The Federal Reserve stepped up its efforts to reduce volatility in short-term lending markets, announcing on Friday that it would inject up to $90bn in two-week loans into the financial system starting next week.

The new facility was revealed after the Federal Reserve Bank of New York offered overnight loans for a fourth consecutive day, helping steady conditions in the US repo market, where banks and investors make short-term loans in exchange for Treasuries and other high quality collateral.

The central bank said that it would expand its interventions beyond overnight loans after the lending rate for two-week funds rose sharply — an indication that investors were anticipating a fresh financing squeeze at the end of the quarter, when companies and traders settle their accounts. The new two-week loans will be offered in three operations on Tuesday, Thursday and Friday.

“The fact they are willing to telegraph this over quarter-end reduces the potential for funding market volatility like we have seen over this week,” said Benjamin Jeffery, an interest rate strategist at BMO Capital Markets. “It should hopefully offer some stability to repo markets over the next 10 days.”

The central bank’s New York branch offered $75bn of overnight funds on Friday, after an unusual jump in borrowing costs earlier this week caused it to intervene in the short-term money markets for the first time in a decade.

The overnight Treasury repo rate had surged to as high as 10 per cent on Tuesday. By Friday, it had receded to 1.95 per cent.

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The effective federal funds rate, which is the Fed’s main policy tool, also fell back to within the central bank’s intended range of 1.75 per cent to 2 per cent. Earlier in the week, it shot above its target in an unusual breach, which some analysts said suggested the central bank had at least temporarily lost control of the market.

The worrisome development on Friday was a rise in the two-week repo rate to 2.7 per cent, up from 2.35 per cent in previous days, suggesting that lending availability over this period has begun to tighten.

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US banks and investors have warned that a flare-up may occur again during quarter and year ends, when there is typically a high demand for cash.

“We think investors should be prepared for deteriorating liquidity in the funding markets into year-end and the impact of this on the financial markets as a whole, with potential costs for levered strategies and risk assets in particular,” said Jerome Schneider, head of short-term portfolio management at Pimco, the world’s biggest bond manager.

Analysts blamed a confluence of factors — some structural and others temporary — for the crunch in a part of the money markets where Treasuries are exchanged for cash in transactions that reverse overnight.

“None of these pressures was extraordinary or unforeseen, but together they had an extraordinary impact,” said Mr Schneider.

He echoed the analysis of others, saying $35bn was yanked from money market funds before US corporate tax payments were due on September 15. At the same time, dealers needed to finance an additional $20bn in Treasuries, acutely increasing the demand for cash sourced through repo transactions.

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Generally, banks would have stepped into the repo market. But falling excess reserves meant that they were less willing to use their cash in repo transactions.

Friday’s overnight repo auction by the New York Fed saw a lower level of demand from borrowers than the previous two days. Bids came in at $75.6bn, down from $84bn on Thursday and $80bn on Wednesday.

On Tuesday, the first day on which the $75bn overnight repo facility was offered, the New York Fed saw $53bn of bids.

Via Financial Times