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Repo Market Chaos Signals Fed May Be Losing Control of Rates

Alexandra Harris

(Bloomberg) -- One of the key U.S. borrowing markets saw a massive surge Monday, a sign the Federal Reserve is having trouble controlling short-term interest rates.

Amid the settlement of Treasury coupon auctions and the influx of quarterly corporate tax payments, the rate on overnight repurchase agreements soared by as much as 248 basis points to 4.75%, the highest level since December, according to ICAP pricing. It came back down to 2.50%, still up 23 basis points for the day. Curvature Securities spotted a different peak: 8%.

While the spike doesn’t necessarily mean credit markets are seizing up or a financial calamity is imminent, it could hamper the Fed’s ability to steer the economy. As the Federal Open Market Committee meets this week, this surge could force yet another tweak to the central bank’s interest on excess reserves rate to help ensure its main tool for guiding the economy -- the fed funds rate -- stays within policy makers’ preferred band.

“The Fed has lost control of funding,” said Mark Cabana, head of U.S. interest rates at Bank of America Corp.

The effective fed funds rate is 2.14% currently. Policy makers want their benchmark between 2% and 2.25%. If EFFR jumps toward the top end of that band in the next update released Tuesday morning, it suggests the central bank “will need to cut IOER to try and get ahead of it,” Cabana said. The bid/ask spread for fed funds shows a jump to at least 2.20% is likely, according to according to ICAP data.

The FOMC’s next decision on rates comes out Wednesday afternoon.

Market participants are watching to see how long these elevated levels persist, as any prolonged pressure could signal unruly funding markets at the end of the year. The spike suggests the next few months could be volatile given the expected increase in Treasury supply, bloated dealer balance sheets, regulatory issues and a banking system where reserves are scarce.

A combination of factors are behind the latest drive higher, including the settlement of the mid-month Treasury coupon auctions that pushed more collateral into the repo market. At the same time, cash is leaving the funding space as corporations withdraw from banks and money-market funds to make their quarterly tax payment.

This is expected to push Treasury’s cash balance higher while depleting the amount of bank reserves in the system. The drop-off in reserves and fund outflows are driving up funding rates and starting to spill into the fed funds market because repo’s attractive yields can draw some lenders away from the unsecured market.

“Secured funding markets are clearly not functioning well,” said Jon Hill, a rates strategist at BMO Capital Markets. Monday’s jump in overnight repo rates, especially since it’s not happening at the end of a quarter, is “bordering on chaos,” he added.

(Updates rates in second paragraph)

To contact the reporter on this story: Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Nick Baker, Greg Chang

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