Something big is happening in the money markets--and it could be a harbinger of further hemorrhaging in the credit markets. It could also indicate there are more problems lingering beneath the surface of the mutual fund industry.

Three curious events at year-end

First, on December 31, 2015, the Fed sold an unprecedented $475 billion in Treasury securities to banks, brokers and funds through its reverse repo facility. This was the highest amount sold through the facility and was 40% greater than the prior high 18 months ago.

Second, a key money market reference rate, the general collateral finance (GCF) repo rate, recently shot to 0.55%, which is sharply above the Federal Reserve’s upper target of 0.50% for the Fed Funds rate.

Third, the actual Fed Funds rate crashed from 0.35% to 0.20% as of year-end, which is below the minimum 0.25% floor the Fed is targeting. Although it is normal for the Fed Funds rate to dip lower at quarter-end and year-end because of peculiarities of the Fed Funds market itself, a divergence this great was unexpected.

When these two short-term rates diverge this much, vast sums of money are being shuffled around, which is confirmed by the $475 billion Fed sale.

The Fed's reverse repo facility

One of the principal tools the Fed uses to put a floor on short-term rates is its reverse repo facility, which had been in test-mode for over two years before the Fed finally raised rates on December 16, 2015.

Separately, the Fed also pays banks interest on excess reserves, which are currently $2.4 trillion. As Yahoo Finance reported, this is the conduit through which the Fed does its heavy lifting with respect to monetary policy.  The reverse repo facility is for fine tuning, with the added benefit of an expanded list of counterparties representing a broader spectrum of the financial sector.

Each day, from 12:45 pm to 1:15 pm, the Fed transacts with up to 163 banks, brokers, government-sponsored enterprises and mutual funds. It temporarily sells Treasury securities to the counterparties on an overnight basis, repurchasing them the next day. The Fed pays interest on the cash it takes from its counterparties—currently 0.25%.

These operations entice counterparties to participate because of the rate of interest paid, which tends to be above the shortest-term Treasury Bill rates, as well as the zero-risk rating of the Fed itself. When it comes to regulatory and financial reporting, counterparty risk matters greatly.

Three problems for the Fed

Before the Fed opened the reverse repo facility in September, 2013, the GCF repo rate had been dipping into negative territory, indicating too much money was chasing too few bonds.

This highlighted another problem. The Fed had purchased so many bonds after three rounds of quantitative easing, there was a fear that in times of stress, there would be a shortage of high quality bonds to serve as collateral. High quality collateral is the currency of the shadow banking market.

The Fed already had a securities lending facility that could provide bonds to primary dealers. That facility charged, rather than paid, interest. And, it was limited to the 22 large broker-dealers that the Fed hand-picked to deal in Treasury auctions.

The Fed’s reverse repo facility, in contrast, has 163 participants, including 20 international banks, 13 government-sponsored enterprises, such as Freddie Mac and Fannie Mae, 108 mutual funds, plus the aforementioned 22 primary dealers.

Critically, this allows the Fed to provide collateral to both the traditional and shadow banking system, where money market mutual funds are the principal source of funding. The Fed had created two emergency facilities in 2007 specifically to provide support to money market mutual funds. However, as they were only temporary, they expired long ago.

Accordingly, when the Fed opened its reverse repo facility, it was attempting to accomplish three things: (1) to test a mechanism that would be used to raise rates, (2) to help put a floor on short-term rates, and (3) to provide high quality collateral to the traditional and shadow banking markets.

Unintended window dressing consequences

When the Fed opened the reverse repo facility in September, 2013, it was putatively a test facility. However, the operations conducted were large enough in size that the counterparties were actually using it for window dressing.

Comparing the various reporting days of month-end, quarter-end and year-end to all other days when reverse repos are conducted, it is clear that the facility is more heavily used on the more important reporting days. These entities must disclose their holdings as of these dates to both regulatory authorities and investors, so they are incentivized to make their balance sheets look as healthy as possible.

The GCF repo rate began spiking higher around reporting days, as participation in the Fed’s reverse repo facility on these days grew. The higher rate in GCF repo indicates lower demand for bonds in that market. Essentially, the Fed has been crowding out other, riskier markets.

A notable exception to the trend involves the two quarters ended June 30, 2014 and September 30, 2014.

On June 30, 2014, a then-record $339 billion of bonds were sold. The Fed took surprise action just prior to the next quarter-end reporting period when it announced there would be a $300 billion cap on the facility. Wall Street scrambled to find other window dressing substitutes, and short-term Treasury yields dipped into negative territory briefly. The GCF repo rate also spiked lower, as it was once again needed for quarter-end window dressing.

However, once the Fed raised rates in December, 2015 and officially switched the facility “on,” it raised the ceiling from $300 billion to $2 trillion. Its number one priority was maintaining the 0.25% floor on the Fed Funds rate. Ironically, it is the outsized usage of the reverse repo facility itself on December 31, 2015 that exacerbated the flight of liquidity from the Fed Funds market that, in turn, caused the rate to drop from 0.35% to 0.20%.

Problems with mutual funds

Third Avenue Focused Credit fund didn't make it to the new year, shuttering its doors after its assets shrank to $789 million, down from $3 billion at their peak. Investors won't get any of the remaining money until December, 2016 at the earliest. 

Janet Yellen weighed-in on the matter at her last press conference. "[Third Avenue] had very concentrated positions in especially risky and illiquid bonds, and it had been facing very significant redemption pressures," said Yellen.  

She also characterized the fund as "unusual." However, recent record redemptions in not only high-yield mutual funds, but also investment grade funds, tell a different story.

It is possible that mutual funds loaded with distressed debt could use another repo market, the tri-party repo market, to offload their underperforming assets in exchange for cash. This cash could then be used to temporarily buy high quality collateral from the Fed through a reverse repo. At year-end, their balance sheets would appear to be composed of higher quality assets with a higher quality counterparty than would otherwise be the case.

Data is scant with regard to the tri-party repo market, but the size of the year-end Fed auction tells the story. A healthy financial system should not need $475 billion in high quality collateral from a zero-risk entity, such as the Fed—unless there are problems with portfolio composition and counterparty risk bubbling beneath the surface.

UPDATE: Yahoo Finance originally reported preliminary Federal Funds trading data of 0.12% for December 31, 2015. On January 4, 2016, the Federal Reserve Bank of New York reported that the Federal Funds weighted average for that date was 0.20%, with a low of 0.08% and a high of 0.63%. The official 0.20% weighted average is lower than the 0.25% lower bound the Federal Reserve is targeting.