How the Fed’s funding struggles highlight the fragility of Wall Street confidence

When obscure corners of the financial markets that are typically considered mundane draw outsize attention on Wall Street, it is always cause for investor concern.

That was the case last week when surging overnight borrowing costs laid bare cracks in a key Wall Street funding mechanism, which left many scrambling for cash and the New York Federal Reserve responding by injecting hundreds of billions of dollars into the financial system to restore calm.

In other words, this was no ordinary week in financial markets and more than a few investors were seeing shades of the 2008 financial crisis, reigniting decade-old nightmares of a systemic funding chaos.

“My initial reaction was fear,” said Hugh Nickola, head of fixed income at Gentrust, and a former head of proprietary trading of global rates at JP Morgan. “There’s really nothing more important than the functioning and transparency of financing markets.”

The sudden spotlight on the short-term “repo” market easily overshadowed Wednesday’s highly anticipated Fed decision on monetary policy, where the U.S. central bank cut federal-funds rates by a quarter-of-a-percentage point to a 1.75%-2% range in a divided 7-3 vote.

Rates on short-term funds, that are typically anchored to fed-funds rates, briefly became unhinged, spiking to nearly 10% on Tuesday.

Nickola said his worries only receded after the Fed started to intervene with a series of short-term funding operations that kicked off Tuesday and totaled nearly $300 billion for the week. On Friday, the central bank tightened its grip on rates ahead of the end of the quarter, when liquidity can become scarce, by extending its daily borrowing facilities through at least October 10, and unveiling three, 14-day term operations.

The short-term rate spike also raised concerns about the potential for the funding tumult to shake consumer confidence, at a time when financial markets often are viewed as a barometer of the economy’s vitality.

Bruce Richards, CEO of Marathon Asset Management said the biggest risk to the U.S. economy was a weakening of consumer sentiment, in remarks Thursday at the CNBC Institutional Investor Delivering Alpha conference.

Richards said that while U.S. households are doing well, it would become “very worrisome” if consumer confidence starts to fade, since two-thirds of the U.S. economy is consumer-driven.

“Right now, it is corporate confidence” that is weakening, he said.

Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, also sees reason to fret due to continuing Wall Street liquidity woes that could seep into the real economy.

He pointed to three factors that still leave the money-market plumbing fragile: heavy U.S. Treasury borrowing to fund the widening fiscal deficit, a flat-to-inverted yield curve, and a regulatory environment that limits the ability of banks to absorb government debt.

LeBas thinks overnight funding operations alone won’t be enough to keep credit flowing over the longer run...

- Source, Market Watch