Markets expect the Fed to act beyond the fed funds rate amid repo crisis

The Federal Reserve (Fed) will announce its latest policy decision today. The Fed is broadly expected to lower the federal funds upper and lower target rates by 25 basis points to 1.75%-2.00% bound.

But investors want to hear more about the Feds plans to increase the short-term liquidity amid this weeks repo crisis sent the overnight repo rate up to 10%, pushing the federal funds effective rate from 2.14% to the Feds upper bound of 2.25%, raising worries that the Fed may be losing control over the short-term borrowing rates an unwished scenario which has sent Lehman Brothers bankrupt back in 2008 and triggered a worldwide financial crisis.

Why did the US short-term liquidity dry up?

Lower liquidity is usually seen at the end of a month or a quarter, where the month, quarter-end payments are settled, but not at the middle of a month.

A combination of several factors caused dried liquidity for the US primary dealers this week: the settlement of last weeks Treasury auctions, corporate tax payments and the recent sovereign bond sell-off during which dealers bought large amounts of securities from investors.

Whats next?

Before we continue, it is important to note that this weeks repo incident in the US doesnt necessarily mean that another liquidity crisis is at the door, but it clearly rings the alarm bell for the Fed, which is now urged to fasten up the launch of a new policy tool, an overnight repo facility, to reduce the pressure on short-term rates and to avoid liquidity from drying up for any reason in the future.

Read the full LCG article

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