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By Richard Leong
NEW YORK, Sept 17 (Reuters) - The U.S. Federal Reserve on Tuesday injected billions into the financial system in an effort to calm money markets that have been roiled since Monday, as lending dwindled partly due to huge payments for taxes and bond supply.
The chaos in money markets added to Fed policymakers’ list of concerns that is already heavy on risks from U.S.-China trade tensions, a weakening global economy and sluggish domestic inflation.
Fed officials began a two-day policy meeting on Tuesday. Traders are expecting the U.S. central bank on Wednesday will cut its policy rate by a quarter of a percentage point.
The surge in borrowing costs, which banks and Wall Street pay to raise cash to fund their trades and loans, also exposed cracks in money markets left by the Fed’s normalization of its massive balance sheet, analysts said.
The central bank’s reduction of its holdings of Treasuries and mortgage-backed securities - which it amassed during three rounds of quantitative easing - was at least partly responsible for a nearly $900 billion decline in bank reserves since 2017.
“The root cause is the shortage of reserves,” said Gennadiy Goldberg, senior interest rates strategist at TD Securities in New York. “This is a funding squeeze.”
At one point on Tuesday, overnight borrowing costs in the $2.2 trillion repurchase agreement market spiked to as high as 10%.
In the repo market, banks and Wall Street dealers use securities as collateral to obtain cash from money market funds and other cash investors.
Another alarming signal was a jump in the average federal funds rate, which the central bank aims to influence. It reached 2.25% on Monday, which matched the upper end of the Fed’s current target range and was a move not seen since the height of global credit crisis more than a decade ago.
Analysts attributed quarterly corporate tax payments and the settlement of $78 billion in supply of Treasuries for the spike on Monday in repo rates.
Compounding this precarious backdrop was likely a flood of Treasuries dumped on dealers due to last week’s dramatic global bond market sell-off, analysts said.
By early Tuesday, there were no signs cash had returned to money markets.
“This increased the pressure on the Fed to doing something,” Goldberg said.
Indeed, the Fed jumped into action.
It announced an overnight repo operation, resulting in a $53.15 billion boost in cash into the banking system.
Repo rates dropped to zero after the Fed’s announcement before reversing back up to about 3.5% in late morning trading on Tuesday.
Now, analysts expect the Fed to do more to calm money markets including a standing repo facility, a decrease on what it pays on excessive reserves and/or an increase of its purchases of Treasuries.
“I think the Fed’s going to have to in some way address what’s going on in the funding markets,” said Justin Lederer, Treasury strategist at Cantor Fitzgerald.
Reporting by Richard Leong Additional reporting by Karen Brettell; Editing by Bernadette Baum and Paul Simao