by Peter Schiff, Schiff Gold:

The Federal Reserve upped the ante in its efforts to hold short-term interest rates down this week, injecting longer-term cash into the financial system.

Last week, the New York Fed began running repurchase operations in an effort to inject liquidity into the financial system. The bank’s repo operations started last Tuesday involving about $53 billion in debt instruments and continued through the week. The New York Fed injected over $270 billion in cash into the system last week and committed to continuing daily repo operations of at least $75 billion each through Oct. 10.

Repurchase operations are an important aspect of the banking system. The repo market enables banks to borrow cash in order to maintain liquidity and meet daily needs. In a repo trade, banks and other firms use Treasurys and other “high quality” securities as collateral for short-term loans. The bank then repurchases the bonds paying a nominal rate of interest – usually within 24 hours.

Interest rates on repo deals typically hover in the same ballpark as the Federal Reserve’s benchmark rate – currently set of 1.75 to 2%. But available cash virtually evaporated last Monday and that rate skyrocketed to over 10%, prompting the NY Fed to take emergency measures.

In effect, the market was pushing the interest rate up and the Fed stepped in and injected billions of dollars into the system to push interest rates back down. Peter Schiff called it a “big deal.”

It shows that the Fed is losing control of the short end of the curve, that market forces are beginning to overwhelm the Fed’s attempts to artificially suppress interest rates.”

“Bond King,” Jeffrey Gundlach said the Fed is “baby-stepping their way to doing QE.”

Is it an imminent disaster? No. The Fed is going to use this warning sign to go back to some balance sheet expansion.”

The Fed took another step in that direction Tuesday when it injected $30 billion in longer-term liquidity into the banking system. The NY Fed offered the additional cash through 14-day repurchase options to primary dealers. According to Reuters, the Fed will hold two more 14-day term operations on both Thursday and Friday worth at least $30 billion each.

This is another step closer to outright quantitative easing where the Fed expands its balance sheet for the long-term. Even the mainstream concedes this will likely be required in order to stabilize the repo market. While experts pinpointed two reasons for the sudden cash shortage last week, including corporations withdrawing funds from money markets in order to make quarterly tax payments, along with banks and investors settling accounts on $78 billion of US Treasury notes sold by the US government, there is an underlying systemic problem.

According to Reuters, cash reserves that banks park with the Fed and are often made available to other banks on an overnight basis are at their lowest since 2011. This is the result of the Fed’s recent balance sheet reduction.

In other words, what we’re seeing in the repo market is a tremor caused by the Federal Reserve’s quantitative tightening.

In the wake of the 2008 crash, the Fed bought more than $3.5 trillion in bonds and banks built up massive cash reserves at the Fed. That level peaked at around $2.8 trillion and began to drop in 2015 when the Fed started raising interest rates. The decline in reserves accelerated when the central bank began its balance sheet reduction operation.  According to Reuters, “bank reserves at the Fed last stood at $1.47 trillion, the lowest level since 2011 and nearly 50% below their peak from five years ago.”

These reserves serve as the primary source of liquidity to fund the repo markets.

The repo operations over the last two weeks seem to be stabilizing the system. Overnight borrowing rates have been running at about 2%. But these short-term Fed actions don’t address the underlying problem. Ultimately, the Fed will likely have to increase its balance sheet to boost bank reserves.

In other words – more QE.

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