Sudden shift in the normally calm US cash markets doesn’t signal a new credit crunch

When it comes to financial markets, dull is normally a good thing. Being dull is predictable, safe and usually reliable. Cash is about as dull as it gets, or at least it should be. 

That’s exactly why sudden mayhem in a sleepy, obscure corner of the overnight lending markets in the US has recently sparked headlines. A chaotic surge in short-term lending rates signalled that capital markets’ plumbing had clogged up, prompting questions about whether this was a symptom of a more serious problem related to the “normalisation” of the Federal Reserve’s balance sheet.

I grew up in a pretty rural area where rainwater was collected in a tank and then piped to the house. When you turned on the tap and nothing came out, it was either because the tank was empty or the pipes were blocked. This is a simple way of thinking about how the US cash market works.

The Fed is a water tank whose job it is to ensure there is enough liquidity for the smooth operation of markets and to keep the cost of money – that is, the interest rate – as close to the target for the Fed funds rate as possible. The level of water in the tank can vary as the Fed goes about its normal daily operations but, on balance, it has increased markedly over the past decade thanks to successive rounds of quantitative easing to promote economic growth and reach inflation targets.

The pipes that carry the water around the house are the plumbing of the financial system. How fast the water flows and whether it gets to where it is needed depends on the efficient operation of these channels. Just like where I grew up, if debris blocks the pipes, the taps are liable to dry up. The question here is whether a plumbing problem becomes a more systemic market confidence issue.

During the global financial crisis, liquidity and cash in the financial system was restricted because the pipes were blocked. In that instance, the blockage was counterparty risk. Banks were worried about lending to each other in case the borrower collapsed and the lender never got their money back.

Since then, regulatory changes have been implemented to make the system safer and the pipes stronger.

Market participants were concerned that the spike in short-term lending rates in the past few weeks could be the start of another credit crunch or a symptom of something more serious in cash markets. However, what happened in the US was not a signal of a seriously delinquent market or a repeat of the credit crunch; rather, it was a temporary mismatch between supply and demand.

The inconvenient truth about monetary easing

There are points during the year when there will be higher than usual demand for cash. Often, these are just before holiday periods or towards the end of fiscal quarters as banks work to settle balances ahead of peak periods.

However, two main factors led to that anticipated extra demand being even higher: companies needed extra cash to settle their quarterly tax payments, while some large US Treasury settlements were occurring at the same time, further drawing liquidity from the market.

The resulting surge in demand without a commensurate increase in supply caused cash rates to surge and move above the top end of the Fed’s target band at the time. In the end, the Fed calmed markets by stepping in and temporarily providing the needed liquidity to balance out supply and demand, something it hasn’t had to do since the global financial crisis.

The spike in short-term lending rates sharpened the focus on the trajectory of the Fed’s balance sheet and plans to reduce its size. The Fed has been “normalising” the size of its balance sheet by bringing down the level of assets it owns as it slowly unwinds the successive rounds of bond buying it conducted after 2008. To many, this may appear to be effectively reducing the amount of water in the tank.

However, the Fed is conscious that there is simply more money in the economy than there was a decade ago and, as such, the reserves it holds and the overall balance sheet need to be larger to ensure the effective running of the system and implementation of monetary policy. So, the Fed’s balance sheet is likely to grow in size rather than shrink, ensuring that there is enough liquidity.

Former Fed chair Janet Yellen once said the reduction in the size of the balance sheet would be as exciting as watching paint dry. That hasn’t been the case and the balance sheet will remain a topic of debate. But this is not another credit crunch and its reassuring that the Fed is keeping such a close eye on the plumbing.

Kerry Craig is a global market strategist at JP Morgan Asset Management