The NY Fed's rescue is working. But it hasn't fixed the market

That emergency action from the New York Fed appears to have done the trick. The severe stress that emerged in overnight lending markets has largely faded. After spiking last week, borrowing rates have mostly gotten back in line.

But the cash crunch has only subsided because of all that free money being pumped in by the Fed. Without emergency cash injections, stress would probably return. Although the NY Fed's rescue is working, it hasn't fixed the underlying problem.

"It's like a painkiller. It works, but you're never really dealing with why the market is broken in the first place," said James Bianco.... "You're just medicating the market, you're not figuring out why the pain exists."

That pain could come back as the third quarter winds to an end next week. Liquidity normally dries up at quarter-end as banks pull back. And these aren't normal times.

"There is still a lot of caution and nervousness amongst many traders and clients," said Mark Cabana, rates strategist at Bank of America Merrill Lynch. "Quarter-end is a test."

Broken plumbing

Normally, Wall Street pays very little attention to the overnight lending markets. But that's not because they don't matter. Overnight lending markets are like the plumbing of US capital markets. They allow banks, hedge funds and other financial institutions to quickly and cheaply borrow money for short periods of time.

Investors were surprised to learn last week that the plumbing is broken. The rate on overnight repurchase, or repo, agreements surged to 5% on September 16. That's more than twice the target range for short-term borrowing set by the Federal Reserve.

Such a spike is alarming because it signaled strains in the market at a time of relative calm. What would happen during market turbulence? And sustained pressure could lead investors to fear the Fed is no longer in control of short-term borrowing rates.

The stress worsened the next day, when the rate spiked as high as 10%. The NY Fed responded by pumping $53 billion into the system through what's known as an "overnight repo operation." These cash injections, which are promptly repaid, were aimed at getting borrowing costs to get back in line.

Borrowing costs tumbled immediately, but the Fed realized more help was needed. The NY Fed pumped in $75 billion during each of the final three days last week.

"We were prepared for such an event, acted quickly and appropriately, and our actions were successful," NY Fed President John Williams said in a speech earlier this week.

Clamor for cash

But those operations drew strong demand, suggesting the Fed couldn't step away. And so the Fed announced last Friday that it would continue to pump in money each weekday until October 10. Addressing concerns about the end of the quarter, the Fed also announced three repo operations, each with a 14-day term.

The clamor on Wall Street for Fed cash has persisted. Tuesday's 14-day repo operation drew $62 billion worth of demand. That's more than twice as much as the NY Fed was offering.

"That says the Fed is not providing enough liquidity," said Bank of America's Cabana.

In other words, there just isn't enough cash in the financial system.

The strong demand could also just show that Wall Street firms are being prudent by making sure they take advantage of the cash being offered.

"If heaven forbid something goes wrong and you didn't try to get money from the Fed, you'd be fired," said Seth Carpenter, an economist at UBS.

'Wacky explanations'

In any case, the market is signaling the Fed shouldn't turn off the cash injections just yet. And that continued need for liquidity casts doubt on some of the early theories for the market stress.

Last week, Fed Chief Jerome Powell supported the idea that the turmoil was driven by two one-off factors: The withdrawal of cash by US companies to make quarterly tax payments to the Treasury Department and the settlement of a large amount of Treasury purchases.

"Those events are in the rearview mirror, so what's happening now?" asked Nicholas Colas, co-founder of DataTrek Research. "There have been so many wacky explanations."

Others have pinned the blame on post-crisis rules that limit the ability of banks to provide liquidity when it's needed.

The Fed's inability to explain the market stress suggests they are still trying to make sense of it themselves. Officials are struggling to determine just how much cash needs to be in the system to keep it operating smoothly.

"If they knew what the funding needs were, last week never would have happened," said Bianco. "They don't want to look like they're flailing around, making it as up they go along."

'Just a blip' or something more?

Markets may not go back to normal until the Fed comes up with a long-term fix, said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

"We'll have these daily fires that need to be put out," Boockvar said.

Analysts said the Fed is likely to prevent future liquidity squeezes by either creating a standing repo facility or by agreeing to increase the size of its balance sheet again.

Bank of America estimates that the Fed may need to boost its balance sheet by $400 billion over the course of a year to address funding pressures.

"The Fed can just create money out of thin air," said Bianco.

Many observers are confident the Fed can get the overnight lending markets functioning once again. Although the stress in the market has brought back memories of 2008, this does not appear to be a repeat of the financial crisis.

"So far, it's just a blip," said UBS's Carpenter. "But remember, back in 2007 defaults on subprime mortgages were just a blip."

Carpenter said he's not suggesting there will be another financial crisis. However, he said it's important for the Fed to fix this problem before it causes investors to retrench, dealing a blow to both markets and the economy.