NEW YORK The Federal Reserve's efforts to lower U.S. interest rates and increase borrowing to stimulate the economy may be running into a problem of the Fed's own making: the stubbornly high cost to borrow short-term funds is constraining the ability of banks to make cheap loans.
The Fed has been selling short-dated Treasuries in order to finance its purchases of longer-dated government bonds. It hopes this will reduce longer-term interest rates and boost borrowing needed to raise spending and reduce the jobless rate.
The sales have pushed up the cost to borrow in the vital $5 trillion repurchase agreement (repo), even though other borrowing rates have declined, as banks struggle under the weight of absorbing the short-term debt.
This is making it more costly for banks to fund new consumer and corporate loans, and for companies such as REITs to finance purchases of mortgage-backed debt that help borrowers buy homes.
If high repo rates persist, the Fed may choose to intervene in the market to try to bring them down, a move that could prove politically unpopular, analysts said.
"If the Fed's intention is to provide unlimited liquidity and ensure a cheap cost of credit, elevated repo rates run counter to this goal," said Boris Rjavinski, an interest rate strategist at UBS in Stamford, Connecticut.
The cost to borrow overnight in repo has increased to around 23 basis points, from around 10 basis points at the beginning of the year. At the same time, the three-month unsecured London interbank offered rate (Libor) has declined to 31 basis points, from 58 basis points.
The higher rates offered by repo loans are also luring investors such as money funds, at the expense of other loans directed at companies or consumers.
"The Fed would much rather see money market funds sponsor direct forces of credit creation to consumers and companies, but as long as repo is an attractive alternative, its going to siphon some of the money market funds lending capacity away from other loans," said Rjavinski.
Money funds increased their repo lending to record levels in July and August, where the loans topped 25 percent of the total assets of taxable money funds for the first time, according to data firm Crane Data.
At the same time as the repo loans increased, loans made to government agencies that guarantee mortgages and to companies through commercial paper declined, Crane data show.
Repo loans fell in September due to quarterly "window-dressing", but "October data will no doubt show a rebound," said Peter Crane, President at the firm.
High repo rates also hurt Real Estate Investment Trusts (REITs), which use repo funding to purchase mortgage-backed securities, and profit from the difference between the two rates.
REITs typically borrow at leverage of 6 or more times, which further magnifies the spread compression as repo rates rise and as mortgage-backed debt yields are held down by Fed purchases.
Recently, "REITs are not reported to have been as active in buying MBS, and part of the reason could be elevated funding costs," said Walter Schmidt, head of mortgage strategy at FTN Financial in Chicago.
For large banks, the high repo rate is further constraining their capacity to lend at the same time as new regulations and higher capital requirements shrink their balance sheets.
It is further reducing profits to their large fixed income operations, which are already suffering from the low yielding environment and reduced trading activity.
"Repo affects liquidity a little bit among dealers," said Schmidt.
Some analysts expect the high repo rate should ease by next year as the Fed's sales of short-dated debt in its Operation Twist program are due to expire at the end of this year.
Should the high rate continue, the Fed may be forced to intervene, a strategy that could require it to further expand its balance sheet.
This might prove unpopular as many oppose the Fed's money printing, which has weighed on the dollar. There are also concerns more easing will make an exit from the Fed's ultra loose monetary policy more difficult when the economy improves.
The Fed could lower the rate in a reverse repo operation, in which the Fed would lend funds to banks, in return for Treasuries the banks post to back the loans.
"We think that the Fed may address repo rates in its next easing effort," said UBS' Rjavinski.
Another option may be for the Fed to undertake more roll financing in the MBS market, said FTN's Schmidt.
In these transactions, the Fed can sell MBS for one month, then by it back at a later date for a lower price, a strategy that has the effect of lowering the financing cost.
A lower cost of roll financing would then have the effect of bringing down repo rates, because of the arbitrage opportunity between the two rates, Schmidt said.
"Once we get past the election they might choose to be more active in the roll markets, that would help roll financing for money managers and it would help repo financing," he said.
(Editing by Andrew Hay)