Wall Street's funding markets exhale after Fed moves to boost short-term liquidity

By Kate Duguid and Megan Davies

NEW YORK (Reuters) - Fears of a credit crunch in Wall Street's cash-starved funding markets eased Tuesday after the Federal Reserve announced a series of moves aimed at bolstering liquidity and improving investor confidence amid a spreading coronavirus pandemic.

Prices for high-grade commercial paper - short-term loans that companies use to meet financing needs for things like payrolls, accounts payable and inventories - improved after the Fed announced the reintroduction of its Commercial Paper Funding Facility (CPFF), said Nick Maroutsos, co-head of global bonds at Janus Henderson Investors, an active investor in commercial paper.

"It's pretty skinny on details, but it is a good first step," said Maroutsos, about the announcement.

Investors generally saw the move as an important step in boosting sentiment and kickstarting short-term lending markets that had threatened to seize up in the face of a deep plunge in stocks and oil prices.

A logjam in these markets, which keep money flowing between banks and companies, could quickly spread throughout the financial system, causing ructions in everything from global trade to corporate cashflow.

"This certainly helps the plumbing of the financial system," said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors. "For commercial paper to seize up, that is an ominous sign of bad things to come."

The spread between interest rates on lower- and higher-rated overnight commercial paper had increased on Monday to the widest level since 2008, signalling investors were demanding a hefty premium to hold riskier debt.

The Fed said later Tuesday that it would offer short-term loans to two dozen Wall Street primary dealers. Borrowers will be able to pledge a wide range of securities including commercial paper and investment grade corporate debt securities.

"The Fed is starting to roll out some of the programs that helped us to get through the financial crisis," said William Zox, chief investment officer for fixed income at Diamond Hill Capital Management. "This is the right thing to do but I am sure the Fed - and the administration and Congress - will have to get more creative in the coming days."

The moves were part of a series of measures the central bank has taken in recent days - including cutting interest rates to near zero and launching a $700 billion quantitative easing programme - aimed at keeping important parts of the financial system functioning in the face of a coronavirus pandemic that is slowing economic activity around the world.

"There was a lot of uncertainty about the smooth functioning of the Treasury market, the commercial paper market and the mortgage market, as well as swaps, and now you're seeing some of that open up," said George Schultze, founder of Schultze Asset Management in New York.

Some market players also worried whether the CPFF and other recent measures aimed at bolstering liquidity would be enough to keep the financial system running smoothly amid broad asset market volatility.

Lower-rated paper, issued by companies with riskier credit profiles, will largely be left out of the operations, a concern for some market participants. Citi analysts also suggested the cost for these issuers to borrow from the Fed may be significantly higher than it is for high-grade paper.

"Our concern is that this channel will not be fast enough to deal with a problem that gets worse over time," wrote an analyst at Citi.

On the cost side, the price being offered by the Fed is 200 basis points over the Overnight Interest Swap rate - steeper than some had expected.

That suggests the facility is intended to function more as a backstop for the market rather than an easy source of funding, said Kevin Giddis, chief fixed income strategist at Raymond James.

"It's a steep price to pay for liquidity," he said.

The FRA-OIS spread, a proxy for risk in the banking sector, widened by more than 15 basis points on Tuesday following the Fed announcement as investors bet that companies will continue to draw on existing lines of credit at banks, potentially putting them under stress.

"Directionally that's the opposite of what (the Fed) wants to see," said Jon Hill, U.S. rates strategist at BMO Capital Markets.

(Reporting by Kate Duguid; Additional reporting by Megan Davies and April Joyner; Writing by Ira Iosebashvili; Editing by Chris Reese, Tom Brown and Richard Pullin)