Investors take for granted that the Federal Reserve controls interest rates. They rarely have to think how.
But a surprisingly lively few days in short-term money markets means that "how" has become almost as important as "why."
Stress began on Monday in the market for repurchase agreements or reposts. The market for repo channels over $ 1 trillion on Wall Street every day, usually without fanfare. This money is used to pay for the day-to-day operations of major banks and hedge funds.
Then the Fed's top interest rate, known as the federal unds r eats, hit 2.3 percent on Tuesday. This is above the target of the central bank and the rise reflects unexpected tensions.
In the past, when the repo markets managed to make headlines, it was in extreme episodes of market stress – for example, in the early days of the financial crisis.
This time there is little reason to worry that an economic disaster is on the offensive. But the movement emphasized the importance of a market that usually operates in the background.
The repo market is critical to a functioning Wall Street.
Reposts are short-term loans used primarily by banks and hedge funds in their daily bond trading and brokerage activities.
Usually these companies pay for their investments with borrowed money, and the repo market offers these large sums daily. The money comes from other financial institutions as money market mutual funds that lend it
for very short periods. A repo market borrower can take this money overnight for example, to cover purchases made the previous day.
But this week went wrong: the cost of borrowing from the repo market shot sharply higher than Monday, which caught people off guard.
Interest rates on overnight loans, which average approximately 2.2% since early August, jumped to 2.88% on Monday. Then on Tuesday they rose to 6 percent.
Repo rates are designed to reflect the percentage of federal funds, and this decreases as the central bank lowers its interest rate target to strengthen the economy.
The jump in interest rates may come for some time.
When big money is available for big banks to borrow every night, interest rates remain low.
But in recent days a number of factors have squeezed funds out of the market. Monday was the deadline for paying big business taxes and vacationing in Japan, which meant that a large source of funds was off. And after a recent government bond auction, people had to divert money to pay it.
These were the likely trigger events for this week's jump. But the amount of money raised in this market has been diminishing for some time. And it's because of the Fed.
As of 2018, the Fed shrinks its bond holdings and turns its crisis era policy to push money into the financial system.
The change effectively reduced the supply of money available in the short-term credit markets, The speed of short-term rates suggests that the Fed may have eliminated a little too much, making reserves too scarce.
"The problem is we don't know what this minimum level is and we just dropped into it," says Gennady Goldberg, senior US interest strategist at TD Securities USA.
The buy-back market is just one of the short-term money markets where short-term cash and bank reserves are channeled to borrowers and the increase in interest rates on some may affect others.
In the commercial paper market – unsecured loans to banks and other large corporations – overnight interest rates have also risen.
In the past, strange moves in the repo market were a sign of problems.
The good news is that a short increase in short-term interest rates probably won't mean much to the broad economy.
This may briefly increase the cost of trading financial firms by damaging their profits. And if it continues, it may undermine the belief in the financial markets that the Federal Reserve can effectively implement monetary policy as it intends.
The main reason that the influx of the repo market has attracted attention is because it reminds people of the last time the market was seamless.
Back then, market problems were centered around the mortgage backed securities market, often referred to as AAAs and used by borrowers as collateral in the redemption markets.
After investors became aware of the deep problems in the US mortgage market, they began to avoid lending to a mortgage. Repo interest rates have risen, reflecting the realization of increased credit risk on those bonds, which were often built on bad housing loans.
This time is different. Not really.
The speed of repo rates does not mean that investors now consider bond bonds to be risky. If this were the case, the interest rates on the bond market would be higher. In fact, they are quite low. The yield on the 10-year note was approximately 1.8 percent on Wednesday.
"Although these issues are important for the functioning of the market and market players, they do not affect the economy or monetary policy position," Fed President Jerome H. Powell said at a news conference Wednesday.
Essentially, the history of the repo market this week is essentially a hoot for the technocrats at the central bank, leaving markets without enough money to go around.
This is not great to see, but there is no reason to believe that this is the leading indicator of another financial crisis.
Jeanne Smialek contributed to the reporting.