Late December is always a peculiar time for money markets. Consumers are out buying gifts like mad and keeping far more cash than normal in their pockets and their bank accounts. Bond traders, who have made money for their firms during the year and don't want to risk losing those profits or their bonuses in some year-end market spasm, generally are sitting on their hands waiting for the new year.
This year all these seasonal forces have been magnified enormously by the concerns surrounding the looming century date change and the risk that something could go wrong that would prevent people from getting access to cash or that could disrupt the financial system.
Banks have stockpiled tens of billions of dollars of currency in their vaults to meet any heightened demand for cash by their customers worried that automated teller machines may not work. In addition to supplying the currency, the Federal Reserve has taken a series of unprecedented steps to ensure there is plenty of money in the nation's financial system to keep it working as smoothly as possible.
As of this week, the U.S. Treasury has reached its announced goal of having about $80 billion on hand, about double the normal year-end amount, as a cash cushion just in case.
By all accounts, the Fed's actions have succeeded in calming fears that markets might seize up again, as they did after the Russian financial crisis last year, or that short-term interest rates would soar uncontrollably as financial firms scrambled to obtain funds.
Now the Fed is keeping a wary eye on all that extra liquidity in case it all starts flooding back into the central bank's coffers at once after the first of the year. That could create sharp, potentially unmanageable changes in the overnight interest rates that the Fed tries to keep close to its chosen target. That volatility could then spill over into other parts of the market.
Earlier in the year, many large corporations and financial firms were worried about there being too little liquidity. They planned to wrap up their financing needs and shed riskier assets no later than October, to avoid having to raise money close to year-end. When the Federal Reserve began raising short-term interest rates last summer to cool off the nation's torrid economic growth, that timetable was advanced.
As Peter Fisher, an executive vice president in charge of the markets section of the New York Federal Reserve bank, said in a speech earlier this month: "Instead of a fourth-quarter race to clean up balance sheets beginning in October, we had a third-quarter race to clean up balance sheets before the end of August."
Economist Robert V. DiClemente of Salomon Smith Barney Inc. in New York said concerns about being able to get financing late in the year were so strong last summer that "people paid up to keep from paying up. In retrospect, a lot of financing was done at the widest spreads [relative to yields on comparable U.S. Treasury securities] of the year."
In other words, firms paid a pretty penny to avoid a Y2K risk. But they got their financing and now, DiClemente said, "There are a few things going on, but there is such a dearth of activity that I have turned off my screen."
Meanwhile, because there are few large buyers around, and because many financial analysts expect the Fed to raise rates again in February or March--the central bank has done so three times since the end of June--yields on Treasury securities are at their highest level in more than two years. For example, $15 billion in two-year notes auctioned Wednesday by Treasury yielded 6.23 percent, the highest since June 1997.
Robert Dugger of Tudor Investments, a hedge fund, said about the only investors really active in the bond market are those who generally have to put money to work on a regular schedule, such as managers of pension funds. Moreover, the slowdown in activity is worldwide, he said.
"Markets are more subdued than they usually are this time of year," Dugger said. "It reflects, of course, Y2K. Current markets and bond markets are very thin from a trading standpoint."
Even when buyers emerge, that demand "is not met with the usual supply response. As a result, prices are a bit firm. . . . It is just not possible now to acquire large volumes of assets, or to sell them, without moving markets," he said.
It would be far worse, he added, if the Fed, the European Central Bank and the Bank of Japan had not "gone a long way" well in advance of year-end to make sure markets would have the necessary cash and credit to keep functioning.
The New York Federal Reserve Bank, acting on behalf of the entire Federal Reserve system, regularly feeds money into the U.S. banking system by buying securities--usually Treasury securities--from a group of financial firms, known as primary dealers.
In exchange, the Fed credits the firms' accounts at Federal Reserve banks, from which the dealers can withdraw as they see fit. At the same time, the Fed supplies actual currency to banks in whatever quantity the institutions want, with banks paying for the currency from funds on deposit at the Fed.
This year the Fed was worried that Y2K fears could make it difficult to feed enough cash into the system to keep interest rates close to the central bank's target. If the firms didn't have enough securities on hand, the Fed might not be able to move the cash.
On the flip side, the firms might need more cash to meet customers' demands than the Fed wanted to supply. And everyone assumed the public would want enormous amounts of currency on hand near to the end of year.
In the back of everyone's mind was the lesson learned last fall when, after a default by the Russian government on part of its debt, trading on world financial markets all but halted in some sectors.
So Fed officials gave Fisher's markets group authority to do some things never done before to address all these potential problems. To avoid any year-end crunch, the Fed's open market desk lengthened the maximum maturity on its deals to supply cash through the primary dealers to 90 days from 60 and began many weeks ago to enter into transactions that run beyond Jan. 1. Meanwhile, to ensure that dealers don't face a shortage of securities to supply to the Fed in such deals, the desk greatly expanded the types of securities it would accept. In particular, much of the huge volume of outstanding mortgage-backed securities became eligible for the first time.
Then to cope with the possibility that the demand for money would be greater than the Fed wanted to supply to keep interest rates close to target, the Fed created and then sold options to the primary dealers. The options allow a buyer to present securities to the Fed in exchange for cash at the buyer's option rather than the Fed's.
CAPTION: Brochures on Y2K compliance to help ease consumers' fears have been a fixture at banks.
CAPTION: New York Fed chief Peter Fisher's markets group was given the special authority to address potential problems associated with Y2K.