A crack just emerged in the financial markets: The NY Fed spends $53 billion to rescue the overnight lending market

Borrowing rates skyrocketed on Tuesday in a sleepy corner of Wall Street that is critical to the functioning of the global financial system.

The spike in overnight borrowing rates in the so-called repo market forced the New York Federal Reserve to come to the rescue with a special operation aimed to ease stress in financial markets. It was the NY Fed’s first such rescue operation in a decade, the last occurring during the 2008 financial crisis, according to Bloomberg.

The NY Fed’s first attempted overnight reverse repo operation was initially canceled because of “technical difficulties.” But minutes later, the NY Fed successfully injected $53 billion into the system.

The episode demonstrates evidence of emerging strains in financial markets and raises concern that the Federal Reserve could be losing its grip on short-term rates.

“The funding markets are clearly stressed,” said Guy LeBas, managing director of fixed income strategy at Janney Capital Markets. “It’s going to require Fed action.”

The rate on overnight repurchase agreements hit 5% on Monday, according to Refinitiv data. That’s up from 2.29% late last week and well above the target range set in July by the Federal Reserve, which was 2% to 2.25%. The surge continued Tuesday, with the overnight rate hitting a high of 10% before the NY Fed stepped in.

“USD funding markets broke today,” analysts at Bank of America Merrill Lynch wrote in a note on Monday.

Although it doesn’t get as much attention as the Dow or the 10-year Treasury rate, this overnight market plays a central role in modern finance. It allows banks to quickly and cheaply borrow money, often to buy bonds like Treasuries. It’s like a mortgage, except instead of a house, banks are purchasing bonds. This market broke down during the 2008 financial crisis.

The NY Fed, which conducts financial market operations for the central bank, said in a statement that the goal of the repurchase operation was to “help maintain the federal funds rate within the target range.”

It’s unclear what exactly is causing the stress in the overnight market, or how long it will last.

“No one knows why this is happening,” Jim Bianco CEO of Bianco Research, said on Twitter. “If it persists more than another day or two, it will be a problem.”

One theory is that the rate spike could be a symptom of the sharp increase in Treasury bonds being issued to fund the federal government. The federal deficit has spiked to $1 trillion this fiscal year because of the tax cuts and surge in government spending.

Banks typically buy Treasuries by borrowing in the overnight market. The jump in Treasury issuance caused a large increase in demand for short-term financing.

Another theory is that rates spiked as US companies withdrew money to make quarterly tax payments to the Treasury Department.

No matter the cause, more Fed action may be needed, including additional temporary NY Fed operations.

“They may have to do the same thing tomorrow morning,” said LeBas.

Barclays predicted the Fed, which is meeting on Tuesday and Wednesday, may need to begin expanding its balance sheet again. The Fed’s bond buying program, known as quantitative easing, was launched during the financial crisis to keep borrowing costs extremely low. As the economy healed, the Fed reversed course and started to shrink its balance sheet.