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The New York branch of the U.S. Federal Reserve added billions more in liquidity to gummed-up intrabank lending markets Wednesday, following the first intervention in more than a decade only yesterday, as a worrying spike in overnight borrowing costs continues to perplex investors and complicate today's Fed rate decision.

The New York Fed offered $75 billion in cash to broader markets, in exchange for eligible collateral such as U.S. Treasury bonds or mortgage-backed securities, in order to hold the Fed's key rate inside its target range of between 2% and 2.25%. It accepted its full allotment, even as bids totaled $80 billion, lowing the range from 2.6% to 3% prior to the operation to 2.25% to 2.6% immediately afterwards.

The New York Fed was forced yesterday to inject $53.2 billion after overnight borrowing costs surged close to 10%, thanks in part to the hefty burden of primary dealers in the Fed system taking down nearly $45 billion each day in gross U.S. Treasury bond issuance, and reducing spare cash -- known as excess reserves -- at the same time. In fact, excess reserves have fallen by $171 billion so far this year, according to Fed data, and are down $1.4 trillion from 2014 levels. 

Nonetheless, the repeat overnight repo operation later today -- only the second in ten years -- will add to market jitters as to what Powell and his colleagues are likely to say about future rate hikes, and the unwinding of the Fed's $3.8 trillion balance sheet, in the months ahead.

"We think that the culprit is the scarcity of bank reserves, which are the only asset that provides banks with intraday liquidity," said TD Securities head of global rate strategy Priya Misra. "Reserves have been declining since 2014 and we expect them to decline further as Treasury's cash balance increases and currency in circulation grows."

"Ultimately, we believe the Fed needs to start growing the asset side of its balance sheet to prevent the decline in excess reserves," he added. " If the Fed views the repo spikes as a sign that reserves may have already become scarce (at least at a certain point), they may decide to begin buying Treasuries to keep pace with the growth of currency in circulation."

With the U.S. budget deficit topping the $1 trillion mark for only the second time on record this year, as the Treasury ramps-up borrowing to pay for the massive $1.5 trillion in Republican-led tax cuts passed in late 2017, the 24 primary dealers in the Federal Reserve system have been taking down some $45 billion gross Treasury bond issuance each and every trading day this year.

Furthermore, with the suspension of the debt ceiling earlier this summer, Treasury borrowing projections estimate a further $814 billion in new bonds will need to be absorbed by the market between now and the end of the year, placing even more stress on the level of excess reserves in the Fed system. 

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DoubleLine Capital's Jeffrey Gundlach told Reuters Tuesday that the repo market 'squeeze' would likely drive the Fed towards further bond purchases, a move that would also ease real market interest rates as well as home borrowing costs, in order to address the 50% decline in excess reserves in the Fed system over the past five years.

The so-called Repo operation, during which twenty-four Primary Dealers in the Fed system can exchange eligible collateral, such as U.S. Treasury bonds or mortgage-backed securities, for cash, comes amid a massive surge in the price of what is known as 'general collateral", which is normally the cheapest batch of securities that banks use to pledge against cash, or other assets. 

In a repurchase, or repo, transaction, the buyer of the securities, in this case the NY Fed, agrees to sell them back at a fixed point in time, in this case a 24-hour period that would end tomorrow morning.

The costs for borrowing general collateral, often referred to as GC, spiked by 2.5% on Monday, and was followed by a 6% surge today, taking the price to as high as 8.75% at one point, some 6.5% higher than the upper-end of the Fed's target rate range.

The Fed's announced operation, however, pushed that overnight rate back down to 0% shortly after it was launched, isolating, for the moment at least, any cash crunch that either a primary dealer or one of its largest clients could be facing. That rate, however, climbed to around 4% in early Wednesday trading.

The U.S. dollar index, which tracks the greenback against a basket of six global currencies, was marked 0.2% at 98.45 in early New York trading, but was trading below yesterday's levels, suggesting no major rush for dollars in international markets. Benchmark 2-year Treasury note yields, meanwhile, were seen at 1.715%., some four basis points south of Tuesday's late-trading levels.

The CME Group's FedWatch tool, which attempts to assign a tradeable probability to near-term rate moves, is only pricing in a 56.5% chance of a 25 basis point rate cut later today in Washington, but that figure likely under-estimates the market's actual expectation, given that yesterday's spike in overnight funding rates likely caused one-time movements in money markets that influenced the FedWatch calculations.

"Unless there's a big surprise, the markets' response to tomorrow's Fed announcement will focus on forward guidance," said LPL Financial chief investment strategist John Lynch. "U.S. economic data has been stabilizing, but the risks around trade and slowing global growtth are still in play."

"Fed Chair Jerome Powell will have to steer a careful course between reassuring markets and recognizing an economy still exhibiting record low unemployment, fairly steady growth, and signs of a small but meaningful uptick in inflation," Lynch added.