Markets expect the Fed to act beyond the fed funds rate amid repo crisis, UK inflation in focus

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 Fed’s plans to increase the short-term liquidity amid this week’s repo crisis sent the overnight repo rate up to 10%, pushing the federal funds effective rate from 2.14% to the Fed’s 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 week’s Treasury auctions, corporate tax payments and the recent sovereign bond sell-off during which dealers bought large amounts of securities from investors.

What’s next for the Fed?

Before we continue, it is important to note that this week’s repo incident in the US doesn’t 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.

For now, the Fed pulled out an old gun, the open market operations. The New York Fed bought $53.2 billion worth of securities in exchange of cash on Tuesday and is planning to buy another $75 billion on Wednesday to calm down the market. Cash injections via open market operations were commonly used before the Fed introduced a broad-based asset purchases program to expand its balance sheet from $880 billion in 2008 to $4.5 trillion by 2015. With the end of the so-called Quantitative Easing (QE) program, which consisted in buying massive amounts of Treasuries, agency debt and mortgage-backed securities on monthly basis, the Fed’s balance sheet started to retract slowly. Today, the Fed’s balance sheet is worth nearly $3.8 trillion.

Henceforth, the Fed could also be expected to re-launch a broad-based asset purchases program. In other words, a new Quantitative Easing could be down the road, following the European Central Bank’s (ECB) announcement of $20 billion-euro worth of monthly purchases re-starting from November.

What’s happening in the markets?

The US dollar recovered a part of Tuesday weakness against the G10 currencies, amid the repo crisis boosted the dovish Fed expectations ahead of today’s decision announcement.

The US 10-year yield settled around the 1.80% mark, compared to the two-week high of 1.90% seen on Friday.

The probability of a 50-basis-point Fed rate cut rose up to 19%, from nearly zero percent at the beginning of this week.

US equities are in a wait-and-see mode. The S&P500 advanced to 3005 into Tuesday’s close, as the Dow Jones settled past 27’100. Both markets could renew record following the Fed announcement, given that the Fed has little choice but to deliver a sufficiently dovish decision today.

Asian equities traded mixed. Japanese stock markets slid, shares in Hong Kong and Shanghai recorded timid gains, while Australian stocks traded marginally lower.

FTSE (-0.16%) and DAX futures (-0.09%) hint at a softer start in Europe.

Gold attempts to clear resistance near $1500-$1510 an ounce, while haven investors remain reluctant from moving their capital into the yellow metal ahead of the important Fed announcement.

All eyes are on the Fed. The Fed has the power to reverse the risk sentiment and encourage a relief rally in risky assets as early as today.

Softer inflation doesn’t mean softer pound

The pound tested the 1.2520/1.2530 resistance zone for the second time since last week, as the US dollar weakened amid a short-term liquidity crisis hit the US money markets earlier this week.

Meanwhile, UK’s Supreme Court hearing against Johnson’s suspension of Parliament began and will last three days. British policymakers urge Johnson to announce his plans if he loses the case. The pound trades on increased hope of no no-deal Brexit. For now, buyers are rare above the 1.25 mark against the US dollar, but if the MPs are allowed to return, the pound could jump significantly.

Data-wise, the UK will release the latest inflation figures today. The consumer price inflation may have slid below the Bank of England’s (BoE) 2% policy target in August, from 2.1% printed a month earlier. A softer inflation could revive the BoE doves, as other major central banks shift toward increasingly unorthodox monetary policies, but the BoE is broadly expected to stay pat at this week’s monetary policy meeting and the upcoming ones, given that the Brexit uncertainties threaten the price stability in Britain and refrain British policymakers from taking any action. Hence, the impact of a potentially slower inflation on sterling should remain limited.