe it may force the Fed to launch another round of quantitative easing.

Some Fed watchers say the worries about year-end are overblown. Even if there is a spike, it may not have much of an effect on other markets if it is not as dramatic as the jump in September and if it is resolved quickly, said Joseph Gagnon, a former Fed official and senior fellow at the Peterson Institute for International Economics. "If it's just temporary spike I don't think it's a huge problem," Gagnon said.

Fed Chair Jerome Powell said Wednesday after the central bank's policy meeting that officials are dedicated to keeping money markets calm through year end. He also said policymakers are open to suggestions for adjusting supervisory and regulatory practices in a manner that does not affect the safety and soundness of the banking system.

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"We think the pressures appear manageable and we stand ready to adjust the details of our operations as necessary to keep the federal funds rate in the target range," he said.

(Reporting by Jonnelle Marte; Editing by Dan Burns and Lisa Shumaker)