(Bloomberg) — As markets staged a monster rally following the Federal Reserve’s shift toward loosening monetary policy, one corner of the financial system had reason to remain on edge.
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For participants in the overnight funding markets — a key conduit for bank borrowing and linchpin for determining interest rates — Wednesday’s policy meeting contained a more pertinent message from Chair Jerome Powell than the one that sent stocks soaring and pushed the 10-year US yield below 4%: namely, that the Fed’s balance sheet reduction would continue as planned.
A debate is simmering over whether the Fed is misjudging how far it can shrink its balance sheet — a process known as quantitative tightening — without causing dislocations in places like the repurchase-agreement markets, part of the essential plumbing of the financial system. Recent stresses there caused one benchmark rate to hit an all-time high, evoking memories of September 2019, when a different overnight market rate soared five-fold to as high as 10% and the central bank was forced to intervene.
The latest disruptions were indeed of a much lesser degree than four years ago and required no intervention, but both episodes shine a light on the increasingly delicate balance between the Fed, banks and other institutions that helps keep the overnight funding market functioning properly. Four years ago, increased government borrowing exacerbated a shortage of bank reserves that was created…
