Investors take for granted that the Federal Reserve controls interest rates. Rarely do they have to think about how.
But a surprisingly lively couple of days in short-lived money markets have made "how" almost as important as "why."
The stress started on Monday in the market for repurchase agreements or repairs. The repo market channels more than $ 1 trillion in funds through Wall Street every day, usually without fanfare. This money is used to pay for the day-to-day operations of large banks and hedge funds.
Since the Fed's policy rate, known as the federal f and r rose 2.3 percent on Tuesday. This is above the central bank's target, and the increase reflected unexpected pressures.
This time, there is little reason to worry about an economic disaster coming. But the movement pointed out the importance of a market that usually operates in the background.
The repo market is crucial for a functioning Wall Street.
Repos are short-term loans primarily used by banks and hedge funds in their daily bonds and brokers.
These companies usually pay for their borrowed money investments, and the repo market provides these large sums of money daily. The money comes from other financial institutions as liquid funds in money markets that lend them
for very short periods. A borrower in the repo market can take the money for a single night to cover purchases made the day before.
But something went wrong this week: The cost of taking out a loan on the repo market shot sharply higher beginning Monday, which caught people off guard.
Interest rates on overnight loans, which have averaged 2.2 percent since the beginning of August, jumped to 2.88 percent on Monday. Since Tuesday, they have risen to as much as 6 percent.
Repo rates are intended to reflect the federal funds and it falls when the central bank lowers its interest rate target to strengthen the economy.
The interest rate increase may have come for a while.
When there is a lot of money available for the big banks to borrow every night, the prices remain low.
But in recent days, a number of factors had drained money from the market. Monday was a tax payment deadline for large companies and a holiday in Japan, which meant a major source of funds was shut down. And after a recent auction of government bonds, people had to pass on cash to pay for them.
These were the likely trigger events for this week's wave. But the amount of money pooled in this market has decreased for a while. And that's because of the Fed.
Since 2018, the Fed has shrunk its bond holdings and reversed its crisis period policy to drive money into the financial system.
The change has effectively reduced the availability of available money in the short-term lending markets. . The increase in short-term interest rates indicates that the Fed may have removed a little too much, which made the reserve too scarce.
"The problem is, we don't know what that minimum level is and we just slammed into it," said Gennadiy Goldberg, senior US stock strategist at TD Securities USA.
The repurchase market is just one of the short-term money markets where short-term cash and bank reserves are channeled to borrowers and interest rate hikes in one can affect the other.
In the market for commercial paper – unsecured loans to banks and other large companies – the rates for overnight loans also rose.
Previously, strange movements in the repo market were a sign of problems.
The good news is that a short rise in short interest rates is not likely to mean much to the broader economy.
It can briefly raise the cost of trading at finance companies and damage their profits. And if it continues, it could undermine the belief of those in the financial markets that the Federal Reserve can effectively apply monetary policy as it intends.
The main reason why the powerful repo market has received attention is because it reminds people of the last time the market went high holders.
Then, the problems in the market centered around the market for mortgage-backed securities, which were often labeled AAA and used by borrowers as collateral in the repurchase markets.
As investors began to become aware of the deep problems of the US mortgage market, they began to avoid lending against mortgages. Repo rates increased, reflecting the realization of increased credit risk in these types of bonds, which were often built by poorly made home loans.
This time is different. No really.
The increase in repo rates does not mean that investors now think government bonds are risky. In that case, interest rates on the bond market would be higher. They are actually quite low. The return on the 10-year banknote was about 1.8 percent on Wednesday.
"Although these issues are important for market function and market participants, they have no implications for the economy or monetary policy position," Fed Chairman Jerome H. Powell said at a news conference on Wednesday.
Basically, the history of the repo market this week is basically a hiccup for the central bank technocrats and leaves the markets without enough money to go around.
It is not good to see, but there is no reason to believe that this is the leading indicator of another financial crisis.
Jeanna Smialek contributed reporting.