Fed cuts rates, but that wasn't the biggest monetary story

As expected, the Federal Reserve cut interest rates by another 25 basis points on Wednesday.

The Federal Reserve approved a much-anticipated quarter-point interest rate cut Wednesday but offered few indications that further reductions are ahead as members split on what to do next.

Following its two-day policy meeting, the central bank announced that it would take down its benchmark overnight lending rate to a target range of 1.75% to 2%. That comes nearly two months after the policymaking Federal Open Market Committee went ahead with its first cut in 11 years.

While a majority agreed with the 0.25% reduction, one Fed member wanted a cut of 0.5%, while 2 didn't want any cut at all.

The stock market whipsawed as a result. Wall Street originally was unhappy (I think) because the Fed statement led them to believe that the rate cuts might end sooner than later, and the DOW was down more than 200 points in the first hour after the meeting. But then that reversed and the DOW ended up 36 points....because they figured MOAR COCAINE after all?

But a big story emerged in the days before the Fed meeting, as there was a mini-panic on Wall Street with banks were running low on short-term cash.

Repurchase agreements are the grease that keeps the financial system’s wheels spinning, allowing different market participants to borrow and lend to each other to cover short-term cash needs.

On Tuesday, the wheels stopped turning. The so-called repo rate soared to a high of 10 per cent, when it typically trades in line with the Federal Reserve’s target interest rate of between 2 per cent and 2.25 per cent. The New York branch of the Fed had to step in and inject tens of billions of cash into the system in an attempt to restore order, doubling down on Wednesday with a second short-term injection.

That’s not comforting. So what’s going on here? Let's allow Janney Funds' main bond guy to give his explanation.

The underlying problem is that primary dealer balance sheets are chalk full of Treasuries (caused by increased issuance) and dealers desperately need to finance those Treasuries, which limits the flexibility of the system when short term needs arise. 7/x pic.twitter.com/781dHAVlOm

— Guy LeBas (@lebas_janney) September 17, 2019

My worry is a simple one: when repo rates spike, the weakest borrower get squeezed the hardest, and "surprises" tend to emerge, because there's no cheap financing to paper them over. 9/x pic.twitter.com/WqnarbSeUv

— Guy LeBas (@lebas_janney) September 17, 2019

To me, it sounds like that situation in Vegas where you're tell others “I have no cash because I made a bunch of bets and the games haven’t been played,” but you have to pay for other things and do some other things, and you have no money.

The Fed also played a role in this freeze-up, as the improving economy throughout the 2010s meant that they didn’t have to do as much to help the stock market and economy by being a buyer of certain securities.

The Fed has been reducing the size of its balance sheet, letting the Treasuries and mortgage bonds it bought following the financial crisis roll off. In turn, that reduces the amount of cash reserves banks hold at the Fed. In 2014, banks held $2.9tn in “excess reserves” with the central bank. Since then, that number has dropped to about $1.3tn, where it has hovered all summer.

Fewer cash reserves means less money available at the banks to cover short-term funding stress.

At Wednesday's meeting, Fed did not necessarily say they would buy up more securities, but they did say it was time to loosen up reserves and make them a source of lower rates for banks.

In addition to the reduction, the Fed cut the interest it pays on excess reserves by 30 basis points, greater than the funds rate cut, amid a breakdown this week in the overnight repurchase lending market. The move was aimed at keeping the funds rate within its target range; the interest on excessive reserves (IOER) historically has acted as a guardrail for the funds rate, which traded 5 basis points above the target.

The next Fed meeting comes at the end of October, and I would have to think that economic data that comes in over the next month is going to be a big deal here, combined with whether these cash crunches are continuing for companies over the coming weeks (another repo operation is scheduled for tomorrow).

It feels like the Fed is in a catch-22/ If the economy seems to have overcome its August and September jitters, that along with 2.4% core inflation would not make more rate cuts a sensible move (no matter what debt-ridden Donald Trump says). On the flip side, the Fed funds rate is now down to 1.75%-2%, so cutting the rates again would send a message that the overall economy is weak and shaky (which Trump and other GOPs wouldn’t want to admit).

As I’ve said a lot in recent weeks, things don’t seem to add up on either Wall Street or in the overall economy these days. And today’s Fed decision seemed to match that level of confused cautiousness, with Fed Chairman Powell admitting the Fed has to make "difficult judgments" with all the cross-pressures.