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Wednesday November 17, 7:10 pm Eastern Time

Fed's Y2K liquidity measures keep markets calm

By Ross Finley

NEW YORK, Nov 17 (Reuters) - While the Federal Reserve has financial markets guessing whether Tuesday's interest-rate increase may be the last for several months, the central bank has taken great pains to quell fears about year-end liquidity.

The Fed has put in place a series of measures to make sure markets work smoothly when the clocks on the world's computers change over to 2000 and investors decide whether to hold their positions or convert to cash because of fears of technology-related disruptions on the financial markets.

New York Federal Reserve Bank President William McDonough affirmed on Wednesday that the Fed had ``gone a long way'' toward addressing year-end liquidity fears that peaked in August and September of this year.

Analysts, economists, market players and primary dealers -- the firms that conduct securities transactions with the New York Fed -- agreed.

``It's certainly been useful -- it's a valuable backstop to have there. The mere fact that the Fed has been so aggressive has been helpful,'' said Lou Crandall, chief economist at R.H. Wrightson & Associates.

Economists also say market interest in the Fed's new liquidity insurance scheme means investors are approaching the issue calmly rather than with panic.

Until the Fed came to the rescue, many investors said they were content to park money in safe, liquid short-term U.S. Treasuries and keep their money away from riskier assets such as stocks or debt from corporations and government-sponsored agencies. If that occurred, it might have led to a liquidity squeeze similar to what was seen last year at this time.

Instead, stocks have rallied and so-called spread products have also performed rather well.

But many analysts added that the bond market's resilience running into the last quarter before the date changes to 2000 is only partly a result of the Fed's preemptive measures.

Crandall cited the concern several months ago in the corporate bond and mortgage-backed markets about widening of spreads -- which indicated a preference by investors for Treasuries, securities which are much easier to turn over in the event of a crisis.

``We've seen liquidity in lots of other markets hold up,'' Crandall said. ``The corporate bond market had this expectation spreads would widen dramatically and they haven't.''

One of the Fed's main tools in fighting Y2K fears is STRIPs options -- securities that allow dealers to cash in the value of the option on one of three maturity dates offered.

This ability to exchange STRIPs for cash readily if needed is the kind of safety net prudent dealers crave as insurance against a year-end liquidity crunch. The December 30 maturity date, two days before computer clocks change over, has met the highest demand. The other two maturities are December 23 and January 6.

The Fed has auctioned five separate offerings of STRIPs since October 20, all of which have generated widespread interest, according to the New York Fed.

``There has been a tremendous amount of interest in the options auctions that have taken place,'' the New York Fed's McDonough said on Wednesday.

Analysts say that with five of seven STRIPs options auctions already behind them -- totaling just over $370 billion -- many market players who were concerned about cash on hand at year-end have already taken out their respective millennium insurance policies and are now sitting comfortably.

Citing strong demand, the Fed on November 4 added two additional STRIPs auctions to the original total of five and said it could add more if there were a further strengthening in demand.

The Fed has twice increased the amount of securities offered in individual auctions, also citing increased demand. But the amounts offered in the November 17 auctions decreased slightly, indicating the market may be more confident about year-end cash flows.

``In terms of why they were recently cut back, I would say it could reflect a number of things -- perhaps some greater confidence in the market about Y2K itself and how it will go,'' said Spence Hilton, associate vice president at the Federal Reserve Bank of New York.

In addition to the STRIPs auctions, the New York Fed also announced in September that it would begin entering into repurchase transactions with maturities up to 90 days, up from the previous maximum period of 60 days.

The Fed has already tied up approximately $30 billion in long-term repurchase agreements, a further reinforcement against liquidity concerns in the repo market.

``The only risk at this point is customers -- and by that I mean mutual funds having large withdrawals at the end of the term,'' said Marc Wanshel, economist at J.P. Morgan & Co. ``But the dealers, I think, are very comfortable.''

Vincent Verterano, head government bond trader at Nomura Securities International, said the STRIPs options provide good insurance for dealers who need extra liquidity toward year-end. But he underlined that insurance doesn't come for free.

``The Fed's going to make a ton of money on this,'' Verterano said. ``Chances are they (the options) are not going to be exercised.''

The interest rate on options is 150 basis points (1-1/2 percentage points) above the Federal funds rate, now at 5.50 percent, but traders see the insurance as cheap.

Before Wednesday's auction, the total amount the Fed had received in premiums was ``just shy of $5 million -- a little bit more with today's sale,'' Hilton said.

Many traders say that the premium is a small price to pay for what amounts to peace of mind running up to the new year.

In addition to the options auctions, The Fed now accepts a broader range of collateral for its open market repurchase operations. And it introduced in September a special facility to ease pressure on smaller regional banks toward year-end.

Despite the fact few banks have stepped forward and used the facility, Crandall and other analysts acknowledged that the very fact the Fed made the liquidity facility available to small banks if they needed it was a positive step forward.

-- (M@rket.trends), November 17, 1999

Answers

The Fed is doing a wonderful job of keeping all the plates spinning. Everyday they will be adding a few more, over the next few months. Can they keep it up?

-- Bill (bill@tinfoil.com), November 18, 1999.